My wife and I went under contract on a new home this past week. It’s all very exciting but also kind of a stressful situation. The new home won’t be finished until spring so we have a few months to plot our course of action on how to sell our current home in the meantime.
The thing I’ve come to understand since becoming a homeowner about 10 years ago is that the way homes are priced is not a science by any stretch of the imagination. The price setting mechanism seems to revolve around sticking your finger in the air and seeing which way the wind blows.
There’s no daily market price on an exchange that you can use to gauge a fair market value. You can look at comps on the Internet or see the prices of recently sold homes in your area, but there are rarely perfect comps for most homes. Buyers and sellers alike are fickle and driven by emotion because our homes are emotional assets. Throughout our home search, I’ve looked at countless houses where the prices seemed completely detached from reality.
Sellers always hope to get the highest price they can while buyers hope to undercut that price.
Not only are buyers and sellers dealing with each other’s often skewed opinions about the value and price of a home, but they’re also dealing with real estate agents who may or may not have their best interests in mind (for the record, our real estate agent is great).
The average realtor commission is around 6% on the sale price of a house. But the way it typically works is that 6% is split evenly between the buyer’s agent and the seller’s agent. So that takes it down to 3% per sale. Then the realtors roughly split that take with their agency, leaving them 1.5% of the total take. So for every $10,000 bump in price they only earn an extra $150 or so. That $10,000 can mean a lot for the seller, but not quite as much to the real-estate agent.
I’m sure many realtors have to wonder if it’s worth the extra time and effort for them to get you a little more cash on a sale or just close the deal for less and move on to the next house.
Stephen Dubner and Steven Levitt performed a study in their book, Freakonomics, to see how these incentives can play out in the marketplace:
There’s one way to find out: measure the difference between the sales data for houses that belong to real-estate agents themselves and the houses they sold on behalf of clients. Using the data from the sales of those 100,000 Chicago homes, and controlling for any number of variables — locations, age and quality of the house, aesthetics, whether or not the property was an investment, and so on — it turns out that a real-estate agent keeps her own home on the market an average of ten days longer and sells it for an extra 3-plus percent, or $10,000 on a $300,000 house. When she sells her own house, an agent holds out for the best offer; when she sells yours, she encourages you to take the first offer that comes along. Like a stockbroker churning commissions, she wants to make deals and make them fast. Why not? Her share of a better offer — $150 — is too puny an incentive to encourage her to do otherwise.
I’m not convinced that there are all kinds of real estate agents acting in such a nefarious way as these guys suggest, but humans do respond to incentives and sometimes those incentives guide our actions even if we don’t realize it.
On the other hand, most homeowners assume their home is worth more than it really is. During the real estate crash, many people were anchoring to peak bubble prices when in reality the entire market dynamic had changed and their homes were worth much less than they thought. We have huge blind spots when trying to realistically price our own assets.
Richard Thaler and Daniel Kahneman performed a study with college undergrads which helps illustrate this point. First, they gave brand new coffee mugs to half the class while leaving the rest of the students empty handed. Next, they went about trying to set market prices for the coffee cups through a series of negotiations. They found that those doing the selling wouldn’t part ways with their new cups for anything less than $5.25 while those who didn’t have the cups wouldn’t pay more than $2.75 or so for a new mug.
This idea — called the endowment effect — stems from the fact that we humans are loss averse. We hate letting go of something for less than perceived value. There is also the idea that we place a higher value on something we currently own or possess. Once something comes into our possession it’s tough to think about its value in a rational manner.
Now imagine how many times this endowment effect is amplified with all of the pride and emotions that come into play with the roof over your head. My wife and I love our current home. It’s going to be really hard to say goodbye to it. We have a lot of fond memories there. I know I should make an unemotional decision but that’s not always so easy.
Pricing a home feels like an antiquated process yet somehow the residential real estate market continues to function. I guess the best solution is to find some middle ground between what a real-estate agent may tell you a home is worth and what you personally think it’s worth by splitting the difference. Half way between commission incentives and the endowment effect could be the perfect selling price for your home.
Hopefully, I’ll be able to take my own advice as I go through this process…
Animal Spirits in the Real Estate Market