The Real Estate Commission Puzzle

Some seven years ago I wrote that the system of real estate commissions is horribly inefficient:

Consider, house prices are much higher in California than in Idaho but commissions are stable at around six percent. Thus, even though the realtor’s job, brokering a deal, is the same in California as in Idaho, a realtor in California will make much more per-house. As a result, there are far too many realtors in California and many of them will spend an entire year selling only a handful of houses. [At the height of the real estate boom in CA there were 437,000 real estate agents and only 680,000 home sales a year!, AT added 2013] Indeed, many realtor’s spend most of their time prospecting for clients rather than actually selling houses – this is a huge waste of resources. The same relationship holds over time as over space. That is, when house prices go up we don’t see a fall in commission rates. Instead, we see more entry. Since the same number of houses are being bought and sold, the extra realtors don’t make the buyer or seller better off and sadly the realtors aren’t better off either – instead the excess return is siphoned off in wasteful prospecting for clients. Unfortunately, no one really understands why commissions are stable.

When I wrote this in 2005 many commentators argued that fees would drop with the entry of online brokers. That has not happened. Indeed, as a recent piece in Bloomberg titled Why Redfin, Zillow, and Trulia Haven’t Killed Off Real Estate Brokers notes, the puzzle has in some ways gotten more difficult to understand. Today, lots of people use the internet to find homes by themselves, so brokers are doing less work, yet fees have by and large not fallen and most sales continue to use agents. Add to all this the Levitt and Syverson result that brokers sell houses too quickly and get lower prices than would be optimal for the seller and the puzzle deepens even further. As I wrote earlier the obvious answers don’t seem correct:

The answer is not monopoly. It’s very easy to enter the market for realtors. So why don’t commissions fall? One can certainly point to some restrictive practices by the NAR but I don’t think that is the whole or even the major part of the story. A clue to the puzzle is that we also see stable commission rates in law (contingency fees) and in services (tipping). Why is the appropriate tip 15% at an expensive restaurant and at a cheap restaurant? Does the tuxedoed waiter really have a harder job than the diner waitress? Maybe (indeed, I have argued along these lines elsewhere) but the commonality across these very different markets tells me something else is going on. Is it signaling? Would you distrust a realtor offering lower commissions? Again, maybe, but it’s hard to believe that with so much money at stake there aren’t enough people willing to take a risk on a discount realtor for long enough for reputations to be established. I think part of the problem in the realtor market is that other realtors can easily discriminate against discount brokers by pushing their clients one way or the other – that says the antitrust actions will probably not be very effective [and may help to explain why Zillow and Trulia which don’t compete with agents have been very successful while Redfin which offers more value but does compete with agents is still a very small player, AT 2013]. But this doesn’t explain stable commissions in law or waiting.

Hat tip: Newmark’s Door.


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