Realtor Commissions: A Lesson in Incentive Compensation

May 11, 2014

The standard realtor commission structure doesn’t motivate the realtor to do his or her best for you. As you read this post and my suggested improvement, think about how this situation relates to the incentive compensation plans in your own enterprise, and why incentive compensation is such a delicate art.

Here’s the problem: The standard realtor commission is a straight 6% of the sales price, paid by the seller. That 6% is divided evenly between the listing firm and the buyer’s firm, and each firm’s 3% is divided evenly between the firm and the individual realtor. So if you sell your property for, say, $500,000, your realtor pockets 1.5%, or $7,500.

Now, how hard will your realtor work to get you a price that’s, say, $20,000 higher, if that means an extra couple of weeks work? $20,000 is certainly material to you, but that only means an extra $300 in your realtor’s pocket – hardly enough to justify the distraction from working with other clients. [This incentive problem has long been pointed out, most notably in Freakonomics, the excellent book by Steven Levitt and Stephen Dubner.]

Instead, let me offer this modest proposal for revising the commission structure: Each realtor competing for the listing proposes an asking price for the property. The owner chooses one of the realtors. The “Base Commission” is 6% of the asking price proposed by the winning realtor. The actual commission depends on the sales price, and is computed as follows:

  • Exactly the asking price – the Base Commission (just like the old way)
  • Above the asking price – the Base Commission, plus 12% (not 6%) of the difference between the actual sales price and the asking price
  • Below the asking price – the Base Commission, minus 12% of the difference between the asking price and the actual sales price

The advantages of this approach are:
  • Sellers will still be inclined to choose the realtor proposing the highest asking price, because (a) that minimizes the commission at any given sales price and (b) a high suggested asking price may indicate an enthusiastic realtor.
  • Even so, realtors will think twice about proposing too high an asking price because their actual commission is affected by that asking price. The result is a disincentive to “highball” the asking price – a disincentive that certainly doesn’t exist under the current scheme.
  • Realtors will try harder to get the seller a better price, because the marginal commission rate of 12% on the additional dollars is double the Base Commission rate of 6%.

The most important lesson, which applies to all incentive compensation schemes, is this: The real art lies in paying the recipient fairly not when he/she exactly achieves expected performance – anyone can design a comp plan to do that – but when actual performance is significantly above or below expectations.

“Painting with Numbers” is my effort to get people to focus on making numbers understandable. I welcome your feedback and your favorite examples. Follow me on twitter at @RandallBolten.

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