Bullet Point Summary
The Homeowner’s Dilemma
Have you ever considered how much time and effort you dedicate to research before making a big purchase? For instance, when buying a car worth $20,000 or more, you probably spend hours reading reviews, comparing prices, and negotiating with multiple dealers. However, when it comes to hiring a real estate agent to sell a home, which could cost you around $20,000 for a $750,000 home, most people only interview one agent and pay them a commission of 2.5 to 3%. Beyond just the direct cost, a real estate agent also influences the selling price of your home, which is typically your most valuable asset. To ensure you get the best results when selling your home, it is essential to compare pricing and services across multiple agents and find a way to incentivize them to get the highest possible price for your home.
Most homeowners want to maximize their profits when selling their home. To do this, you want to get the highest possible sale price while reducing expenses such as agent commissions and escrow and title fees. Real estate agent commissions are usually the single largest cost, and you also have a great deal of control over them. On average, homeowners pay 2.7% of the sale price to their selling agent, and an additional 2.6% to the buyer's agent, making a total commission of 5.3%. While it's possible to find a selling agent who charges less than the standard 2.5% to 3% commission rate, they are not commonly used. Many people are hesitant to hire discount agents, worrying that they may be less skilled or motivated, resulting in a lower sale price. Opting for a cheaper agent carries potential risks, but playing it safe by paying the standard commission doesn't guarantee optimal results either. With the transparency of the real estate market today, anyone can access MLS data, historical sales records, and free online valuation tools, which raises the question: is paying a 2.5 or 3% commission to your agent justified by the potential higher sale price it may bring?
The Importance of Incentives
An agent only has a limited impact on the price of a home, so when you pay them a flat percentage fee you are giving them a largely predetermined amount of money regardless of how well or poorly they perform. While the final commission varies slightly based upon the final sale price, the agent largely knows what they will make once they secure the listing. For instance, suppose there is a home worth around $750,000 and the agent is paid an average 2.7% commission. The agent will receive $20,250 if they sell it for $750,000. However, if they put in extra time and effort to ensure the home shows well, attract the perfect buyer, and negotiate skillfully, maybe they could sell the home for 5% or $40,000 more. While that is a significant gain for the homeowner, the selling agent would only receive an additional $1,080. In a flat percentage fee structure, small percentage changes in the sale price do not have a significant impact on the agent's earnings. Therefore, the agent's primary incentive is to ensure the sale goes through, regardless of the sale price.
The impact of misaligned agent incentives was evident in a study by Steven Levitt, economist, and author of the popular book Freakonomics. Levitt and his co-authors compared the selling results of homes agents sold for themselves versus homes they were hired to sell. They discovered that real estate agents sold their own homes for 3.7% more than homes they were hired to sell. Also, real estate agents left their own homes on the market for 9.5 days longer. Levitt and his co-authors concluded, “Because real estate agents receive only a small share of the incremental profit when a house sells for a higher value, there is an incentive for them to convince their clients to sell their houses too cheaply and too quickly.” While a flat percentage fee is great if you simply want a real estate agent to sell your home, if you want an agent to care about the final sale price you need to consider a different approach.
Academic research suggests that to motivate salespeople to achieve desired results, it is optimal to provide a modest fixed compensation along with meaningful variable or incentive pay that is related to the goals you want them to achieve. This is the same approach that most companies use to pay their salespeople. Homeowners can adopt a similar strategy when selling their home by first determining their goals. If your goals are to sell your home for the highest possible price and in the shortest time, a better approach would be to offer a small base payment to cover basic listing costs and overhead, and an incentive payment tied to the final sale price. These payments should be made upon completion of the sale, as is the current practice.
The ListWise Solution
We have devised and implemented a specific variant of this strategy and are assisting homeowners in adopting it with real estate agents. The base payment is 0.75% of the sale price, which covers the basic costs and overhead of a listing. The incentive payment is calculated by taking 20% of the amount by which the sale price exceeds a pre-agreed “Participation Price”. (The Participation Price is agreed in advance before a listing agreement with the agent is signed.) In essence, once the sale price exceeds the Participating Price, you compensate the agent with 20% of every additional dollar, while retaining 80% for yourself. By providing the agent with a substantial share of the incremental price increases, you motivate them to work diligently and maximize the sale price of your property.
By using this approach, you can calculate beforehand the agent's earnings for any potential sale price. Consider the prior example of a house worth around $750,000 and suppose you negotiated a Participating Price of $700,000. If the house sells for $750,000, you would pay a base fee of $5,625 (0.75% of $750,000) plus an incentive payment of $10,000 (20% of $50,000, the difference between the sale price and the Participation Price), resulting in a total commission of $15,625, or 2.08%. However, if the agent did the extra work we spoke of before and sold the home for $790,000, they would earn $23,925, or 3.03%, which is nearly 50% more. The following charts illustrate the commission amount in both dollar and percentage terms for different sale prices. The traditional approach of considering an agent's pay as a single number to be minimized is too simplistic and flawed. In today's more efficient real estate market, selling a home for an average price requires less skill and is likely worth less than the standard 2.5 to 3% commission. However, an agent who adds value and helps you achieve an above-market price is very valuable.
The fee structure outlined above aligns the incentives for the homeowner and the agent by ensuring both have a meaningful financial benefit from higher sale prices. Adopting this approach requires negotiation of only one number, the Participation Price. While some homeowners may have a strong view on the value of their home and what they want they are willing to pay an agent to achieve that result, it is not necessary to estimate the Participation Price on your own. Instead, it’s better to leverage the benefits of competition and the power of the market to set this number. As part of our incentive-based sales approach, we find the top agents in each area and select three to five of them to provide a Participation Price for your home, fostering competition among agents and providing you with the best terms.
Competition Yields Better Outcomes
Agents set their Participation Price based upon both how much they want to get paid and their estimate of the sale price they can achieve. For instance, if Agent A gives a Participation Price of $700,000 and Agent B gives a Participation Price of $715,000, it means Agent B believes they can sell the home for more money or that they are willing to receive less total commission for the same final sale price. Agent B may provide a higher Participation Price because they want to win more business, or perhaps, they think the home will be relatively less work to sell than Agent A. Alternatively, Agent B might just be more skilled and able to generate a higher sale price than Agent A. Just because one agent bids a higher Participation Price than others does not guarantee they will receive less compensation, but it does mean they will have to deliver more value to receive the same compensation.
The approach we propose encourages competition between agents, and it focuses attention on what is most important, getting the highest price for your home. It is not just about paying less, but about paying for performance rather than promises used to obtain a listing. This approach gives you a variety of agents and Participation Prices, and you can hire whoever is the best fit for you. Once you hire an agent at a certain Participation Price, they will have a genuine incentive to keep working hard for you and obtain the highest possible price for your home. The amount you pay them will reflect their results.
Become an Early Adopter
When you hire an agent to sell your home, you are entrusting them with a significant responsibility, and with the traditional flat percentage commission model, you bear all the risks associated with their results. By contrast, our incentive-based commission model ensures that the agent is betting on their own abilities and sharing that risk with you.
If you are interested in exploring a more effective method to sell your house and are an early adopter, please get in touch by emailing me at firstname.lastname@example.org. We offer commission schedules and listing agreements, and we assist homeowners in obtaining Participation Price bids from agents in their area, at no cost to the homeowner.
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