This post was co-authored with Ruwin Perera (Formerly Softbank, Google, BCG). It's the first in a series that looks at real-estate startups.
For most people, buying or selling a home is the most expensive transaction they will ever conduct. After recently putting our Russian Hill, San Francisco home on the market, we keep asking ourselves why selling a home is as expensive as it is.
After all, many of the best online marketplaces use the internet to cut out the (usually less efficient human) middleman. Stocks change hands via online brokers; travel arrangements via OTAs; and even labor via Mechanical Turk. So, it’s hard to fathom why the ~$60 billion residential US real estate market [1] hasn’t been disrupted by the internet.
Let's start by looking at the primary transaction costs of a sale. They include agent fees, legal and recording fees, title insurance and transfer taxes. And regardless of whether the buyers or sellers notionally “pay”, these costs are baked into the sale price, so the sellers always pay in the end. In the US, these costs can amount to as much as 10% of the closing price.
If we assume that US residential property increases in value at a rate of 3-5% per year [2], and the average American stays in their home for 13 years [3], that 10% transaction cost quickly becomes a sizable chunk of real gains. Of course, that’s without taking into account that most people would be hard pressed to see a 5% CAGR outside of strong real estate markets like New York and San Francisco.
What’s more, this 10% rate seems higher than other culturally and economically similar countries:
Source: Global Property Guide, updated 2014.
Note: this is based on typical values, as many costs and taxes are calculated on a sliding scale
That’s not to say that each of the individual fees are excessive. Government transfer taxes are a much higher proportion in some countries. This can be a good thing because these costs are often imposed to dampen speculation and volatility in the market. However, it’s hard to apply that same reasoning to agent fees. Now, we believe agents provide real value and should be well compensated for their work. Our only question is why the agent's share is higher in the US. Here’s the comparison of just the typical agent fees for the same group of countries:
Source: Global Property Guide, updated 2014
Is there a model where Americans could pay lower agent fees? We evaluated the cost-cutting approaches, and we couldn't find any that would work successfully in the current market structure.
You can’t cut buyer’s commissions (e.g., exclusive listings, FSBO, REX).
Much of the cost differential above is driven by the fact that the UK and Australia don’t use buyer’s agents. But their role in the US seems assured for the foreseeable future. For one, many US buyers tend to value the service they provide, and two, sellers pay both the seller’s and the buyer’s agent commission, so there's little incentive for buyers to forgo agents.
Buyer’s agents are motivated to show clients properties that they get paid on. So if the commission is cut, buyers agents may simply ghost the property. Why waste time going to open houses, doing market research and supporting a client through the process only to not get paid when they finally make an offer?
And while the sellers might not like paying the fee, they know that the more buyers, the better the chance of a high offer. Today, 87% of buyers are represented by agents. Interestingly, penetration is highest amongst those under the age of 35. It is a very brave seller who will risk losing out on 87% of the market.
Source: National Association of Realtors, Accessed 2016
You can’t cut seller’s commissions (e.g., Redfin and other discount brokers)
This is one of the biggest transactions in a seller's life, so there is a huge perceived monetary risk in choosing a "bad" agent. For this reason, even discount brokers need to hire the best agents. We think the best agents are those who can provably move the most dollars of real estate. Of course, "best" can be defined in many other ways but a history of high sale prices is extremely compelling to a seller.
Now, there are a lot of agents in the US; the average UK agent closes 40 deals per year but the average US agent closes only 7 deals [4]. However, this is somewhat misleading because the US has many part-time agents who only close 1-2 deals per year. For example, in 2011, part timers made up 43% of all agents [5]. So there are “agents” and then there are agents. For the purposes of this post, we only care about the top tier of the latter group.
Those agents are already well served, as the system today rewards the best. The top 5% producing agents can keep more than 80% of the fees they generate, with less than 20% going to the firm. Put another way, they pocket nearly 2% of the purchase price of the property.
Given these economics, it’s hard for us to see how a salary + bonus + cost reimbursement model (e.g., Redfin) can both make money and attract top agents when their proceeds from the sale are only 1.5%. Redfin passes through the typical buyers commission.
While we haven’t factored in the costs of being an independent agent, which will decrease net pay, these costs are a smaller percentage of revenue for a top agent vs an average agent. If you believe that agent quality is the key determinant for success, it follows that discount brokerages will have a hard time hiring and keeping the best agents. And if they can't get the best agents, they can't convince the sellers.
So, if you can't just cut commissions on either side, what else might you do? That’s the next post in this series. Stay tuned.
Sources:
[1] Wall Street Journal | U.S. Existing-Home Sales Rebound in December derived from 2015 units sold and median sale price, assuming 5% commission
[2] Federal Housing Financial Agency Statistics
[3] Eye on Housing | National Association of Home Builders
[4] The Economist | The Great Realtor Rip-off
[5] Redfin | How Much Does a Redfin Agent Earn?