“I’m very harsh on real estate agents. I’m not sure why. Maybe it’s because of how the call every small house �?charming’ and every run-down house a �?great fixer-upper’. Just once, I’d like them to show me a house and declare, �?This one’s a piece of crap’.”
― Stephan Pastis
Once upon a time, I convinced a couple of people I knew to go in with me on a fixer-upper on the wrong side of the tracks in Richmond, Virginia. According to our grand plan, we were supposed to get renovation tax credits from the federal government and the state government since the house was in a historic district. According to reality, we didn’t qualify for the credits and our overexuberant contractor ran way over budget, leaving us with the, by far, nicest house in a neighborhood where, just on our street of about 10 houses, there were daily drug deals and a couple of murders. We gave the police a key to the house (surreptitiously) and let them use it as a base for stakeouts.
Unsurprisingly, after a few months, we were ready to do anything to get that house from underneath us, almost regardless of what the losses were. We put it on the market and got very little movement. We switched Realtors. We lowered the price. Still, nothing.
Finally, I asked the new Realtor, who lived in the area, what we needed to do to goose up demand short of offering it for free.
“Offer a buyer’s agent’s bonus,” he told me.
“What? You mean 3% of the sales price isn’t enough?” I responded, incredulously.
“Sometimes, it’s not enough. Depends on how mangy your dog is.”
At least he was honest. We offered a 2% buyer’s agent bonus. Suddenly, prospects came pouring in, and within a month, we’d closed and started the process of licking our wounds.
The process got me to thinking about whether or not our incentives were truly aligned. The idea behind the extra commission was to get Realtors to bring by their clients when they might not have otherwise done so. When it works, it works great for the seller.
However, how well does it work for the buyer?
Sure, Realtors will swear up and down on their mothers’ graves that they’re only going to show houses which are right for their clients because they depend on referrals, those clients will move in three years and need a Realtor, yadda yadda yadda.
But, the reality is that they’re human just like the rest of us, and they’re self-interested. If they can show you two houses and one of them will offer a heftier commission, don’t you think they’re going to try every little nudge in the book to get you to buy the house that gives them more money at the closing?
The evidence for such behavior was described in the book Freakonomics (#aff), which showed that Realtors are out for the fastest sale possible; when they sold their own homes, they sold them for 3% more and held out 10 days longer. The National Bureau of Economic Research published their own study which showed that houses that are listed with Realtors sell for 5.9% to 7.7% less than those that are not listed with brokers.
If you step back from the marketing blitz that Realtors use to bombard you with the notion that everybody in America needs to own a house, you can see how the logic of the perverse incentives works. You list a home with a Realtor. The Realtor has to do the advertising, make signs, list the property in MLS. The longer the house doesn’t sell, the higher the costs run, as those ads don’t just write themselves. It’s, in a way, similar to having inventory in a store. Stores and Realtors have an incentive to turn through inventory as quickly as possible, as selling quickly will provide the highest ROI possible. If a Realtor has a house that is listed for $100,000, then he or she is usually in line to receive about 1.5% of that, or $1,500. If the house sells for $90,000, it’s not that big of a deal to the Realtor, as it really only means a $150 hit to the pocketbook, and with listing and advertising costs, it’s probably the same as selling it for $100,000 two months later. A Realtor would rather get the sure thing than have uncertainty about getting $150 more sometime in the future.
It’s the Prospect Theory in action; we hate loss more than we like an equivalent gain, and once a $90,000 offer hits the table, the Realtor’s Monkey Brain sees $1,350 in the wallet.
From a seller’s point of view, though, that $10,000 could be a huge amount. It could be the difference between selling the house and having some money left over or just paying off the mortgage (or worse, paying out of pocket at closing to pay off the mortgage). Yet, the homeowner is probably getting subtle pressure from the Realtor because $150 isn’t that big of a deal to the Realtor, particularly compared to how $10,000 could affect the seller.
“It’s a little low, but it’s not bad. This might be the only offer you get for a while.”
“The market is slowing down.”
“The buyer’s prequalified. We don’t have to worry about financing.”
“You don’t want to be on the market once the school year starts, because it really slows down after that.”
This isn’t to say that Realtors are bad. They’re probably not as good as the puffery indicates, but, as the previously cited NBER study shows, if you want to move a house fast, you’re better off using one than not using one.
The reality is that their incentives aren’t really lined up with a seller’s incentives. They’re all lined up with the buyers. When a buyer buys, the buyer’s agent and the seller’s agent both win. They get a commission. If the buyer’s agent convinced the buyer to put in a lower offer and haggle off the price, then the buyer is happy because he got a discount. The Realtors both still got a sale, and even if they took a little haircut, the number of hairs on the floor is a minute quality compared to what happens to the seller.
By the way, as a buyer of rental properties, I LOVE my Realtor (I <3 you Misty, in case you’re reading!), and it’s for the reasons I outlined above. She has an incentive to get me properties as cheaply as possible because she knows two things:
- I’ll have her manage the property. She’ll make as much in a year off of the property management fees as she will off of the commission on the sale. Since I am a buy and hold investor, she makes a lot more in the long game, even if she takes no commission on the sale.
- If I’m happy with the buying experience, I’ll use her to buy more properties. When I can walk out of a closing knowing that I just paid $0.75 on the dollar for the property I just purchased, I’m a happy camper. My Realtor wants me to acquire as many properties as I can get my grubby little hands on. Our relationship is a virtuous one.
The only time the seller wins in that proposition is if the seller is distressed and absolutely, positively has to get rid of the property as quickly as possible. Then again, that’s about the only type of purchase I make, so, again, everybody wins, but in most scenarios, that’s not the case. My Realtor can sing her siren song to the seller’s Realtor to hurry along a sale: “My buyer can close with cash in 7 days, but you have until tonight to get this done. If not, we walk.”
Nothing says pressure to a seller’s agent like watching a surefire commission go flying out of the cage.
Alas, real estate is not the only industry where perverse incentives create alignment against potential customers. Whenever you walk into the office of an “investment advisor” who wants you to give him all of your money so that he can “manage” it for you (implicitly telling you that you’re not smart enough to do this on your own), he’s really looking for one of two things:
- Commissions in selling you front-loaded mutual funds. If he can do that, he’s won the holy grail. 5.9% of your net worth right up front into his pocket. One and done. If you leave the next day, no big deal. He already has his money. If you invest more with him, great! More money for him.
- Assets under management fees. If you stick around, he’ll bill you 1% per year, regardless of how well he does. Chalk another one up for him.
As long as the money remains parked where it is, then he’s in hog heaven. He does a little work on occasion, and yanks out some hefty fee every year for the privilege.
If he’s a better marketer than a manager, he doesn’t care how well he performs, either. If you leave, there will be two suckers to replace you. Performance will be almost irrelevant as long as he can keep the pipeline of the gullible filled.
After all, if you lost your shirt getting your money “managed,” how many people are you really going to tell? Money is darn near a taboo topic in the United States as it is, lest you appear to be ostentatious, and with the prevalence of the Joneses and their niceties, you certainly don’t want to appear as if you can’t keep up with them. It’s embarrassing. Thus, the bad word of mouth rarely happens with the “investment advisor” who drove you into the ditch.
In both cases, those who were supposed to serve you and who didn’t don’t face the negative consequences in the marketplace.
Why is this so?
- In both cases, you don’t pay a fee up front. Monkey Brain, as we know, hates whipping out the wallet to pay for something. If he can pretend that the cost isn’t there by burying it in paperwork, either through a HUD-1 statement at closing or through the annual report that the “investment advisor” provides, then he won’t feel the pain. It doesn’t change the fact that you’re paying the money, but Monkey Brain gets to use mental accounting to act as if those costs don’t really count.
- Perceived switching costs are high. If you’re selling a house, once your Realtor has set everything up and got the marketing machine cranked up, you feel committed to that Realtor. If you decide down the road to switch, then you have to do a whole new set of pictures, relist it, get all of the people interested in your place (if there were any) to talk to the new Realtor. It takes time to get this accomplished, and that’s time that the house isn’t on the market. What is the perfect buyer was shopping on the one weekend when your house wasn’t listed?!? Misericordia! The same goes for switching “money managers.” There are forms. You have to get to know the new person. You have to figure out if you can trust them, if they know what they’re doing, and if they’re good rather than lucky (the answer: they’re lucky). We never even, at that point, think of the alternative of doing it ourselves because we’ve built up this mental image, whether it’s of the “horrors” of having to market it or the “difficulties” of managing our own money. Instead, we just think of the switching costs that we’ve built up in our minds, of switching horses rather than thinking of going from a horse to an automobile.
- Each of them takes risks which aren’t in our best interests. Remember, the Realtor wants a sale as quickly as possible, and even if it’s not as high as possible, a sure sale at a slight discount is a much better situation than an uncertain selling position, at least from the Realtor’s point of view. Therefore, the Realtor will take the risk of a lower price to improve the chances a quick sale and, where possible, to ensure a sure thing. An “investment advisor” will take outsized risks to try to grow your portfolio. While this sounds great in theory – your interests are aligned! Yay! – the reality is that active management, over time, leads to lower returns. So, by overtrading and by trying to find the magic pixie dust in the market which isn’t there, the “money manager” manages to lose some money for you. If you go from $500,000 to $450,000, that’s a big swipe out of your nest egg, but for the strip mall advisory firm, that’s usually a $500 loss, and he’s still going to get $4,500. You lose $50,000 and he gets paid $4,500 for failure.
- Both of them have strong marketing behind them. From the government providing incentives for you to buy a house to brokerage firms bombarding you with advertising telling you that you can’t manage your own money, both Realtors and “investment advisors” have a ton of media flooding your brain with the same message: you can’t do it yourself. If you hear it enough, you will believe it. The asset management industry, for all of its lack of performance, is HUGELY, HUGELY profitable. Few people can make money off of telling you that you can do it yourself once you’re taught how to do so (though I have a premium course that takes this exact approach). Lots of people make money if you believe that someone else can do better with your investments. Oh, and you’re not one of them.
If you go into the situation with eyes wide open, then you can understand the costs that you’re paying. We have used Realtors to sell every house that we’ve owned. We also do our research and know the market value. We simply don’t want to engage in the effort to market a place, and we’re willing to make that tradeoff. We frame it as a cost rather than trying to hide it behind marketing. We’re educated consumers.
If losing 1-6% of your net worth each year is worth it for you not to have to spend the few hours necessary to “fool with” your assets, then so be it. Make that conscious decision to go with an investment advisor.
However, don’t just go blindly into believing that they have your best interests at heart. Despite what Realtors and “money managers” will tell you, their incentives are not aligned with yours.