Removing Conflict of Interest for Agents of Homebuyers

In real estate transactions, sellers' agents have weak incentives to market homes sufficiently long to secure top prices for their clients. Buyers' agents, however, face completely backward incentives: They get paid more when their clients pay more for their homes. We discuss an a la carte compensation model for buyers' agents that eliminates this conflict of interest.

One of the basic lessons in economics is that people respond to incentives. In fact, in his best-selling textbook Principles of Economics, Harvard economist Greg Mankiw includes this lesson as one of his 10 fundamental principles of economics. It should therefore be no surprise that, as economists, we like to examine the alignment of incentives in various real-life situations.

Broadly, incentives are aligned if doing what one is supposed to be doing does not stand in conflict with one's self-interest. When incentives are aligned, we can further examine how strongly they will affect an economic agent's behavior. If the agent's self-interest is merely not hurt, we say that her incentives are weak. If the agent stands to gain a lot privately by taking socially desired actions, her incentives are aligned and strong. Incentives are misaligned (or backward) if actions expected from the agent actually hurt his or her self-interest.

Weak Incentives for Sellers' Agents in Real Estate Transactions

In this article, we follow the work of Steven Levitt and Stephen Dubner, who in their 2005 bestseller Freakonomics examined the incentives of real estate agents. While they focused on agents working for homeowners selling their homes, we focus on agents working for buyers looking to purchase a home.

In a typical real estate transaction in the U.S., agents' commissions constitute between 5 percent and 6 percent of the home's value, with the total commission split roughly equally between the seller's and the buyer's agent. In the aggregate, that's a lot of money.

According to the National Association of Realtors (NAR), the average value of an existing home (meaning pre-owned, not new construction) sold in 2022 was $386,400. Assuming a total commission of 5.5 percent, that's $21,250 in commissions per transaction, on average. The NAR reports that the total volume of homes sold in 2022 was slightly over 5 million homes, which implies that approximately $106 billion was paid in Realtor commissions in 2022.

In their book, Levitt and Dubner point out that real estate agents representing home sellers face very weak incentives to market homes long enough to obtain maximum possible prices for their clients. Levitt and Dubner's argument goes as follows: Assuming a 6 percent total commission, the seller's agent collects 3 percent. Of this amount, about 1.5 percent goes to the real estate brokerage firm and 1.5 percent to the agent herself. Suppose the agent can work hard marketing the home to secure a 1 percent higher price for the seller at the cost of the home staying on the market one week longer. By doing so, the agent increases her compensation from 1.5 percent of the original price to 1.01*0.015 = 1.515 percent of the original price, which means she gains an additional 0.015 percent of the original price. Using the average 2022 home price of $386,400 reported by the NAR, that additional 0.015 percent is worth $58. The agent is unlikely to be willing to work hard an extra week for $58.

Here, incentives are not misaligned, as the agent does get paid marginally more if the home is sold at a higher price. However, the incentives are very weak. In fact, Levitt and Dubner examine data from transactions in which real estate agents sell their own homes. They find that homes sit on the market longer in these transactions and fetch higher prices. While an additional 0.015 percent in commission may be not worth a week's wait, the full 1 percent may well be.

Backward Incentives for Buyers' Agents

The conflict of interest becomes much more apparent if we examine the incentives of real estate agents representing homebuyers. Like sellers' agents, buyers' agents are compensated proportionally to the transaction price, which means they get paid more if their clients pay more for the homes they buy.

This compensation structure gives buyers' agents a direct disincentive to help their clients locate suitable homes with low asking prices posted by the sellers. Further, after a suitable home has been located, the buyer's agent represents her client in negotiations with the seller over the final transaction price. Here, as well, the harder and smarter the buyer's agent negotiates on behalf of her client, the less she gets paid at closing.

Compensation Structures Eliminating Conflict of Interest for Buyers' Agents

Buyers' agents provide a host of services to their clients commonly bundled under a single exclusive contract, where the buyer promises to pay the agent a fee specified as a given percentage of the purchased home's price (typically 3 percent). On the other side of the market, sellers are contracted to cover the agents' fee for the buyer, which releases the buyer's obligation toward their agent.¹ If the buyer doesn't find a suitable home before the end of the contract period (usually 60 or 90 days), the agent does not get paid.

The services that buyers' agents perform typically include:

• Locating suitable listings
• Showing homes to their clients
• Assisting with preparation of a written offer of purchase, including contingencies, with possible revisions
• Handling communications between the buyer and the seller's agent
• Helping the buyer with a bidding strategy
• Assisting with closing of the transaction if offer is accepted

An a la carte pricing system would remove the buyer agent's conflict of interest present in the current bundled compensation structure. Under such a pricing system, the homebuyer would pay the agent for each task performed (independent of the final price of the home bought), with each of the above tasks priced separately. That means a price for an initial consultation, a price for each showing, a price for help with writing each offer, a price for assistance with closing, etc.

With the final price of the home not affecting the buyer agent's compensation, helping the buyer locate and negotiate the lowest possible transaction price would no longer be inconsistent with the agent's self-interest.

An a la carte pricing system may have additional benefits. Currently, buyers do not internalize the agents' costs of showing properties, and they may therefore overuse this service. Paying the agent directly for her time to show each property could encourage buyers to search more efficiently. Economic efficiency is often improved when products are unbundled because, with separate prices for smaller pieces of products or services, the market mechanism can better match providers' costs to consumers' marginal willingness to pay. Such efficiency improvements have been discussed in the context of pricing of airline tickets and TV channels, among others.

Further, with a la carte pricing, there would be no need for a buyer to work with a single agent throughout a search 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.

Conclusion

Homebuying is a complicated process in which the self-interests of several parties clash. Among these, the agency relationship between homebuyers and their agents is fraught with agent conflict of interest, where an agent's compensation increases when her client pays more for the home. An alternative compensation scheme where the buyer's agent is paid directly for each task she performs removes this conflict of interest and shows a promise for introducing additional efficiency gains to the overall homebuying process.

Borys Grochulski is a senior economist and Zhu Wang is vice president for research in financial and payments systems in the Research Department at the Federal Reserve Bank of Richmond.

To cite this Economic Brief, please use the following format: Grochulski, Borys; and Wang, Zhu. (October 2023) "Removing Conflict of Interest for Agents of Homebuyers." Federal Reserve Bank of Richmond Economic Brief, No. 23-34.

This article may be photocopied or reprinted in its entirety. Please credit the authors, source, and the Federal Reserve Bank of Richmond and include the italicized statement below.

Views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.