Funmurphys: the Blog

How Real Estate Commissions Work

We sold our house. I gathered a number of stories along the way, some good and some bad. I also learned a few things about how real estate commissions work. This information was surprisingly hard to obtain, but very important and valuable. So I'm sharing it with you for free, all part of the life services we offer here at funmurphys.com.

First, some definitions: The seller owns the house and wants to sell it. The buyer is thinking of buying a house. The seller and buyer may be working through real estate agents who represent them, the seller's agent and the buyer's agent. The seller's agent is also called the listing agent. Licensed real estate agents are often known as Realtors (TM).

Here's the executive summary: The home seller pays a percentage commission to the selling (listing) agent, which the agent splits in half with her office. If there is a buyer's agent, that agent also receives a percentage commission, deducted from the selling agent's commission. The buying agent also splits the commission in half with his office. A lot of implications flow from this seemingly simple arrangement. Take a deep breath . . .

You can simply sell or buy a house on your own, but it's a Big Scary Process involving a lot of legal paperwork and financial transactions. So most home sellers sign a listing contract with a seller's agent and let them deal with all that. The seller and agent agree on a commission based on the price of the house; the "classic" real estate commission is 6% of the sales price, but that percentage is neither the typical commission nor the average commission (more on that later). The seller's agent receives her commission at closing, when the house is finally sold. If the house does not sell during the term of the listing contract, the agent gets nothing. Of course she'll try to avoid that scenario.

Let's use a house base price of $400,000, which should be fairly typical for people reading this column. A 6% commission of $400k is $24,000. The seller's agent usually splits the commission 50-50% with his real estate office. In this case the agent would receive $12k at closing, and the agent's office would receive $12k.

The 6% real estate commission is not sacrosanct! Many real estate agents want to list and sell your house, so the seller can negotiate that commission. You can ask if a potential agent will accept a 5% commission, or even a 4% commission; and if they want your business, they may take it. Or try some fractional percentage. They might take you up on the offer, depending on a lot of factors like their workload, the house's likely price, how quickly your house is likely to sell, and so on. "Everything is negotiable." Sellers who calculate the commission amount before signing the listing contract often realize that $24k is a big chunk of change to be sending out the door, and start to wonder if there is some way they can reduce that amount? How about a 5% commission instead, or $20k?

At this point we have enough information to bust one myth right away. Here is the myth: Real estate agents will seek the highest sales price for your house because it means a bigger commission for them. Like most myths, there is a grain of truth in this statement. Anybody with a calculator (and most people without one) can see that a higher sales price yields a higher commission.

But "everything is negotiable," especially the price of the home itself. The seller may occasionally get a buyer who will pay the listing price right away, but more often the buyer offers less than the asking price. How much less? A buyer might offer $380k, the seller might counter to $390k, and the two parties will eventually agree on $387k. The monetary increments in house negotiation are on the order of $10k. Amounts of $10k will make or break the deal.

$10k is a lot of money to the buyer and the seller - you can take your family on a Hawaiian vacation for that! It's worth haggling over. Are you working on margin? - you've probably got a mortgage to pay off, or another house to buy. But what is that $10k to the real estate agent? She and her office stand to collect $24k if the sale closes successfully. The difference in commission over a $10k difference is only $600. Does she want to risk the entire $24k over a measly six hundred bucks? No way! She wants the deal to go through. Her motivation structure is set up to reward deals completed, not to squeeze the most commission out of each deal and risk losing the sale entirely. Yes, it would be nice to earn a higher commission, and the seller will probably give her glowing referrals if she gets a good price. But the motivation structure of the traditional real estate commission is set up primarily to reward sales completed. Price increments in the amount of $10k are of secondary importance to the agent.

Now let's suppose the seller has negotiated a 5% commission with the listing agent, and the house is on the market. A buyer comes along in the company of a real estate agent, which is the usual scenario. The buyer likes the house right away and offers the full $400k. How does the buyer's agent get paid?

The buying and selling agents do NOT split the real estate commission 50-50! Surprise! The commission for the buyer's agent is fixed, and this percentage is sacrosanct for the local area! In my region of Colorado the buyer's commission is 2.8%, fixed not by law but by rigid local custom and practice. Real estate companies that subscribe to the Multiple Listing Service (MLS) agree to honor the buyer's commission. If you look at the bottom of an MLS listing you may see something like "BA 2.80". This means Buyer Agency 2.80%, which is what the seller has agreed to pay a real estate agent working for the buyer.

Everybody wants to attract a buyer, and one way to do this is to attract the buyer's agent. The 2.8% buyer's agent commission is sacred because nobody wants their 2.5% commission sneered at, and passed over, by those buying agents out there trolling for properties. So everybody marches in step with the standard buyer's agent commission, and dares not go below that amount. The professionals know these rules and are very reluctant to break them. And a standard buyer's commission helps to keep the agent neutral with regard to multiple houses. (In some places there has even emerged a practice of offering agent incentives - a larger commission for the buyer's agent - as a way of attracting buying agents. This practice is pretty much a bribe and ought to be illegal, but isn't. Yet.)

Back to the example. The total 5% commission paid by the seller on $400k is $20k. The buying agent gets 2.8%, or $11,200. The selling agent gets what's left over: 2.2%, or $8,800. Notice that the buying agent gets more than the selling agent. $2,400 more. Are you comfortable with that?

You might be more comfortable to learn that buying agents do most of the property tours and walk-throughs. 9 out of 10 showings on our house were conducted by buyer's agents, not by the listing agent or by me. The listing agent puts on open houses, posts advertising, and talks up the property, but most of the showings are done by another agent (working with the buyer). Feel better? Maybe, but it still seems weird to me that the commission is not split 50-50. That's Weirdness #1.

Since the buyer's commission is fixed at 2.8%, you can see that the listing agent gets really squeezed by lower commissions. A 4% total commission only leaves the selling agent with 1.2%, and anything below 3% will lose them money.

The standard listing contract states that the real estate commission is paid by the seller. In our earlier example, the buying agent received $11,200 of that commission. Colorado has a required notice to clarify the relationships, saying that the buying agent is working in the buyer's interests, and the selling agent is working in the seller's interests. Nice to know. So our poor seller is paying the buyer's agent $11,200 to negotiate intentionally, deliberately, and professionally against him! That is Weirdness #2. The seller pays the buyer's agent to work against him and against his best interests. I am not making this up.

A listing contract is a pretty thorough document, specifying conditions and terms and payment. The relationship of a home-buyer with a buyer's agent is less well-defined. Suppose you have looked over a bunch of houses over the past year, got serious about a few of them, and have finally settled on one house to buy. Who is your buyer's agent, and who gets the buying agent's commission?

Real estate agents are professionals, and they want to avoid problems with each other and with their clients. To this end, they have adopted certain practices to ensure fairness and avoid client-stealing. The accepted practice is this: The licensed agent who first showed you the property receives the real estate commission. "Showing the property" means accompanying you in person on a physical tour of the home and grounds. The official buyer's agent is the one who first set foot on the property with you.

Quiz

This practice has some implications that might not be obvious to the casual "Looky Louie" browsing through the neighborhood. Take this test:

You and your spouse are thinking that you might move someday, and you come upon a neighborhood that looks nice. Sure enough, you see a house for sale that's attractive from the outside. You pick up a flyer from the sign on the lawn, and call the listing agent to arrange a showing.

A couple days later you tour the house with the listing agent. But the bedrooms are not laid out the way you want, or the back yard is too small, or something else is not right. It's a nice house, but it won't do for you. You thank the agent politely for her time. As you are leaving, she says, "Before I left the office I gathered a few listings of similar homes in the neighborhood. Would you have time to go look at those?" How do you respond?

Possible Responses:
A. "Sure, we have another hour to spare. Let's go look at them."
B. "Not on your life! What are you trying to do, trick me?!! Get away!"
C. "Not today, but if you give me your business card I might call you later."
D. Without a word, you snatch the listings from her hand, jump in your car, and speed off! As you make your get-away you copy down the addresses and then shred the listings!
E. "No, thank you."

The answer here is that you can do anything you want, but the agent's innocuous offer has some big implications that most people don't realize. Consider Response A: If the agent (whom you just met) accompanies you physically to the 2-3 other houses this afternoon, she will have locked up your buying relationship with that house. That's the commonly accepted practice among real estate agents, remember? In other words, if you later decide to buy one of those 2-3 houses, you'll have to buy it through her. Did you realize that?

When you called to make the original appointment, the agency may have asked you, "Are you working with a real estate agent?" You truthfully answered "No," because you were just looking around at that point. You expected to deal with the listing agent on the original house, but she doesn't represent the 2-3 other properties. At least, she didn't until this afternoon. But now she represents you if you want to buy one of those other houses. That's Weirdness #3.

Response B is not good; it's rarely productive to be rude to someone for no good reason. But at least it demonstrates that you know what's at stake here. (To be fair, she's probably not trying to "trick you", she's merely offering professional assistance. Then again, her name is printed at the bottom of each listing, leading you to believe that she is the listing agent for those properties, too.)

Response D is a dramatic flourish for the Walter Mitty in all of us, and it would be nice to have those other listings. But the agent has performed a small service for you in running a property search - it would be more ethical to log onto realtor.com or coloproperty.com or zillow.com and find those listings yourself.

Response A is okay if you really want to use that agent to buy those properties. But bear in mind that buying a house can be stressful, and you have at least a month of high-intensity business relationship ahead of you before closing. Weren't you going to interview a few real estate agents before choosing one to work with? Now you're stuck with one you didn't even select.

Response E is kind of abrupt. But it's clear.

Response C is my choice, unless I really take a dislike to the agent. We might decide to work with her after talking it over, and she's already shown some initiative. Why not take her business card without promising anything?

Who Pays?

Who really pays the real estate commission? The seller does, right? It says so right there in black and white on the listing contract! The buyer gets all these real estate services for free, right?

Not so fast! Remember that the seller sets the asking price for the house, knowing that they will have to pay a 5% commission out of that sales price. The seller will only sell if they get a certain minimal amount in return. So it's natural for the seller to raise their asking price by 5%. Now it's the buyer who pays the commission, because they have to pay a higher sales price. Remember that the buyer is the one who will supply all the money to complete this transaction. The buyer has to finance the full amount of the sales price, which includes the real estate commission.

In summary: It's not clear who really pays the real estate commission. But no matter how you figure it, real estate commissions have the effect of sending 5% of the property's value off into the real estate industry every time a house is sold.

Most home-buyers go around with a buyer's agent because they think that they are getting something for free. But it's not free! The buyer is paying for that service whether they realize it or not.

Yes, I know that a buyer's agent will negotiate for you, will protect your interests, and so on. They can make sure that a few hundred dollars of plumbing repairs are completed before closing. But most buyer's agents I worked with urged me to raise the offers I was making! "You're going to insult the seller with a lowball offer." Most seller's agents urged me to lower my asking price. It felt like they were working for the other party, not for me. Remember that real estate agents are motivated to close the deal.

Real estate agents are professionals who provide a service. If the value of that service to you is worth $10,000, then go ahead and hire them. But make sure you know what you're getting, and what the real costs and implications are. If you are searching for properties on your own, calling listing agents to arrange showings, checking out comparable sales on zillow.com, and you know the local neighborhood; do you really need to pay an agent $10,000 to tag along behind you and fill out some spaces on a standard sales contract?

The Unattached Buyer

Weirdness #4 comes when you consider an unattached buyer. Let's call him George. George has read the first part of this article, has done some research, has bought and sold houses before, and has decided to buy a house on his own this time. He'd like to save some money somehow. George has successfully fended off the overtures of agents at open houses, has never gone on additional showings offered by listing agents, and certainly has never signed an exclusive right-to-buy contract.

George finds a $400k home that he likes, and he thinks the asking price is reasonable. Knowing that the seller will not have to pay the 2.8% buyer's commission, he considers offering 2.8% under the asking price. But George is a good guy, and he realizes that the selling agent will have to do more work because he's not familiar with mortgages and inspections and title companies and the like. It's just easier to work with another licensed agent. So George offers 2% less than the asking price, figuring that this offer will save everybody money and compensate the agent fairly.

And he's right! Unfortunately, the seller has signed a listing contract with her agent, without first reading the contract carefully and considering what happens to an unattached buyer. The usual listing contract specifies that if a buyer has no agent, the selling agent will work as a "transaction broker" instead. The transaction broker works for neither party, but guides the transaction to completion. That's great. But the transaction broker still receives the full 5% commission, according to the standard listing contract!

George submits an offer for $392k, and is puzzled when the seller doesn't consider this to be a full-price offer. The problem is that the listing agent has already claimed the 2.8% buyer's commission by the terms of the listing contract. The seller did not notice this provision, and there is no automatic discount for unattached buyers. There should be.

It's not clear how George can get the discount that he rightfully earned by doing all the legwork himself. This is Weirdness #4. The selling agent knows perfectly well what's going on, but might not explain it to the seller. The seller might simply accept the offer as is. But if not, George and the seller have to hope that the listing agent will agree to reduce her commission in order to make the sale. Will she do that? Will she kick up a fuss even though she comes out better off than if George had an agent? Who knows?

The seller could have insisted on a 2% discount for unattached buyers, and written that into the listing contract up front (and specified a 3% commission to the transaction broker). The listing agent will probably say that "most agents wouldn't do this" and agree to it anyway. Real estate agents know that most buyers come with an agent. But the seller wants to sell her house, and one way to do that is to offer discounts to whomever she can.

Recommendations:

The buyer and the seller should each pay for their own services rendered to them. This practice of the seller paying the buyer's agent is just nuts.

If you are a home buyer, and you want to work with a real estate agent in the classical manner, go ahead. A professional can save you a lot of hassle. But don't get attached to an agent without realizing what is happening, and what the implications are when you set foot on a new property.

An unattached buyer has about a 2% negotiating advantage, but it's not clear how to use that edge. Be creative and negotiate. Consider signing up with one of the buyer services that refund most of the buyer's commission to the buyer.

If you are a seller, consider listing your house with one of the discount brokerages. They charge a monthly fee of about $100 for the MLS listing, and a flat fee on the order of $1,000 to handle closing. Don't worry about showing the house yourself - the few times that you personally walk someone through will be enjoyable!

Consider hiring a real estate agent on a flat fee basis. They really do know a lot! $1,000 is a reasonable fee to walk you through the process once the sales price is agreed upon, especially if there are problems. The title company is supposed to manage the transaction itself, but an agent can work out disagreements over the inspection and other matters.

If you are a seller, get one of your friends who has an eye for interior design and decorating (you know who they are). Ask them to walk through your house and let you know how to spruce it up (or clean it out) for sale. Serve them dinner afterwards.

Buy a five-gallon bucket of white semi-gloss interior paint. Start repainting the rooms that are not white. Do not stop painting until the bucket is empty.

Good luck!

High School Musical 2

If you have fruit of the loins of a certain ripeness, as I do, then you know all about High School Musical -- the name implying all the creativity went into the show with nothing left over for the title. I say the smashing success of the movie is due to its complete lack of irony, edge, or other trendiness and the focus on telling a simple story in song and dance. What a concept.

Tonight Disney is hoping to catch lightning in a bottle twice by bringing everybody back for a second installment. Why yes, my daughter is going to a HSM2 party tonight, which I found last night when she wouldn't let me eat any of the chocolate chip cookies she was cooking for the event. For all I know, I'll be watching it while eating popcorn. I might even enjoy it.

After reading the New York Times hate piece on it, I'm liking my odds of enjoying it a lot better. And I'm thinking the reviewer will enjoy life in general a lot more once they pull the giant pickle out of their ass and stop worrying about what other people think.

For a pickle-less review, we turn to the LA Times whose reviewer got into the spirit of the show. I'm betting the rhythm is going to get all of us watching tonight.

UPDATE:
Apparently 17.2 million viewers tuned in last night, making HSM2 the highest rated basic cable telecast ever, and beating the original by 10 million viewers. I only saw the first half hour, then it was off to walk the dog, and then Monk, which was when I ate my popcorn. My daughter enjoyed the party but her and her friends take was that it wasn't near as good as the original (I believe the word "stank" was used).

Letters I've Never Sent

Dear Senator Obama,

How about a foreign policy where we talk to our friends and invade our enemies? Just a thought.

Your Friend,
Kevin Murphy

PS Horse goes in front of the cart. Hope this helps.