Maxims in residential real estate are plentiful. False ones, such as ‘you get what you pay for,’ have been thoroughly debunked by academics. But other maxims such as ‘anyone can become an agent’ or that ‘agents work very hard’ actually turn out to be true.
It is easy and quick to get a real estate license and in the United States–the barrier is notably low. In fact, many states allow you to get your license to buy or sell real estate with less than 2 weeks of coursework followed by a test. These low barriers to entry help brokers keep a lot of agents paying desk fees to their brokerage office and ensure a steady stream of new recruits ready to chase high commission deals. And we know that agents are spending a lot of time working too, with many full-time agents often working evenings and definitely weekends.
But what are they working on exactly?
Academic researchers Chang-Tai Hsieh and Enrico Moretti figured it out and published a groundbreaking paper on the topic titled Can Free Entry Be Inefficient? Fixed Commissions and Social Waste in the Real Estate Industry. Hsieh and Moretti found that the combination of low barriers to entry combined with little price competition below the prevailing commission rate of 6% creates a very unique and peculiar economic scenario in the United States.
Specifically, they found that as house prices go up over time, each real estate transaction becomes more lucrative since the prevailing commission rates are fixed as a percentage of the home sale price. With increasingly lucrative deals, more people decide to become licensed agents. But since the number of transactions is unaffected by higher home prices, we end up with more agents chasing after the same number of deals. As a result, the productivity of agents goes down, as defined by the number of completed transaction in a year. Interestingly, agents end up making the same amount of money on average since the deals they end up doing are more lucrative due to the higher home prices. So what changes? As more agents compete for the same number of transactions, each agent spends more time prospecting for new clients and less time actually rendering real estate services during a transaction.
This prospecting time benefits the agent directly, but presents a large opportunity cost and social waste: as the number of agents increases, the cost of finding a customer goes up without generating benefits to the customers. Overall, the social loss may represent more than half of total commissions–often called a deadweight loss. See below for a graphic explanation.
Most traditional real estate agents feel that their compensation at 6% is justified given how much effort they put into a transaction. But, a huge portion of their time is spent prospecting and trying to find buyers or sellers. As David Mamet details in his film Glengary Glen Ross, it becomes all about the leads for most agents. The deadweight loss to society comes from the fact that these buyers or sellers are going to transact real estate no matter who finds them first. So most of the work that we end up paying for in residential real estate commissions has very little to do the actual transaction–buyers and sellers end up paying money for being found!