The principal-agent relationship is necessary for many of life’s adventures. When you purchase a house, you have an agent help you find the home of your dreams. When you own stock, you have a CEO act in your best interest to manage your company.
Agency relationships are everywhere. However, while the agent provides many benefits from being educated or skilled in an area that you are not, there are inherent conflicts that may arise.
What is an Agency Relationship?
Apart from limited liability, perhaps the most significant benefit that owning stock in a company provides is the separation of ownership and management. You can be an owner of Tesla, Apple, or Ford and not know the difference between an engine and transmission or the code that allows you to read this post on your phone.
This separation enables investors to diversify and participate in the ownership of companies outside of their expertise.
There are, however, potential disadvantages from the separation of ownership and management. An agency conflict occurs when the agent begins to work in their best interest to the detriment of the principle.
For example, a CEO has your company purchase unnecessarily lavish travel accommodations for a board meeting. These accommodations are a benefit to the CEO, but a cost to company shareholders. The agent is not working in the best interest of the principle.
Aligning agent interests with the principle is one of the most popular ways to suppress agency conflicts. Public company executives receive the majority of their pay in stock options and restricted stock grants opposed to a cash salary to increase their exposure to company performance.
If the CEO was paid in cash, then there is no skin in the game. If the company succeeds or fails, year-end pay stays the same. However, if compensation is tied to firm performance, then the CEO will be better aligned with shareholders of the company.
Other stakeholders, specifically bondholders, can align their interests with the CEO by providing compensation packages that include long-term compensation such as pensions, or other long-term incentive plans. These long-term commitments help the bondholders ensure that the CEO will not focus only on short-term goals that appease shareholders, but also on the long-term success of the company.
When working with someone who is working as your agent, take a step back and look at the incentives for both sides of the relationship. Is everything aligned correctly so that the agent’s success is tied to the success of you as the principle? If everything fails, does the agent still get paid?
Conflicts of Interest for Real Estate Agents
The most challenging agency relationship is that of a real estate agent. After recently purchasing a house, I couldn’t believe the potential for agency conflict and the lack of aligned incentives for real estate agents, especially for a buyers agent. Unfortunately, this is a relationship that many will face.
To set the stage, a real estate agent is typically paid around 6% to sell a home. In this case, the agent is representing the seller. In many cases, this 6% will be split between the buyer’s agent once the home sells. For our purposes, we’ll assume a 50/50 split of 3% for each agent.
The Seller’s Agent
The seller’s agent has the responsibility to sell the home for the maximum amount possible. The higher price the home sells for, the higher the commission. So far, not an issue.
The incentives are aligned in the correct direction and if the house doesn’t sell then both the agent and seller receive nothing. The potential for agency conflict arises from the timing of the sale and the willingness to negotiate.
If a seller wants to sell their house for $200,000, the seller’s agent is looking at a commission of $6,000 or 3% of the sales price. Let’s assume an offer comes in one week after the agent lists the house for $150,000. If the seller takes this offer, they will lose $50,000 of their initial selling price and the commission, but it will only cost the agent $1,500 in potential commission. 3% of $150,000 still provides a $4,500 commission, and fast.
The seller’s agent may be inclined to convince the seller to take the offer because the $1,500 difference in commission isn’t worth their time and effort to continue looking for another buyer even though it will cost the seller $50,000.
On top of this, because the magnitudes of incentives are different, there is less potential to negotiate. The agent has a bird in the hand of $4,500 in commission. Trying to negotiate a sales price $10,000 higher will only provide an additional $300.
In these cases, while the incentive is in the correct direction, agency conflicts can still arise when selling a home.
The Buyer’s Agent
The buyer’s agent has even more of an agency conflict. For one, the direction of the incentive is in the opposite direction. The buyer’s agent is paid 3% of the sales price. The buyer hopes to spend as little as possible, but their agent is paid more when the house sells for more. This is a direct conflict of interest.
Also, even though the buyer has many housing options and would be better off looking at as many homes as possible, the buyer’s agent is incentivized to find a home quickly and a home that is at that the top of or excess of the buyer’s budget.
Finding a home quickly or making the situation seem like houses are in short supply only guarantees a faster payout for the agent. Trying to convince the buyer to purchase a home at the top of their price range gives a higher commission.
In the same case as the seller’s agent, the buyer’s agent is also not incentivized to negotiate or purchase at a discount. Doing so will only reduce their payday upon closing.
Is there a solution?
It is clear that there are incentive alignment issues, especially for a buyer’s agent. Much like investment advisors, a flat fee relationship would provide a better environment for this type of agency relationship. Paying a flat fee regardless of property price would help make sure the agent offers advice that is consistent with the buyer or seller getting what they want opposed to having the potential for agency conflict.