Picket Fence Preview -- Real Estate for Sale by Owner

Market Distortions when Agents are Better Informed: The Value of Information
in Real Estate Transactions

Steven D. Levitt, Ph.D. and Chad Syverson, Ph.D
Department of Economics, University of Chicago

Editor's Note: Following are excerpts from a 35 page academic paper published by the National Bureau of Economic
Research in December 2004. A link to the full text (in html or pdf format) is provided at
Click here to download the pdf file from the University of Chicago!

Summary Agents are often better informed than the clients who hire them and may exploit this informational advantage. Real-estate agents, who know much more about the housing market than the typical homeowner, are one example. Because real estate agents receive only a small share of the incremental profit when a house sell for a higher value, there is an incentive for them to convince their clients to sell their houses too cheaply and too quickly. We test these predictions by comparing home sales in which real estate agents are hired by others to sell a home to instances in which a real estate agents sells his or her own home. In the former case, the agent has distorted incentives; in the latter case, the agent wants to pursue the first-best. Consistent with the theory, we find homes owned by real state agents sell for about 3.7 percent more than other houses and stay on the market about 9.5 days longer, even after controlling for a wide range of housing characteristics. Situations in which the agent's informational advantage is larger lead to even greater distortions. Introduction Because of specialization, individuals rely heavily on the advice of experts in making decisions. For activities as varied as medical treatment, repairing a car, legal advice, planning for retirement, or selling a home (to name just a few), there are experts with particular skills, knowledge, and experience willing to provide their services. A defining characteristic of transactions involving the hiring of an expert is the informational advantage enjoyed by the expert relative to the client seeking advice. As a result of this private information, expert agents may mislead their clients by exaggerating the costs or difficulty of a solution, providing unneeded services, or otherwise distorting the information to maximize the expert's own payoff. In this paper, we focus on the relationship between a real estate agent and a home seller. The real estate agent is likely better informed about the value of the house and the state of the local housing market than is the seller. Because of the particular form of residential real estate contracts, the real estate agent receives only a small fraction of the purchase price of a home, but bears much of the cost of selling the house (eg. expenditures on advertising and marketing, showing the home to prospective buyers, and hosting open houses), inducing a misalignment of incentives between the seller and the agent. The agent has strong incentives to sell a house quickly, even at a substantially lower price, and thus may encourage clients to accept sub-optimally low offers too quickly.... When a real estate agent sells his own home, he is the residual claimant on the full surplus from the sale and thus had optimal incentives. ..By comparing the sales prices and time on the market for homes in which the agent is hired by a client versus when the agent sells his or her own home (and controlling for other factors), we have a simple test of the distortions induced by the private information of experts. The extent of the distortion induced by misaligned agent incentives may be considerable. Real estate agents typically bear a substantial fraction of the marketing costs involved with a home sale... however, the agent receives only about 1.5 percent of each marginal dollar of the price for which the house sells. (The total share of the sale price that goes to agents is usually 6 %, split evenly between the buyer's and seller's agents. Of the selling agent's 3 %, roughly half goes to the agent's firm, leaving 1.5 % for the agent.)... Using a data set of nearly 100,000 home sales [in Cook County, Illinois] between 1992 -2002, of which roughly 3,300 are agent-owned, we find that agent-owned homes sell for about 3.7 percent (or roughly $7700 at the median sales price) more than comparable houses and stay on the market an extra 9.5 days (about 10 %) longer, even after controlling for a wide array of house and neighborhood characteristics. If our analysis is correct, sellers sell too quickly not only because of impatience, but also because agents "trick" them into doing so. In areas with nearly identical homes, sellers can learn much about their own homes' values simply by noting nearby sales prices. When housing stock in an area is very heterogeneous, however, other sales prices convey less information to sellers about their homes' values. In order to be included in the anaysis, we require at least 3 homes to be sold on the block. Houses are classified into 21 different styles (e.g. ranch, colonial, prairie, contemporary).. the sales price difference between agent-owned homes and other homes is indeed highest on blocks where the houses are most different. Here, the price difference is 4.3 percent. The gap is smaller in the moderate-heterogeneity blocks (3.9 percent), and smaller still on the low-heterogeneity blocks (2.3 percent - roughly half of that of the most dissimilar blocks), all in accordance with the notion that neighborhoods with dissimilar houses present a larger information advantage for realtors. The time on the market differences reflect similar contrasts... Agents on the more heterogeneous blocks clearly keep their houses on the market for a longer period than non-agents, while there is no statistically significant time-to-sale gap on those blocks with the most similar houses.1 The second dimension along which we expect to see systematic differences in agents' information advantage relates to the introduction of the internet.In recent years information about house sale prices have become readily available to the general public on the Chicago Tribune website. In addiition, sellers can now directly access a limited version of the MLS. There are also web-based services that will predict the market value of a home based on econometric models (e.g. Case and Shiller 1990) and information the seller enters into the program. Because of the improved information dissemination, we expect that the information advantage of realtors has fallen over time.* As expected, the largest average sales price difference between agent-owned and non-agent-owned homes --- 4.9 percent --- is in the earliest period. This falls by about one-third, to 3.2 %, during 1996- 1999 (where the internet is starting to widely diffuse), and drops again slightly after 1999. The time-on-market differences echo these patterns; agent-owners wait more than two weeks longer before 1996, just over a week longer in the middle period, and 2 2/3 days longer in 2000 - 2002. The implied information advantages, again reflect that agents were more able to act opportunistically in the earlier part of the sample Our results are not easily reconciled with either a model in which realtor houses are more attractive on unobservable dimensions such as good taste in choices of decor by realtors, or by the standard principal-agent model in which realtors exert more effort when selling their own homes. In both models, one would expect realtor homes to sell more quickly, not more slowly. Conclusion Experts hold valuable information. This information is helpful to those who hire them, but can also be a source of welfare-reducing distortions... The greater informational advantage the agent enjoys, the larger the difference between the price and time on the market experience of agents and the clients they represent. The combination of real estate agents' information advantage along with the commission form of the typical real estate contract combine to create distortions from the first best. Homeowners are induced by their agents to sell too quickly and at a price that is too low. (Emphasis ours) Why, in spite of the obvious flaws, has the current contractual form in real estate remained so pervasive and resistant to change, even as parallel improvements in information have so radically altered the market and commission structures for travel agents and stock brokers? If agents' only service to home sellers is the information they provide about valuations and likely offers, it is surprising that more sellers don't more frequently hire an independent appraiser to inform them of the value of their home. An appraiser is disinterested in the final transaction price, which would eliminate the distortions created by the agent's contractual form. Furthermore, appraisers can provide this information at a fairly low cost.   History and Background for the Department of Economics The Department of Economics at Chicago has always ranked among the handful of leading departments in the world. It has claimed a disproportionate share of the honors the economics profession can bestow. Since 1969, when the Nobel Prize in economic sciences was first awarded, twenty-two recipients of that prize have been faculty, students, or researchers in the Department of Economics, Law School, or Graduate School of Business at the Unviersity of Chicago, including Milton Friedman and George Stigler. The John Bates Clark Medal has been awarded to five Chicago economists: Milton Friedman, Gary S. Becker, James J. Heckman, Steven Levitt, and Kevin M. Murphy. Since World War II, the department has had, relative to its size, a larger number of faculty than any other serving as presidents of the American Economic Association. Former faculty members and students currently hold leading positions as economists inside and outside academic life. -------------------------- *One variant used homes' original list prices as the dependent variable, since it is possible that agents' information advantage also impacts the way listing prices are set. We found that agent-owned homes are put on the market at higher prices than non-agent-owned homes and have longer expected times-to-sale. 1- Publishers note - because of historically low mortgage interest rates many homeowners have refinanced during the latter part of this time-period and may have gained market value information from the appraisal that was part of the process.

Publisher's Comments on "Market Distortions when Agents are Better Informed: The Value of Information in Real Estate Transactions" According to this study, the real cost of a real estate commission has now increased from 6% to 9.7% when the under-selling is factored in. Another way to look at these results is that people who pay a 6% real estate commission are paying for the privilege to lose another 3.7% of their equity because of the agent's behavior. One question that we asked the authors was the generalizability of the results beyond the greater Chicago area. Perhaps the findings are peculiar to this region. Dr. Syverson pointed out that given the sample size (~100,000) and the magnitude of the statistical effects that these results are applicable everywhere. In fact, since the realtor's own MLS data was used claims of data improprieties are not tenable. Plus, realtors claim that their 'brand' ensures a standard of ethics and professionalism that transcends local markets and is applicable on a national scale. Finally, the extent of the effect (under-selling) varied in a linear fashion with the informational advantage the agent had over the client (neighborhood pricing information) suggesting the identification of a cause and effect relationship. We also wondered what the implications of these results were for real estate appraisals. According to this study, real estate values have an artificial discount systematically applied to them when realtors are involved in the sale of another's property. As such, estimates of market value (typically obtained from MLS data by appraisers) are systematically incorrect because of realtor bias. On a practical level, this may mean that if a realtor initially prices a property using deflated MLS sales data and then under-sells the property as described in the paper, that the owner may suffer yet again. The authors suggested that the best way for a homeseller to price their property was have an appraisal from an unbiased real estate appraiser. This is good advice but we now wonder about the accuracy of MLS data for this task. Appraisers need to factor in the significant for sale by owner market in this region and draw their data from these sources as well. Like any good science, the root of discovery begins with observation. The idea for this research project came when Steven Levitt had direct dealing with real estate agents. He fixed up and sold several houses in a suburb of Chicago and , when working with real estate agents, "got the impression they weren't working solely in their clients' best interest." The specific economic relationship between a realtor and a client has inherent, and based on this research, fatal flaws that jeopardize the consumer's financial welfare. The authors point out that the realtor-client arrangement creates economic conflict between the realtor's own welfare and those of his client's. The agent is faced with the choice of accepting less of an offer for his clients to guarantee a commission vs. waiting longer for a higher price and risking not getting a commission. If the agent's were operating in their clients best interests, they would wait longer for a higher price - as the realtors do when they are selling their own homes. Since we started Picket Fence Preview back in 1993, we have emphasized that the best person to look out for the homeowner's interests when selling real estate is the owner and his attorney. Levitt & Syverson have exposed the economic weakness in residential real estate when using a realtor and, importantly, they have quantified the extent of the damages on a percentage and dollar basis. Finally, we'd like to commend Drs. Levitt and Syverson and The University of Chicago for having the courage to publish this research article that exposes the inner workings of the principal-client relationships as it pertains to Realtors and homesellers.

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