How do numerical biases affect how a consumer perceives realtor fees?
Paying $15,000 to purchase a $500,000 home for what? For a broker to open a door for you? You can find a house on Zillow or realtor.com, right?
There has been a lot of discussion in the news lately about Realtor fees, and it goes something like the above.
Some consumers perceive the fees associated with transacting real estate are too high. But are they really, or do people just not understand the size of the leveraged asset they are purchasing and the quality of the consulting services they should be getting?
I have been puzzling over the math of Realtor professional fees since the NAR lawsuit hit the news. Why is there such controversy about these fees, and yet our group of very sophisticated clientele doesn’t seem to see an issue at all with our fees? Something isn’t adding up.
I started thinking about the math involved and have been working on different ways to explain the services we provide in the broader context of a real estate investment over time.
Real estate is not meant to be bought and sold quickly and frequently. One should only purchase if they think they will be living in the same place or investing in this location, for a longer period of time. Over a short period of time, real estate, like all markets, can be volatile, but over a longer period of time, it tends to be more forgiving.
The St Louis Fed chart of Austin MSA housing prices is below.
I started with our portfolio built over the last 24 years to analyze how realtor fees impacted long-term profits. Doing back-of-the-envelope math, it was apparent that the realtor's fees were negligible in my portfolio (had I used a realtor), but I wanted to build a simple explanation to visualize the concept so I could share it easily.
Here is a screenshot from that tool
The model is a theoretical purchase, a sales price of $500,000.
$100,000 down payment with a modest 3% appreciation and holding for 30 years.
The chart below shows a 20-year timeline.
This tool can modify the appreciation assumptions.
We always like to use 3% appreciation because the Fed's target rate of inflation is 2%. 3% seems like a modest conservative long-term guesstimate. A few years ago, pre-2020, we downloaded the Austin data, and it had been 3% on average over the prior 30 years, which I think serves me well for long-term worst-case scenario planning.
The red areas in the chart are the fees that would be incurred. While professional fees are always negotiable, I used 3% of the sales price on the purchase and sale to give an example. The grey area is equity, which refers to both the initial investment and equity growth over time.
The equity grows from $100,000, the consumer's capital investment when they purchase, to $664,000 over 20 years, an increase of $554,000.
While significant in terms of how we spend money in our everyday lives, the $15,000 professional fee involved in purchasing a $500,000 asset that can grow into $1M over 20 years isn’t a large percentage of the equity built over time. Getting great advice on an asset to be sure a consumer purchases a property without latent defects, and one that is likely to appreciate as much as possible over time, seems well worth the cost, considering the 20-year outlook of expected profit is more than $500,000.
So why is there a disconnect between public musings about realtor fees and this math?
I believe at the heart of this is an observational bias that people have when it comes to analyzing large numbers. We saw this in a trading environment when we were managing the risk of other traders. Traders would become paralyzed by the numbers when they had large positions because humans are not used to leveraged transactions of this magnitude. It was not unusual for somebody with a $100,000 trading account to trade $10 million in positions. This could rob them of the confidence to think clearly and make good decisions.
We have also seen this same bias when helping long-time property owners prep their properties for sale. Sellers who purchased their homes for $300,000 15 years ago and have their homes on the market for 1.5 million agonize over spending $3,000 on staging.
Why would somebody be so concerned about spending 1/4 of one percent to prep a $1.5 million asset? If they purchase their home for $300,000 and own it for 15 or 20 years, they have the opportunity to refinance at some point, and their mortgage payment is likely less than $600 a month. The $3000 monthly staging fee is five months' mortgaged payments. While this feels astronomical in how they spend money every day, is doesn’t take into account the asset and how best to present it visually to capitalize on the potential profits.
The difficulty people have in understanding large numbers and the value of a percentage in the context of large transactions can be related to several cognitive biases and psychological phenomena.
Anchoring Bias: People anchor their thinking on smaller, everyday financial transactions and fail to adjust appropriately when dealing with larger sums of money. For example, a 3% fee on a $10 purchase feels trivial, but the same percentage on a $1,000,000 transaction feels substantial, even though it's the same proportion.
Numeracy Bias: Many people struggle with basic mathematical concepts and large numbers, affecting their ability to accurately assess proportions and percentages. This bias is related to the general difficulty in understanding and processing numerical information.
Most people don’t make massive leverage purchases daily.
It’s not a normal part of everyday life, and it’s very difficult to contextualize. When we were in finance, we had to make decisions on highly leveraged potions daily, so this way of thinking came more naturally to us.
I suspect this is also the reason our C-suite clients have fewer concerns about our professional fees, they are used to making decisions on higher sums than most people are on a daily basis. They also have less tolerance for DIY solutions for anything as their time can be better spent elsewhere, and they believe strongly in outsourcing to professionals who specialize in areas outside their expertise.
We are delighted to be your guides to real estate and always happy to nerd out of the details with you.
Cheers,
Jen & the team
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