The Principal—Agent Problem in Real Estate

The PropertyClub Team
Apr 24th 2019
Have you ever wondered if your real estate agent is working in your best interest? Or are their actions motivated by their own best interest? The principal-agent problem is a common occurrence in real estate and can result in financial harm towards the principal (in real estate this could be the buyer, seller, renter or landlord).

What is the Principal-Agent Problem?

The Principal-Agent problem occurs when a principal has hired an agent to act on their behalf or provide them guidance or other services, and when the interests of the agent and principal do not align. This can cause financial harm to the principal and is consider a moral hazard.

Examples of the Principal-Agent Problem in real estate:

Conflicts of interest can arise in all types of real estate transactions, but the most common in terms of severity are as follows:

Listing and pricing your home can be a major problem as agents may overpromise on price to win a listing, negatively impacting your ability to sell the home. 

Getting the best possible price can present an issue as agents may consider closing a sale quickly to be more important than getting you the best price. 

Buyer agent problems can occur when you are looking to buy (or rent a home) and your agent uses the knowledge they have of your budget and finances to their advantage. 

Listing and pricing your home for sale

The best example of the principal-agent problem occurs when a seller wants to list but hasn’t decided on an agent yet. This creates the possibility of a conflict of interests arising as the seller’s goals are to find the best agent to list the home and get the best price (which includes pricing the home as the listing price has a major effect on the time it takes for a home to sell as well as how much it sells for) while the agent is only interested in getting the listing. And what better way to get a listing than to promise an unrealistic price. There are many agents who overpromise when they pitch and list a home for too high of a price, knowing full well that after X days on the market they’ll come back to the seller and push for a price drop. It’s very difficult to combat against this type of behavior with the existing model (in which listing agents are paid by commission and receive long exclusives that last for 3-6 months at a minimum). Even if a seller makes it explicitly clear that they will not consider any price drops the agent may still be interested in getting the listing (knowing that it won’t sell) as it can be used to generate other business. For realtors a new listing is an invaluable asset which can help them land additional listings and will also generate buyer leads.

How can you help prevent this?

The best strategy would be to hire an agent and compensate them for professional services instead of via commission. Agents who charge a flat listing fee or agents who bill for hourly services will have their interests aligned with your own. Alternatively, you can simply hire an agent to perform a detailed CMA (comparative market analysis) as pricing a home right is essential.

Another tip is to be wary of agents who promise to get you the highest prices. If you interview multiple agents most will give you a rough estimate of the value or even a basic CMA during their pitch and avoiding any outliers on the high-side makes a lot of sense. 

Finally, if you're selling and then buying in the same market using the same agent for both transactions is another great strategy as your agent will be incentivized to provide better service due to the repeat business.  

Selling your home: waiting for the best possible offer

Another issue can arise due to the fact that while agents are compensated on commission, getting the absolute best possible price might not always be in the agent’s interest. Your agent might claim that your interests are aligned due to them earning a greater commission when you get a higher sale price, but is that really the case? Let’s consider for a second that you’ve listed your home for $920,000 and after 2 weeks on the market, you receive an offer of $900,000. If your agent is earning a 3% commission do you think they’ll risk losing out on a $27,000 commission just to try and earn an extra $600? Even if they know they’ll receive more offers is it worth the extra time and effort for them to keep the house on the market for another 2 weeks? In many cases, the answer is “no”. Studies have even shown that when agents sell their own homes they typically keep them on the market for approximately 10 days longer and get around 3% more for them than if they were marketing the same home for a client.

It is worth noting that many sellers consider selling a home to be one of the most stressful experiences in their life and at times it may also be the seller’s interest to get a deal done as quickly as possible, while an agent listing their own home might have more of an appetite for letting a home sit on the market, having more people in their home, etc. This is one of the main benefits owners who sell to ibuyers list. They don’t want to deal with the hassle, headaches, uncertainty, and length of selling traditionally and are willing to leave some money on the table for convenience and transaction speed. At the end of the day, the best advice is that if you’re happy with the offer you should probably accept it and not stress over what other offers could have materialized.

A final note is that this specific example of the principal-agent problem is most likely to occur when homeowners are moving out of a city, as that means there’s less likelihood of repeat business. If the possibility of repeat business exists that will create a strong incentive for the agent to get you the best possible results. One suggestion for sellers who are looking to move within the same area would be to also have their listing agent represent them when they are buying as an agent who sees you as a repeat client or “client for life” will strive to deliver only the best results.

Buying or renting a home

Problems can also occur when you have buyer agent representation. A buyer or renter's agent will be privy to a certain amount of your financial information and can use that their advantage, to help ensure they earn a commission or to increase their earned commission. The two most common examples are when an agent negotiates price less than they could to ensure a deal goes through and they earn a commission or when an agent uses knowledge of your finances to increase your budget, earning them a bigger commission. Many agents will even go through training on how to get their buyers and renters to increase their budget as in large cities like New York City it's quite common for the average renter or buyer to raise their budget by 10 or even 20% over the course of their home search. 

As a general rule, buyer and renter agent problems are less common and less grave than when they happen on the sale side. This is due to the fact that most buy-side agents treat buyers as potential repeat clients/clients for life, resulting in providing them with the best possible service they can. You also have much more flexibility when it comes to choosing your agent representation as you're not locked into a long-term listing agreement, and can always switch to a new agent. This puts added pressure on buy-side agents to act in your best interest.