What Is the Principal Agent Problem in Real Estate?
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. In a real estate transaction, the principal is the party that an agent is representing and can be either the buyer, seller, renter, or landlord.
Principal-Agent Problem Examples in real estate:
Conflicts of interest can arise in all types of real estate transactions, but the most common situations where the principal-agent problem occurs are the following:
Listing and pricing your home can be a significant problem as agents may overpromise on the price to win a listing, negatively impacting your ability to sell the property.
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.
How the Principal-Agent Problem Occurs when 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 significant 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.
Many agents 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 challenging to prevent this type of behavior with the existing model (in which listing agents are paid by commission and receive lengthy exclusive agreements 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 that can help them land additional listings and generate buyer leads.
How can you help prevent this?
There are a variety of strategies you could employ, each with their positives and negatives. One option would be to list your home FSBO (For Sale By Owner), but there’s always a significant risk that you misprice the property. Sellers are notorious for finding reasons to list for too high of a price, ranging from “I’m not in a hurry to sell and can always drop the price later” to “This agent told me it’s worth more.”
One solution would be to hire an agent to perform a detailed CMA report (comparative market analysis) as pricing a home right is essential. This way, you benefit from having an expert price the home while removing any conflict of interest. In general, any type of compensation for professional services over commission will help to align the interests of both parties. In some cases, sellers can even take this a step further by hiring and compensating a broker by the hour. These types of arrangements are highly unusual in the US but have been tried in other parts of the world with excellent results.
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.
How the Principal Agent Problem Occurs When Selling Your Home
The principal-agent problem can also occur 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 fatter commission check 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 two 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 to try and make an extra $600? Even if they know they’ll receive more offers, is it worth the additional time and effort for them to keep the house on the market for another two 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 ten days longer and get around 3% more for them than if they were marketing the same house 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 primary benefits owners who sell to ibuyers mention. 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.
Can the Principal Agent Problem Occur When Buying or Renting a Home?
Conflicts of interest 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. 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% during their home search.
As a general rule, principal-agent problems are less frequent and less grave when they happen with buyers or sellers compared to when they occur on the sale side. This happens because 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.
Principal Agent Problem Bottom Line
The principal-agent problem in real estate arises due to potential misalignments between the homeowner’s goals and the agent’s incentives. Understanding this dynamic is crucial for homeowners to take steps to mitigate the problem, ensuring that their interests are prioritized in the transaction. By implementing strategies like performance-based incentives and maintaining open communication, homeowners can better align their agents’ efforts with their own objectives.