It Matters How Real Estate Agents Get Paid – The FINANCIAL

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Tim Sablik: My guests today are Borys Grochulski and Zhu Wang. Borys is a senior economist and Zhu is the vice president for research in financial and payment systems, both in the Research department of the Richmond Fed. Borys and Zhu, thanks for joining me.

Borys Grochulski: Thanks for having us.

Buy/sell, rent/lease residential &
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Zhu Wang: Thanks for having us.

Sablik: Today, we’re going to be discussing some recent work you’ve done looking at real estate agent compensation. You published an Economic Brief on this topic last October, followed by a working paper and another EB this March. We’ll include links to all those papers in the show notes.

To start, Zhu, could you explain how real estate agents are typically compensated in the U.S.?

Wang: Sure. Many of us may have the experience of selling or buying homes. In the U.S. market, the seller typically pays the seller’s agent a 6 percent commission and half is passed on to the buyer’s agent. This means that for a median-price home — so that is $400,000 — the seller needs to pay $24,000 for commission. Half goes to the seller’s agent and the other half goes to the buyer’s agent.

On the buyer side, buyers do not pay commissions out of pocket and they often enjoy free house showings provided by their agents. But eventually, buyers are likely to pay commissions indirectly through home prices.

Sablik: Borys, how does this compensation structure differ from other countries?

Grochulski: There is a lot of variation when you look across countries, of course. But the U.S. system stands out in terms of the level and structure of agent commissions.

The typical commission rate paid by the seller is less than 2 percent in countries like the United Kingdom, Ireland, the Netherlands, Singapore, Sweden or Norway, much lower than the typical 6 percent in the U.S. In many countries such as Australia, Canada and Denmark, buyers commonly purchase homes without an agent representing them, so there is only the seller’s agent on the transaction. Even if a buyer agent is involved, typically, the buyer pays his or her agent directly, as is the case in China, Japan or Italy, for example.

Sablik: Listeners may have heard about recent court cases related to real estate commissions. What are the potential concerns with the commission system in the U.S.?

Wang: For policymakers and industry observers, one big concern is that agent commissions deviate from underlying costs. In our recent working paper, we focus our research on the buyer agent commission. By convention, buyer agents receive 3 percent of the home sale price as their commission. This uniform percentage rate provides buyer agents a compensation based solely on the price of the home. However, there’s no evidence that buyer agents incur more service costs in helping buy higher-priced homes than helping buy lower-priced ones.

Also, over time, technology advantages have significantly lowered home search and matching costs. They are not reflected by the commission rates. For example, with the wider use of the internet, many homebuyers find their homes independently through the internet, but most of them still retain a buyer agent who continues to be paid at a 3 percent commission rate. Because house prices have continued to rise over time, this implies that buyer agents can earn more for doing less work.

Moreover, the lucrative real estate commissions could drive excessive entry of agents and the cost misallocation of talent and resources. For example, compared with the United Kingdom, where real estate agents earn much lower commissions, the United States has around six times more housing transactions but has 26 times more agents. So, the agent productivity in the U.S. housing sector is significantly lower.

Sablik: So, it sounds like a puzzle that the commissions for buyer agents have been fixed over time, not reflecting advances in technology. How could this happen?

Grochulski: In our view, which was also pointed out in other studies, the main reason for this is that sellers are worried about the so-called “steering” by the buyers’ agents. In the current U.S. system, when the seller lists a home, he or she needs to specify the commission rate that they offer to the buyer’s agent. The convention is 3 percent. Sellers worry that if they offer anything less, buyer agents may steer their clients away toward other homes, those that offer a full 3 percent buyer agent commission. Most sellers don’t want to take that risk, so they conform to the convention.

In this way, the commission rate can stay at the fixed level, not affected by any improvement in search and matching technology or other cost factors. Research suggests that this concern is serious among the sellers, and alleviating it is key to improving competition and market performance.

Sablik: That’s a good segue into your research. So, how do you analyze this market and what have you found?

Wang: In our research, we construct a model of home search and buying in the U.S. residential housing market. In the model, as in reality, homebuyers receive free house showings without having to pay their agents out of pocket. Buyer’s agents receive a commission equal to 3 percent of the house price only after the home is purchased.

We show that such a buyer agent compensation structure deviates from its cost basis in two ways. One is the agent’s actual profits, which push up buyers’ cost of purchasing a home. As a result, buyers have to be more selective in their home search to justify the purchase. Another distortion comes from the free house showings offered by the buyer agents, which lower buyers’ marginal cost of home search and induce home buyers to search too much. Together. the two distortions may lead to elevated home prices, overuse of the agent services and the prolonged home searches.

We then conduct a quantitative analysis based on the model. The results indicate that switching to a cost-based commission model — in which buyer agents do not earn actual profits and the buyers pay for each house showing — may increase U.S. homebuyers’ welfare by more than $30 billion a year. Most of the consumer welfare gains would come from the redistribution of buyer agents’ profits. Net of the redistribution, social surplus would increase by about $800 billion a year, which would come from the improvement of home search efficiency.

Sablik: Let’s dig deeper into your findings. In order to implement the cost-based commission that you mentioned, you propose a system where homebuyers pay their agent for each service with a fee independent of the home price. How exactly would that approach improve the homebuying process and the real estate market?

Grochulski: The findings of our analysis suggest that the cost-based commission system would improve market performance and social welfare. However, this does not necessarily mean policymakers should regulate the level of commission. Rather, we consider an à la carte or fee for service model.

Under this model, sellers and buyers each pay their agents directly. This should mitigate the threat of steering by buyer agents and the steering problem, as we have mentioned, is a key reason why the current buyer agent commission rate stays above cost.

In the à la carte system, buyers are able to pay their agents for each task separately, independently of the final price of the home purchase. This allows buyers to shop for each service they need and bargain for the price. As a result, competition among agents should align agent compensation with cost and buyers would not overuse agent services as if they were free.

An à la carte commission system may also provide additional benefits. Right now, with the buyer agent commission increasing in the price that the buyer pays for the home, the buyer agent acts against their own best interest if they help their client negotiate for the lowest price that would be acceptable by the seller. Under the alternative system, with the commission no longer tied to the house purchase price, helping the buyer locate and negotiate for the lowest possible home price would no longer be hurting the agent’s bottom line.

Another great feature of the à la carte pricing system is that it makes it clear that there is no real need for a buyer to work with a single agent throughout the whole home search [and] buying process. Clearly, some agents are better at what they do than others and the risk of getting contractually tied to a less productive agent looms large for homebuyers.

Sablik: Are you planning to expand on this work with further research?

Grochulski: Yes, we’re currently working on a follow-up paper in which we dig deeper into the question you asked earlier. How is it possible that real estate commissions have not come down since the times before the internet and why is the commission rate the same for a $2 million home as it is for a $200,000 home? In that paper, we examine the so-called “two-sided market structure” of the real estate agent platform as a whole. The steering concern that we talked about appears to be sustained by the fact that sellers and buyers are bound to the platform by exclusive agent representation contracts.

Perhaps we should hold off on saying more about this until we finish doing the math, cross all the t’s and dot all the i’s.

Sablik: That sounds good. It’ll be another reason to have you both on the show to talk about that work.

Borys and Zhu, thanks so much for coming on today to talk about this research.

Grochulski: Thank you very much, Tim.

Wang: Thank you.

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