Realtor Commissions Have Always Been Broken. Game Theory Can Help.

Realtor Commissions Have Always Been Broken. Game Theory Can Help.

Get paid more to do a poor job negotiating. Get paid more to get your client to spend more. However, you explain it, this is
what a buyer’s agent is incentivized to do.
Alternatively, a little game theory math optimizes the buyer’s agent’s commission.

Go to the bottom of this post to see the math.

BuyerPrice Stepped on My Soap Box

Like most everyone else who has bought a house using an agent, I’ve been bringing this up since I started in real estate. Back in 2006, I made the formulas below. Now, someone has automated this action and are in a position to effectuate change.

BuyerPrice.com guarantees buyers a discounted price on homes for sale in certain markets and pay the difference if unsuccessful. [Inman]

Buh Bye Commission Cartel

This is one more crack in the collapse of the real estate commission cartel.

Seller’s agents have their own conflicts of interest. They are incentivized to get sellers to drop their price in order to speed up the chance of a sale.

Real Estate Commoditization

With the increasing commoditization of real estate, we are about to see big changes within the coming couple of years. More of the human condition will be removed.

How do you think pricing will be affected? Will it optimize the outcome for both buyers and sellers?

 

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Game Theory Math

This is traditional incentives contracts with hidden information and I am offering a simple strategy to resolve it — split the savings (i.e. the buyer pays a percentage of the negotiated savings to the buyer’s agent).

• L is the listing price of a house. This is public information.
• V is the lowest amount the seller will accept for the house. This is hidden information only known by the seller and the seller’s agent.
• S is the sales price of a house
• K is the percentage of the discount the buyer’s agent got from the list price (L-S).

The Current Broken System

• Seller’s agent gets 3% of S
• Buyer’s agent gets 3% of S

This is an increasing function of S. The buyer’s agent will push the buyer to spend as much as possible (i.e. S≥V). We blindly rely on the buyer’s agent’s ethics to get to V. However, agents inherently know that they are incentivized to close the deal rather than spend the extra time to optimize their client’s outcomes.

A Properly Incentivized Contract

The buyer incentivizes the buyer’s agent to get the largest reduction in price (i.e. L-S) for the house but pays no commission if S≥L. Now both party’s interests are aligned.

$$
Buyer’s\ agent’s\ commission = \left\{ \begin{array}{ll}
0.03S + K(L-S) &\mbox{ if $S<$L} \\
0.03S &\mbox{ otherwise}
\end{array} \right.
$$
This is a decreasing function of S. The buyer’s agent will push the seller to reduce their price to the least they are willing to accept (i.e. S=V).

The Buyer

• Pays S + K(L-S)
• Saves (L-S) - K(L-S)

The buyer receives savings when S≤L.

Buyer’s Agent

• Receives
  • 0.03S + K(L-S) when S<L
  • 0.03S when S≥L

Relative to the traditional structure, buyer’s agent receives more money (when they get a reduction in the sales price).

The Problem

Agents are human.

The buyer is paying their agent on an unknown portion of savings (L-S) that the agent may have achieved due to ego and/or morality, without ever knowing if they reached the lowest amount the seller is willing to accept (V). Even seller’s agents aren’t incentivized to maximize their client’s payouts.

While the buyer or seller often faces only one round in this game, their agent must face their opponents in other such games. If an agent negotiates too hard, they will receive a bad reputation and other agents may minimize their and their clients’ interactions with them in search of other opportunities that are likely to close with less headache and/or in less time.

The Solution

Real estate technology.

However, it will likely be a long time before the current real estate agent model is replaced.