Tuesday, March 31, 2015

Weird Incentives: Real Estate

An important part of my job is understanding customer incentives, how product and pricing schemes change agent behavior.  I get a lot of questions around "what happens if we change a marketing incentive? or will our customer mix change if we reduce pricing? or if we change the sales rep commission plan in a certain way, will that actually grow the business/profitablity?"

These types of questions are pretty important, and impact our everyday lives.  One of the better examples comes from the authors of Freakonomics, on asymmetric incentives in real estate, here's a great video that explains the asymmetry:

I experienced the asymmetric incentive issue with real estate commissions in my personal life last year.  We sold our house and bought a new house closer to our workplaces. Here's what I learned:  The example in the above video is only part of the story, the notion of asymmetric incentives impacted nearly every facet of the transaction. 

Here's a summary of some interesting aspects:

Things that happened when selling our old house

We were encouraged by our Realtor to spend over $10,000 on upgrades to our house in order to help the house sell quickly, before the Realtor even put it on the market.  Keep in mind that real estate commissions are calculated as

Commission = Sale Price X 6%


Commission = (Sale Price - Owner incurred sales cost) X 6%

That means the realtor made money directly from our incurred cost, if it did increase the price at sale, for which we were not reimbursed.  We only profited if the sales price increased as much as our incurred cost, but the Realtor benefited from my expenditure if the price increased at all.

Negotiations: As soon as we had an offer on the house we got the line (very similar to the lines from the video).. essentially as this:

Don't do anything to "risk the deal"
This is probably as good as it's going to get

I designed a counter offer, which our real estate agent didn't like, using strategy I learned from dealing with customer behavior.

Essentially: the buyer's offer involved a huge amount seller paid closing costs (read: they couldn't afford to close the loan on their own) and only a 5% down payment (read: we don't have any cash, but LOVE TO FINANCE THINGS).  Realizing that I was dealing with cash sensitive, credit insensitive people I designed a counter offer that involved increasing the price of the house a lot, but hey, they could finance that.

Our real estate agent tried to talk me out of it, in terms of I was "putting the deal at risk."  I refused his advice, and the buyers accepted my counter-offer as is.  The Realtor's incentive put my negotiating position at risk.

Next in the inspection stage of things, the buyers asked for a long list of "fixes" they wanted done to the house.  Most of them were cosmetic, or not warranted, but I felt a little bullied by our agent to "just do them" .. once again, not to "risk" the sale.  A lot of these items could have been fixed with a tube of caulking, which I did, but wasn't the kind of stress I needed during that time period.  And they really would have cancelled the sale over caulking?  Yet another example of inconvenience to protect the sale.

Things when buying our new house

Just one thing here, really.  Our Realtors scheduled closings so that we would close early on Monday for our old house, and close in the afternoon on Monday for our new house.  We were moving the first weekend in June, so we couldn't get a big truck, and would need to move part of our stuff in shifts.

We were moving to an empty house, so I asked the Realtor if we could get permission to move some of our stuff to the new garage the day before, to save us the rental space.

I was categorically denied.  Basically, I was told that we could scare the sellers at this point, and they would call the whole thing off.  Really?  They would walk away from the money, just because I made a reasonable request?

All of these things added up to an experience that backed up the Freakonomics claim, but added to it, that the asymmetric incentives can permeate the entire transaction.  Once a deal starts the Realtor's incentive is to close the deal, no matter what, without any risk to that deal.  What suffers is the buyers and sellers convenience and negotiating position.


  1. My experience is similar to yours. What do you think would provide better incentives? Or is it best to avoid agents altogether and manage the purchase/sale oneself?

    1. I generally think that striking out on your own in a situation where there's potentially a bit of legal risk is a bad idea. I wish I felt more comfortable with "For Sale By Owner" but it gives me a lot of anxiety. I'll probably write another blog on this eventually, but for now here are my thoughts.

      I think restructuring real estate deals from the beginning could make things more competitive. Specifically:

      -Change the deal so that any incremental improvements made in order to sell the house are net-commission neutral. In this instance, if your agent asks you to make $50K in improvements in order to sell the house, then the first $50K of sales price is effectively commission free. This way, the improvements only benefit the realtor, if they also benefit you.
      -Pre-Agree with the agent on a sales price, and any incremental change to this price is an effective commissions accelerator or decelerator. In this case, the real estate agent would make the standard 6% commission on the sales price, + an additional 12%,15%? on any amount above the sales amount. In the same way, a decelartor would be charged back at a rate of 12-15% against commission if it comes in under the agree upon sales price.

      Obviously this isn't exhaustive list, but should get us thinking about two things important to the process:
      -Make it in the realtor's interest to ask for improvement only when it will net benefit you.
      -Make accepting low offers penal, while working hard to get high offers positive to the realtor.

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