Commissions

Who really pays the commissions in real estate sales?

When a home is overpriced, the buyer pays all of the commissions.  Here’s how:

In this example, a home sells for $4,000,000.  The seller originally purchased the home 20 years ago for $1,600,000.  The current property tax assessment, just or “market” value is $2,800,000 (note: this is the value disclosed on the annual TRIM notice, and not necessarily the amount that is used to determine actual taxes to be paid, since many homes are homesteaded).  A recent property appraisal values the home at $3,500,000.

In scenario #1, the buyer pays $4,000,000.  The commission arrangement is 5%, split evenly between the seller’s and buyer’s agents.  The seller’s agent receives $100,000, the buyer’s agent receives $100,000 and the seller receives $3,800,000.

In scenario #2, the buyer pays $3,500,000 (i.e., the appraisal value of the property).  The commission arrangement is 2.5% (i.e., $87,500) being paid to the seller’s agent by the seller, with 2.5% (i.e., $87,500) being paid to the buyer’s agent by the buyer. So the seller would receive $3,412,500 (rather than $3,325,000). 

Interestingly, a NAR settlement agreement changed what the seller in scenario #1 would receive.  Rather than receiving $3,800,000 at closing, the seller would instead receive $3,900,000.  However, the seller was already receiving $387,500 more in scenario #1 than the $3,412,500 in scenario #2.  Especially in the case of a cash sale where no lender is involved to require a property appraisal.     

So if the buyer overpays (i.e., purchases the home for $4M instead of $3.5M), who really pays commissions?

When a home is sold, the commissions paid are based on sales price, not profit. Why?

In the car sales industry, commissions paid are based on profit margin, not sales price.  A vehicle that sells for $40,000 requires an additional factor in order to determine commissions to be paid.  That factor is cost.  If the $40,000 vehicle costs the dealer $32,000, the gross profit margin is $8,000 which is the basis for commissions.  If the vehicle requires additional costs prior to sale, those costs are added which reduces the margin.  So, if a car dealer’s total cost is $34,000 for a vehicle that sells for $40,000, commissions are paid on $6,000, not $40,000.  For example, $1,800 or 30% would be paid to the salesperson involved and $4,200 (i.e., the balance of the profit) would go to the dealer or dealership.

For some odd reason, real estate uses sales price to determine commissions to be paid.  And yes, the more expensive the property the bigger the commission.  The good thing about cars is that most are not overly unique or outfitted with personal preferences.  In vehicle sales, colors, interiors and features are usually industry standards.  However, a home can truly become an extension of one’s tastes.  Appointments, finishes, features, colors, and décor are only a few of the areas that could present a challenge for real estate sales personnel. 

Also interesting with real estate is that maintenance costs and many personal preferences are included in the sales price.  So a home that sells for $4,000,000 that has an appraisal value of $3,500,000 and a property tax assessment just or market value of $2,800,000 uses $4,000,000 as a basis for commissions.

Here’s an alternative solution to consider:

In this example, the seller purchases a home for $1,600,000 twenty years ago.  Over the years timeless and very tasteful upgrades are added to the home which totals $700,000.  Any and all maintenance performed on the home is excluded and noted separately as maintenance costs.  Therefore, the original purchase price plus upgrades equals $2,300,000.  The profit margin would be appraisal value ($3,500,000) less total costs of $2,300,000, equaling $1,200,000.

If the commission arrangement is 2.5%, the seller’s agent would receive $30,000 and the seller would receive $3,470,000.  The buyer would pay $3,500,000 for the home and $30,000 for the buyer’s agent’s commission for a total outlay of $3,530,000.

So the real question is should commission in real estate be based on sales price or profit margin?