Why the Real Estate Buyers Agent's Commission is Paid by the Seller

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I have to admit I'm uncomfortable with it and don't like it. As a buyer's agent, here I am getting paid by someone who not only is not my client, but whose interests are aligned, in most issues, opposite to my clients. They want the highest possible price, my client wants the lowest. They want out of the property without spending money on repairs if possible, my client wants the necessary repairs made. The list goes on and on. About the only issue on which the two sides are in agreement is that they want the transaction to happen. Yet it has become essentially universal for the seller to pay the buyer's agent. Indeed, this is basically the only fig leaf protecting Dual Agency. If the money to pay the listing agent came from the buyers, they'd have to ask themselves "whose interest is this agent looking out for?" with the result being that dual agency would die overnight, and if staking dual agency through the heart doesn't appeal to you, you're unlikely to be on the consumer's side. Not to mention the myth of "Discount price, full service" would die just as quickly, on both buyer's and seller's sides of the transaction. There are protections in place to make it both legal and ethical, but getting paid by the seller when I'm acting on behalf of the buyers still makes me profoundly uncomfortable, and that's aside from facilitating these urban legends.

(The buyers are paying the listing agent, but not directly)

That said, let's consider why it happened, what it would take to make it change, and what the cost of that change would be.

The first paragraph makes obvious the benefits if no sellers were to pay buyer's agents - if what the seller paid out in agency fees was reserved solely to the listing agent, usually contingent upon a successful sale. No "Co-operating Broker" percentage. Not to mention the fact that the seller would come away with a larger percentage of the value of their property. Instead of seven to eight percent, the cost of selling the property would fall to between four and five percent. Not paying the buyer's agent sure looks like a win for the sellers, and one would think explaining that it would be part of an agent's fiduciary responsibility to explain, right?

But the reason that it is in any given seller's best interest is almost as obvious. Ask any agent and any loan officer what the number one obstacle to buyers being able to buy a given property is buyer cash. Okay, there are those unethical persons who will tell you that the problem is qualifying people for property beyond their means, but I'm talking about people who want to buy properties they can otherwise afford. Once they get the loan and the property, they will be able to afford the payments - the real payments on a sustainable loan - and keep up the property and all of the other stuff that essentially goes with "happily ever after". The number one constraint upon people wanting to purchase property they really can afford is cash in their pockets (or equivalently, bank account). The cash for the down payment, the closing costs of the loan, and everything else involved. It takes a long time to save that money, over and above the daily expenses of living. Some people find it difficult; others, impossible. Add the buyer's agent commission to that, and that sets the bar of cash they need to save that much higher.

The seller has the built up equity in their property, from the loan they've been paying on and usually, the increase in property value, and if that property commands a higher sales price, this equity is greater, and getting more money is the reason for them being willing to pay the buyer's agent. This willingness means that the pool of potential buyers doesn't need even more cash, which means that more potential buyers are able to afford this property. The more potential buyers able to potentially afford the property, the higher the likely sales price. The greater the economic demand, the higher the price, holding the supply constant, and there is only one such property. In fact, this increase in the sales price is typically much larger than the cash they pay, thus furnishing incentive for the sellers to be willing to pay the buyer's agent as part of paying their own. By shrinking the necessary pool of cash the buyer needs to a smaller percentage of the purchase price, they increase the potential selling price by more than they cash they put out. Furthermore, if everyone else is willing to pay this money and this particular seller isn't, then by making it harder to purchase their property than the competing ones, they shrink their pool of potential buyers, thus costing them more in eventual sales price than they are likely to recover. If my clients have just enough cash for closing costs plus down payment, they're not prospects for that property, because if they had to write the check for the buyer's agent, they fall short. One alternative is to lump the buyer's agent commission into a seller paid allowance for closing costs, but the six percent aggregate limit that most lenders draw in the sand for that can make it a real constraint. Considered on an individual basis, it's better for sellers to simply agree it's their responsibility in the listing agreement, thus removing the money from that allowance.

Indeed, an argument can be made that offering an average or higher incentive (locally, 3% or more) to a buyer's agent is one of the better ways to get the property sold. Not only do many buyer's agents shop that way explicitly, but if they have an exclusive contract that says 3% (as many do, because their clients aren't educated enough to know what a crock exclusive buyer's agency agreements are in the first place, but they'll also willingly trust the chain agent as to what is "standard"). If the Cooperating Broker's percentage is lower than what it shows on the buyer's agency agreement, that buyer will need to come up with more cash to pay their agent, from out of their limited pool of available cash. When that buyer's agent is in a position to demand 3% whatever property their victim buys, even if they didn't find it and weren't involved, that means properties paying less than that aren't contenders for this buyer's business, unless they've got so much available cash that it just isn't a constraint, and that is rare. A better buyer's agent puts a lower number on a nonexclusive contract, and if they get more, that's certainly fine with them, but because they have a non-exclusive contract, they don't get anything if the buyers become disenchanted with them and stop working with them. This gives a buyer's agent with a non-exclusive contract the incentive to find the property that's a real value to the clients as quickly as possible. I care far less about whether I'm getting two or three percent or something in between on a particular property, than I do about finding the property my clients want that's within their budget. My incentive is to make the clients as happy as possible so that I do get paid, because if I don't, I won't. But the buyer's agent with an exclusive contract that pays three percent has a different set of incentives, which is another reason I advise strongly against signing exclusive buyer's agency agreements, and the existence of such creatures is the reason why it may be a good idea for sellers to offer a higher percentage to a buyer's agent. (There is no consumer oriented reason to keep the amount of the Cooperating Broker's compensation secret, and I strongly support making it part of the general public's available information, which it currently is not on my local MLS.)

So sellers offer a commission because it shrinks the percentage of purchase price that buyers need to have, competing for buyer business as well as expanding the pool of possible buyers theoretically able to consider this property, both of which increase the purchase price more than enough to balance the money they spend. If by paying someone three percent, I increase my take by five percent or more, that's money any rational person will spend. The preliminary numbers I've seen indicate that the seller's increased take is about ten percent of gross price, which translates to almost seven percent more money in their pocket if the property is free and clear, and an even larger percentage if it isn't. On a $100,000 property, you spend $3000, get that money back and another $7000 besides - wouldn't you do that? Doesn't happen on every transaction, but those are the statistical averages. It might not be that much in your particular case - but it could as easily be more as less. If the dice were loaded on your behalf like this in Las Vegas, and that the expected value of a $3000 bet was $10,000, most of those reading this would quit their jobs and move there (at least until the casinos went bankrupt). In reality, it's pretty much the reverse: It'll cost you 10% not to put that 3% on the table.

We've seen what a winner this bet is, in the aggregate, and therefore why rational sellers who are allowed the option will opt to do offer a cooperating broker's percentage, which essentially goes to pay the buyer's agent. The economic incentives under the market therefore reduce it to something like one more tragedy of the commons, although unlike the classic example, it doesn't really hurt anyone directly, it just shifts the market price upwards. The only way to change it is therefore to pass a law prohibiting it. Leaving aside the mechanics of such a law and considerations of whether people could find loopholes in such a law (they would), and consider such a law as being proposed. Consider such a theoretical law as perfectly written and trivial to enforce, such that nobody could successfully get around it. I know that this is ridiculous (as should any adult), but let's pretend to believe this fairy tale for just long enough to tear it apart even under ideal circumstances. What happens? Well the market is priced to include the shift upwards in prices that sellers paying buyer's agents causes. It's just a one time shift, but we've already had the up, so now we'd get the down. Obviously, it would further damage current owners who would like to sell, and make prices more affordable to those who want to buy. Okay, so far we have a 1:1 correspondence between who gets helped and who gets hurt, and even, arguably, a $1:$1 ratio in hurt versus help. For every potential buyer who qualifies on the basis of income but no longer has the necessary cash in hand for a down payment, closing costs and a buyer's agent, to boot, we now have someone new qualify who has the money for the down payment, etcetera, and can now qualify on the basis of income. Like I said, direct effects help someone for every person they hurt. Before we leave direct effects, we might ask about how likely people are to vote to harm people who bought into the current system of homeownership based upon the status quo, in order to benefit an equal number of people who aren't - or aren't yet - part of that system at all. That equation doesn't play well very often in the United States.

Now let's consider the indirect effects. You see, people who want to sell and people who want to buy aren't the only ones affected. People who own, but want to hang on to their current properties will also be hurt. When prices fall 10%, everyone with less than 10% equity is suddenly upside-down, with all of the problems that brings. In the current market, the chances of them being able to obtain refinancing are essentially nonexistent. Maybe you're been paying attention to the news recently, maybe you haven't. There's an awful lot of people who want to hang on to their properties right now, and are having a very hard time. Just because I don't think the one proposal that's been made to bail them out directly is a good idea, doesn't mean I want to actively sabotage their efforts. This would flush all but a vanishingly small percentage of them out of their homes and back into rentals - after completely ruining their credit and making it difficult (costly) for them to persuade a landlord to rent to them.

Furthermore, there's a ripple effect across the rest of the loan to value spectrum. People who now have significantly less equity find it harder to refinance, and end up with higher rates, higher cost of money, etcetera. When prices shift downwards by ten percent, someone who had ten percent equity suddenly has none, making their loan much more difficult and costly. Someone who had eighty percent loan to value is now essentially at ninety. Someone who was at seventy is now almost to eighty, and indeed, a a 77 percent loan to value ratio is an eighty percent loan according to all lender guidelines. It's not until you get below sixty-three percent of current value (which becomes seventy once values have shifted downwards), that the differences become small enough to ignore. In a significant number of those cases, this is going to make enough of a difference such that these owners will not be able to refinance even though they need to, or they'll have to accept loans they can't really make the payments on. Whichever is the case, they lose the property. How many people who bought in the last few years have a loan to value ratio below 63%? Not a whole lot, it turns out. Even when value increases would have more than caused that level of equity, they've taken out equity lines to pay for improvements, cashed out for toys, or even in order to put the down payment on more real estate. Maybe they shouldn't have done that. It's not my place to make that kind of judgment. I'm only going to say that they did so having no reason to believe the status quo would change, and intentionally shifting it even further on them is moving the goalposts, and to the extent it causes current homeowners to fall short of their goals of meeting their financial obligations and lose their homes, is vile.

All this leads up to the killer reason: When I first wrote this, according to Statistical Abstract of the United States, residential real estate in the United States was valued at about 25.3 trillion dollars. Let it be devalued by ten percent, and that's 2 trillion, 530 billion dollars in real wealth, just gone. I could freak out enough people just by talking about the thirty billion, or roughly $100 for every man, woman, and child in the United States, but that's only the third decimal place of the loss, in this particular case. Accounting phantom consisting of numbers on paper or not, this is real money, every bit as real as that $100 in your checking account. Every penny that vanishes means that someone doesn't have it to invest in the economy. Whether it's an individual, a corporation, a lender, or what have you, it means that suddenly the last year or so of economic expansion goes poof!. This two and a half trillion dollars vanishing has second and third order consequences, each dislocation causing more troubles further down the line. The global depression of the 1930s had much milder causes, even considered proportionately. You want to know who gets hurt? The little guy and the emerging entrepreneur, who would have been responsible for most of tomorrow's growth. Old Money comes out fine, by and large. The depression was an inconvenience to the Astors and the DuPonts, to be sure, but that inconvenience didn't much effect their personal lifestyle. It economically killed a generation of innovators in addition to causing well documented economic misery among those who were less well off. Rereading this later, let me ask if there is anybody that seriously wants to argue for more of what we've been going through because real estate prices fell?

So now you know why the sellers pay the buyer's agents, you know why it is in the individual seller's best interest that it be so, what it would take to change this, and what the results of such a change would be. I still don't like it, but changing it would cause more damage, and more immediate damage, than allowing the status quo to continue.

Finally, consider this: The only person bringing any money to the table in a real estate transaction is the buyer. Every penny that seller puts out in order to make the transaction happen comes from cash they get from that buyer in one form or another. Either that buyer paid cash, or that buyer took out a loan that compensates that seller with cash. There is no way to alter the fact that the buyer is effectively paying everyone who gets so much as a penny out of the transaction. If the money they pay their own advocate has to go through a third party in order to pass muster with lenders, accountants, lawyers and regulators (and it does, for many excellent reasons rooted in both very basic principles of accounting as well as legal reasons relating to an "arm's length transaction"), then all the ethical issues it causes are something we need to put up with, because putting up with them is better than any possible alternative.

Caveat Emptor

Original article here

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About this Entry

This page contains a single entry by Dan Melson published on December 12, 2013 7:00 AM.

Restricted Sale Property: Very Difficult to Find A Loan was the previous entry in this blog.

Buying Real Estate Isn't Simple is the next entry in this blog.

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