Are commissions the best way to incentivise real estate agents?

I’ve recently returned from some time in the United States, and I always find Americans' service gratuity or ‘tipping’ an interesting contrast to life back in Australia. Tipping got me thinking of the book Freakonomics (which I’d recommend to anyone who’s interested in bizarre correlations and the hidden rules that govern what’s happening under the surface of everyday life). Tipping jogged my memory of the book, as it asserts that humans respond to incentives.

That idea in itself does not seem terribly revolutionary, but incentives pose some interesting questions. For one, on the whole are wait staff in the United States more courteous, friendly and efficient? If pressed I’d have to say yes, but I’m not allowing for cultural differences, the specific location of the restaurant, the average price of the meal and so on. All of these variables cloud the ability to objectively answer the question of whether tipping is the reason for their superior service. Eliminating variables and drawing conclusions is what the book Freakonomics is all about. Perhaps the conclusion is not always black and white, but the data and the correlations are. Real estate features in the book with specific emphasis on the incentives within a real estate contract of sale.

Real estate sales contracts, and all transactions for that matter, are based on incentives. The incentive for a real estate agent selling your home is that they’ll be paid once a sale has been achieved. Generally they’ll also have the added incentive that the higher the sale price, the higher their commission. The home owner’s win in this transaction is that they’re engaging the services of an expert who knows the market well, has connections with buyers and knows the best strategy for achieving the highest sale price.

Selling the property for the highest price is the reason why the agent is engaged, but what if the incentives aren’t geared correctly to achieve this aim? Within the book, the authors Levitt & Dubner examine the incentives for a real estate agent in the US and source data to analyse whether the incentive is perfectly aligned with the aim of achieving the highest price.

As most of us are aware, the commission structure in the US differs from here in Australia. For one, the commission is split between the seller’s agent and the buyer’s agent. Not to be confused by buyer’s agents in Australia, who are paid directly by the buyer. However, and for the purposes of illustrating the point, Levitt & Dubner show that an average 6% real estate commission is first split in the middle to 3% and then typically half again goes to the agency, which leaves a direct 1.5% commission for the real estate agent. On the sale of a $300,000 home, it equates to $4,500 for the agent. This is their basic incentive; once the house is sold for $300,000 they’ll receive their $4,500.

The problem, as Levitt & Dubner point out, is what happens if the property might actually be worth $310,000? They say that the market value of a property is what any one person is willing to pay for it and if someone out there is willing to pay $310,000 then the agent has an incentive to find that person, right? The answer is yes. However, is the incentive strong enough? Thinking back to our 1.5% commission the estate agent will take home, the advantage that the agent receives for finding the new buyer and or negotiating their way up to $310,000 is a mere $150. Will the agent want to risk a guaranteed sale at $300,000 to ensure they get their $150? Perhaps the incentive is not very well aligned with the goal of achieving the highest possible price at all.

Levitt & Dubner discovered a way of finding out for certain. They measured the difference between sales data for houses belonging to real estate agents themselves, compared with houses real estate agents sold on behalf of their clients. They used data from the sale of 100,000 homes in Chicago, controlling for variables such as location, age, investment or occupier, aesthetics and so on. The results showed that on average the real estate agents kept their homes on the market for an extra 10 days and sold for an extra 3%+. The 3% represents the $10,000 in the example. It’s an example of an incentive that is ineffective as the risk of losing a sale for the additional commission is not worthwhile.

Now the authors don’t have an agenda to tarnish the reputation of real estate agents. In fact, they show additional problems with incentives using teachers, doctors and even sumo wrestlers. I personally know many agents who will always go the extra mile as that’s the reason they went into business and love the feeling of a job well done and the repeat business that results from it.

However, the point of analysing this study is to show how incentives are most effective when they’re formulated carefully with the end result in mind. So what can Freakonomics offer the Australian property market, both agents and home owners? I would suggest an insight into the importance of incentives and an opportunity for us to consider how best we can tailor them to achieve a mutually beneficial result. It certainly gives us something to think about when we consider the costs involved in engaging two different service providers.

Real estate sales contracts are a pretty standard document, but it’s not difficult to alter the incentive or commission. I’ve seen a number of properties with a flat commission to a certain point and a higher flat commission over a certain value, a flat out bonus or a sliding scale based on the final sale price. The structure of the incentive within a sales contract is an important consideration for the vendor. To ensure the highest price is achieved, it makes sense that the incentive be aligned to that exact goal. After all, who wouldn’t want their extra $10,000?

Mike Mortlock is a director of MCG Quantity Surveyors specialising in tax depreciation deductions and traditional Quantity Surveying Services.