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Keller Center for Research

How Consumers Respond to Commissions

June 1, 2008

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Ann Mirabito, PhD

The traditional real estate commission structure is under fire. Commissions used to average six or seven percent, but with the escalation in housing prices over the past decade many local markets are seeing four or five percent as the norm. And many sellers are tempted to seek lower commissions. Articles in the popular financial magazines and on consumer web sites encourage home sellers to negotiate commissions. Discount brokers claim that traditional brokers are overpriced. Adding fuel to the fire, in today's soft housing market, the agent's commission may exceed the cash the seller gets from the sale of his home. While many home sellers are satisfied with the traditional commission structure, the constant barrage of warnings leaves many sellers skeptical about the fairness of full-priced commissions.

For some prospective clients, the level of the commission may seem to be unimportant. The human mind has a difficult time translating percentages to dollars. Because the percentage seems like a low number, many home sellers may ignore it until you present the contract. And then, even sellers who may not ask directly often wonder what they're getting for their money.

How Much Do Your Services Cost? Viewing Commissions as Prices

Real estate commissions represent the price sellers pay to brokers for selling their homes. The traditional commission structure has one of the hallmarks of good pricing: it is easy to understand. Cellular telephone service providers offer a bewildering number of service packages and an even more bewildering number of pricing variables within those packages. A consumer's monthly bill depends on the kind of messages transmitted (voice, text, email, pictures), the time of day of transmission (peak and off-peak), and the level of transmissions contracted in advance. Consumers generally prefer simple structures, and the traditional real estate commission structure is simple.

Real estate commissions also eliminate uncertainty for the client, another aspect of good pricing. The price is typically a flat percentage regardless of the number of resources required to perform the service. Some lawyers and architects and other service providers charge their fees based on the number of hours or other resources used. The client knows the hourly rate, but is unsure of the total bill until the project is completed. Consumers are generally risk averse; they prefer to shift that risk to the service provider. Brokers that offer a traditional commission structure remove that risk from their clients.

However, perhaps the most important element of good pricing is that it must reflect the value of the service to the customer. Clients who are unsure of what they are getting for their money are more inclined to think the price is unfair. Value reflects the benefits the consumer receives, less the costs paid to get those benefits. Consumers skilled at assessing the value of other products are often daunted by the task of discerning the value of real estate services.

Service Quality Is Difficult to Evaluate

Think about how you decided how much to pay for your new big screen HDTV and how you decided whether that price was fair. If you're like many people, you visited a couple of home electronics stores and compared the features and costs of various models. You may have read the sales literature and examined the richness and clarity of the pictures on the demo models. If you are particularly price sensitive, you may have looked for rebates or other special pricing. You selected the model that offered the highest quality and the most features for the amount you could afford to spend. You looked for the best value.

Clients cannot evaluate real estate service quality and prices as easily as you evaluated HDTV prices and, as a result, homeowners may be particularly sensitive to the fairness of commissions. Brokers offer clients a service, not a good. And, by their very nature, services are harder to evaluate than goods. Real estate services are intangible. Unlike consumer electronics buyers, home sellers cannot visit a store and head for the real estate aisle where they will examine informational literature and compare the quality and prices of various choices. All real estate offices offer the same solution ("We'll get the best price for your house") but the way they perform the service and their ability and willingness to deliver on the promise varies widely.

Products differ in the extent to which consumers can evaluate their quality and when that evaluation occurs. Services are particularly difficult for consumers to evaluate, and that evaluation often cannot be made until after the service is performed. Economists have coined terms to describe product attributes based on when quality can be evaluated by the consumer. Search characteristics can be evaluated prior to purchase, experience characteristics can be evaluated during or after the purchase, while credence characteristics often are never fully evaluated. Unlike services, the quality of many tangible goods can be evaluated prior to purchase. In buying a sweater, for example, you can often determine the quality of the style, fabric and workmanship before heading to the cash register. The quality of services often cannot be evaluated until the service has been performed. If you're going out for dinner, you can evaluate the menu selection and décor prior to ordering. But you won't be able to evaluate the flavors, textures, and presentation of the entrees and the appropriateness of the service until you've experienced the meal. Restaurant reviews and your prior experiences may help you form expectations for the service quality, but the actual quality of tonight's meal will depend on your server's training and mood, and the chef's ability to procure fresh ingredients for tonight's menu. Some products have so-called credence attributes that are even more difficult to evaluate. A physician's medical skill may forever elude a patient. Was the poor surgical outcome a result of the surgeon's error or because medical science is unable to deal with the patient's particular illness?

Real estate services are rich in hard-to-evaluate experience and credence attributes, those that ultimately are most important to clients. While clients may be able to search for agents who specialize in their neighborhood, they will be unsure of the agent's responsiveness and marketing prowess until after the listing contract has been signed and the agent has begun to perform. The client may never be able to ascertain fully the quality of other aspects of the listing agent's performance.. Did the disappointing contract price reflect the agent's negotiating skill or market conditions? The inability to evaluate real estate services until after committing to the listing agreement - or, perhaps, never - creates a cloud over the client's ability to determine the value of the services.

The quality of service performances are belonging to a thing by its very nature intrinsically composed of parts of different kinds; having widely dissimilar elements or constituents heterogeneous, adding to the risk clients perceive. Manufacturers are better able than service providers to deliver goods of a consistent quality. Despite a firm's best efforts at training and setting quality standards, the quality of the service provided by agents within the office varies. The quality also varies within an individual agent. Clients implicitly recognize this variability in quality, making it difficult to determine the agent's value. Of course, agents also experience the risk associated with services. Service quality often depends on the client's ability and willingness to cooperate with the service provider. Agents are often unsure of how responsive the seller will be to requests to show the home on short notice and what the condition of the property will be when prospective buyers tour the property.

Clients expect your price to be somewhat related to your cost structure. While clients can sometimes discern the cost structure of goods, they tend to underestimate the cost structure of businesses in which the costs are largely overhead. And that highlights another difference between services and goods that influences clients' perceptions of price fairness. You weren't in the Sony factory, observing the manufacture of your big screen HDTV. But your clients may be in your service factory, observing the way you and your colleagues conduct your work. For agents, your service factory is often out in the field, in clients' homes and in your car. Clients observing an agent working an open house or showing homes to prospective buyers may underestimate the skill required to perform those tasks effectively. Good agents make those processes enjoyable for clients. So not only are clients notoriously handicapped in discerning your overhead costs, they may also think it is fun for agents to spend their day showing engaging home buyers interesting properties. Clients' presence in your service factory obscures their ability to figure out fair prices.

Showcase the Value in Your Proposal

Because the value of your services is difficult for clients to appreciate, the listing agent's task is to fully educate home sellers. Evaluate the way your agents present listing proposals to sellers. Clients who object to a full commission are typically ignorant of the value associated with a traditional brokerage. Does your proposal demonstrate the value the home sellers will gain from working with your team? High-quality, traditional brokers offer many services that home sellers may overlook in evaluating the fairness of the proposed commission.

When you're presenting your services, think of the classic Ginsu knife TV commercials. The announcer explains that you get not one, not two, not three, but six knives. And then he promises "But wait, there's more!" Those advertisements leverage an important aspect of consumer psychology: more is better. While you certainly don't want to adopt the tone of a carnival barker, your clients will appreciate knowing all that they are getting from your services. Ask yourself:

• Do you describe your marketing plan in detail? Rather than saying you'll advertise the house, show when and where you'll advertise it. Show the quality of your photography. Explain in detail how agents' open houses work and what you'll do to encourage agents to show the home. Paint a clear picture of how your marketing will attract qualified buyers.

• Do you explain how your telephone system works and the hours that it's manned? Inexperienced home sellers may not understand the importance of having the telephone answered promptly by a pro who can fully describe the home and its special features and arrange for immediate showings.

• Do you demonstrate your special expertise? Are you a great negotiator? Recount a specific example of how your savvy negotiations turned into a higher contract price for a seller. While statistics demonstrating your prowess are powerful, for many clients anecdotes are more memorable.

• Do you show the financial impact of your expertise? By illustrating the benefits of a faster closing and better qualified buyer, sellers will be able to see the impact on their bottom line.

Finally, recognize that the full services provided by traditional brokers may not satisfy all clients' needs. Clients selecting real estate services, like all other clients, are heterogeneous in their needs and ability to pay for services. The value proposition offered by a traditional broker may not meet some clients' needs, but most clients will be better satisfied with your commission structure when they fully appreciate the value you are offering.

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For further reading:

Berry, Leonard L. and Yadav, Manjit S. (1996), "Capture and Communicate Value in the Pricing of Services," Sloan Management Review (Summer) pp 41-51.

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About the Author:

Ann Mirabito, PhD
Assistant Professor of Marketing, Baylor University
Keller Center Faculty member

Ann researches how consumers make complex decisions related to value (quality evaluations, price fairness, risk management) and the role of biases and heuristics in those decisions. Ann earned a PhD from Texas A&M, MBA from Stanford, and BA in Economics from Duke. Before becoming a professor, she was a marketing executive with Time Warner, Frito Lay, and Rapidforms, specializing in revitalizing companies by reinvigorating product lines and infusing employees with a desire to make magic happen for customers.

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