Who works for whom? The broker’s dilemma
A hen is only an egg’s way of making another egg. — Samuel Butler (1835-1902).
When you buy or sell a home, for whom does your real estate broker work?If you’re a seller, the listing agreement you sign says the broker works for you. Now comes a University of Chicago study from two economists (Steven D. Levitt and Chad Syverson), reported in today’s New York Times (subscription required) that finds:
the housing market [$2.17 trillion in 2004, that's $2,170,000,000,000] remains inefficient, and the incentives for agents to maximize profits for their clients aren’t powerful enough.The economists reached their conclusion by an old-standby, a three-ingredient logical triangulation analysis:
1. Start with a personal anecdote, an apple-on-the-noggin perception:
Professor Levitt had fixed up and sold several houses in
Oak Park, Ill., a suburb of Chicago. When working with real estate agents, he said, “I got the impression they weren’t working solely in their clients’ best interest.”
2. Then gargle with statistics:
Along with a colleague, Chad Syverson, Professor Levitt set out to prove it by comparing data on homes that agents sold on behalf of others with those that they owned and sold for themselves.
They analyzed sales from 1992 to 2002 of 98,000 homes in suburban Chicago, of which 3,300 were owned by real estate agents. When the economists constructed an analysis that controlled for amenities, location and the adjectives used to describe the houses, they found that agent-owned homes, on average, stayed on the market 9.5 days longer and commanded median prices that were 3.7 percent higher than comparable homes owned by clients.
In other words, when the broker was working for herself, she took longer and got more. Or, said in reverse, when the broker was working for somebody else, the seller jumped sooner and got a little less money.
3. Finally, unveil the common-sense theory.
Real estate brokers are paid an entirely contingent commission that is a flat percentage of the total price, not the incremental price above some theoretical base. Everyone knows the hardest dollar to get is the last one:Real estate agents have a better sense than others of the best price a home can command. But when they work for others, they don’t have the financial incentive to pursue it. Most home sales generate a 6 percent commission, split between the brokerage firms representing the buyer and seller. The agent generally receives half of the firm’s draw, or 1.5 percent of the sale. So if a home sells for $500,000, the agent personally receives $7,500. Not bad for what may be just a few days of work. If the agent works for an additional week and urges the seller to hold out for $515,000, that’s an extra $15,000 for the seller, but only an extra $225 for the agent. Because every additional dollar throws only a penny and a half into the pocket of the agent, the economists reason, the agent may push clients to accept lowball offers.In effect, Messrs. Levitt and Sylverson are applying a principle of economic theory known, rather clumsily, as agency risk:
Agency risk. The risk that an agent – whose interests are misaligned with its patron – will spend or obligate the patron’s capital imprudently.Agency risk. The risk that an agent – whose interests are misaligned with its patron – will spend or obligate the patron’s capital imprudently.
Agency risk is inherent in complex multi-party environments because all stakeholders see all rules as a game. Thus, from our broker’s perspective, the entire transaction succeeds or fails only if a buyer and a seller come together and exchange money. Everything else is economically subordinate, means to an end, or even worse, economically superfluous.Agency risk is muted for service professionals because they engage in not just one transaction — one seller, one buyer, one home — but a whole series of transactions, a whole career in fact. A broker who betrays a client’s trust on one matter is swiftly known for having done so — through word of mouth and its electronic avatar the Internet, bad news travels very fast — and her reputation may be eroded or entirely ruined. Thus the broker’s posture is akin to the famous game-theoretical exercise the Prisoner’s Dilemma:Two prisoners, lets call them Joe and Sam, are being held for trial. They are being held in separate cells with no means of communication. The prosecutor offers each of them a deal. He also disclosed to each that the deal was made to the other.
The deal he offered is this:
· a) If you will confess that the two of you committed the crime and the other guy denies it, we will let you go free and send him up for five years.
· b) If you both deny the crime, we have enough circumstantial evidence to put both of you away for two years.
· c) If both of you confess to the crime, then you’ll both get 4 year sentences.
To quote Keanu Reeves in Speed, “What do you do? What do you do?”Speed, “What do you do? What do you do?”you do?”
Sandra Bullock confronting the Prisoner’s Dilemma: more movies with Keanu?
What makes the Prisoner’s Dilemma interesting, and relevant for capital markets and affordable housing programs, is its element of indefinite iteration: the game is played over and over again, and the goal is to maximize long-term success. Prisoner’s Dilemma game theory proves to have enormous global implications (in billion-dollar auctions) and evolutionary implications (does it provide the biological basis for altruism?), and a myriad of other complex-systems possibilities. Which brings us back to affordable housing, and the much more complex problems it represents. Agency risk abounds in all forms of real estate investment transaction. In the barest economic terms:
· A property is only a developer’s device for making another development fee.
· A loan is only an originator’s device for generating another origination fee.
· A Section 8 tenant is only a landlord’s device for generating a subsidy payment.
Moreover, an affordable housing property is successful only if it is successful over the long term. Which means that every rental decision, every capital improvements decision, every financing or regulatory action, is another move in an open-ended Prisoner’s Dilemma of decisioning, being played by the developer, owner, manager, lender, regulator, residents …. Government, meanwhile, sits above the fray like Voltaire’s God (are the Ten Commandments God’s Prisoner’s Dilemma decision algorithm?), having set up the universal rules and now being bound to watch as they are played out by hundreds, thousands, even millions of individual actors. So, if you are government, we must once again quote the Great Keanu:
I suppose the most obvious question is, how can I trust you?
Bingo. It is a pickle. No doubt about it. The bad news is there’s no way if you can really know whether I’m here to help you or not, so it’s really up to you. You just have to make up your own damned mind to either accept what I’m going to tell you, or reject it.
