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Understanding In-House Transactions in the Real Estate
Industry*
Brokerage
Lu Han Seung-Hyun Hong
Rotman School of Management Department of Economics
University of Toronto University of Illinois
lu.han©rotman.utoronto.ca hyunhong©illinois.edu
April 8, 2016
Abstract
About 20% of residential real estate transactions in North America are in-house transactions, for
which buyers and sellers are represented by the same brokerage. This paper examines to what
agents'
extent in-house transactions are explained by agents strategic incentives as opposed to matching
efficiency. Using home transaction data, we find that agents are more likelyto promote internal
listings when they are financially rewarded and such effect becomes weaker when consumers are
agents'
more aware of incentives. We further develop a structural model and find that about
agents'
one third of in-house transactions are explained by agents strategic promotion, causing significant
utilityloss for homebuyers.
Keywords: incentive misalignment, realestate brokerage, in-house transaction, agent-intermediated
search, structural estimation
JEL classification: C35, C51, L85, R31
*We thank the editor,two anonymous referees,conference participants at the Stanford Institute of Theoretical Eco-
nomics, Pre-WFA Summer Real Estate Symposium, Rotman Real Estate Microstructure Conference, AREUEA Meeting,
IsraelReal Estate and Urban Economics Symposium, as wellas seminar participants at the Atlanta Fed, Korea Univer-
sity,National Science Foundation, Penn State, Seoul National University, UC Berkeley,UIUC, University ofAmsterdam,
and University ofToronto for theirhelpful comments. Contact information: Lu Han, Rotman School of Management,
University of Toronto, 105 St. George Street,Toronto, Ontario, Canada M5S 3E6. Seung-Hyun Hong, 213 David Kinley
Hall, 1407 West Gregory Drive, Urbana, IL 61801.
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1 Introduction
Over 80% home buyers and sellers carry out their transactions with the assistance of licensed real
estate agents. Yet concerns persist that incentives between real estate agents and their clients might
consumers'
be misaligned, thus causing a loss in consumers welfare. A growing literature has studied such
incentives issues and market efficiencies in real estate brokerage markets, focusing on home sellers and
agents.1
their agents. In this paper, we aim to contribute to the literature by examining a misalignment of
incentives between home buyers and their agents, particularly involving in-house transactions, that is,
transactions for which buyers and sellers are represented by the same brokerage office.
In-house transactions account for about 20% of transactions in North American housing markets.
In theory, in-house transactions could create informational advantages and reduce transaction costs, in
which case buyers may receive higher utility from internal listings than external listings, thus resulting
in efficient matches. However, given that in-house transactions help clear inventories and maximize
total revenues faster, brokerage firms often pay a higher commission to reward agents engaged in
in-house transactions (Gardiner, et al, 2007). As a result, agents may strategically promote in-house
transactions for their own financial interest. Such strategic in-house transactions, ifpresent, can entail
a suboptimal choice for consumers in the search stage and an apparent conflict of interest in the
negotiation stage. For this reason, many jurisdictions have now introduced disclosure requirements
relationship.2
for dual agency in order to help consumers avoid unintended dual agency relationship.
This paper investigates strategic in-house transactions by analyzing reduced-form evidence to test
their and structural estimation to their magnitude and welfare impli-
presence, by employing quantify
cations. To motivate our empirical strategy, we consider a simple agent-intermediated search model
and examine under which circumstances agents are more to promote in-house trans-
likely strategically
¹See, e.g.,Levitt and Syverson (2008a,b), and Hendel, etal. (2009). See Section 2 formore literaturereview.
2Massachusetts, for example, requires that real estatebrokerages and agents involved in dual agency transactions
obtain informed written consent from both sellersand prospective buyers before completing a transaction (254 Code
of Massachusetts Regulations 3.00 13.b). Similar laws have been implemented in other states including Wisconsin
(Wisconsin Statutes 452.135) and Illinois(225 Illinois
Compiled Statutes 454, Article15).
1
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actions. The model shows that when agents are financially rewarded by their brokerage for selling
internal listings, the informational advantage of agents may compound incentive conflicts, thereby
buyers'
enabling cooperating agents (i.e.,buyers agents) to steer buyers toward internal listings, despite the
availability of better external listings. Their ability to do so, however, decreases when clients are more
agents'
informed about agents incentives. Furthermore, the resulting efficiency loss for homebuyers depends
on the difference in the expected matching quality buyers obtain from internal and external listings.
We test these implications, using a rich dataset from the Multiple Listing Service (MLS) in a
large North American metropolitan area. Our empirical strategy is akin to a difference-in-differences
approach. We firstexploit differences in commission structures. Specifically, agents in a traditional
brokerage firm split their commission revenues with their firm on the per-transaction basis. Full
commission brokerage firms, on the other hand, allow their agents to retain 100% of commission
revenues but require fixed amount of upfront fees instead (Munneke and Yavas, 2001). Since the
brokerages'
traditional revenues strictly increase with the number of either end of transactions, these
firms are more likely to offer their agents higher bonuses for promoting in-house sales (Conner, 2010).
Such promotion bonus would be particularly attractive for cooperating agents ifcommission fees they
receive from listing agents are lower than the market rate.
these commission-related effects alone can be as the commission struc-
Nevertheless, problematic,
ture/rate could vary endogenously with the degree of matching efficiency in in-house transactions.
we further examine differences in different commission incentives before and after the imple-
Hence,
"REBBA"
mentation of a new legislation (Real Estate and Business Brokerages Act, or henceforth)
that requires agents engaged in in-house sales to inform their clients about the dual agency relationship
in writing. To the extent that the REBBA informs consumers more about the agency relationship and
agents'
related incentive issues, itcan constrain agents ability to promote internal listings, but it is unlikely
to affect matching efficiency in in-house transactions. Thus, the identification in our model does not
require the commission rates or split structure to be exogenous. Instead, it relies on the assumption
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that no other commission-related factors, except for the REBBA, differentially affect the incidence of
in-house transactions when the REBBA was implemented. To ensure our assumption, we control for
a large number of time-varying house and brokerage observable characteristics. To allow for possible
time-variation in unobservable house and brokerage characteristics that be correlated with com-
may
mission variables, we also include the interaction of the REBBA with house fixed effects as well as
brokerage fixed effects. In addition, we find no systematic changes in observed attributes of houses
sold under different commission structures before and after the REBBA, providing reassuring support
for our identification assumption.
Our reduced-form results show that cooperating agents are more likely to engage in in-house
transactions when they split the commission fees with firms on the per-transaction basis. This effect
is stronger when they receive less compensation from listing agents. More importantly, such effects are
substantially weakened after the introduction of the REBBA. Together, these results are highly in line
with the theoretical predictions, hence providing strong evidence for the presence of strategic in-house
transactions. Moreover, the estimated strategic promotion effect is larger when there are bidding wars.
This is consistent with the notion that in hot markets buyers have less bargaining power while agents
are motivated to clear inventories faster to gain new business.
In light of the reduced-form evidence for strategic promotion, we further attempt to quantify the
extent of strategic versus efficient in-house and evaluate the welfare consequence of strate-
transactions,
gic in-house transactions before and after the REBBA. This calls for structural estimation, because
matching efficiencies are generally unobserved and hard to quantify. The key idea of our structural
approach is as follows. A buyer's decision to purchase an internal listing reflects the difference between
the net utility from internal versus external listings and the net cost associated with searching internal
versus external listings. Ifher agent promotes internal such promo-
cooperating strategically listings,
tion would artificially increase the buyer's cost of searching external listings. Thus, to the extent that
the idiosyncratic matching values for internal and external listings can be recovered, we can estimate
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the implicit costs that the agent may impose on the buyer for searching external listings.
To that end, we first use a nonparametric hedonic approach developed by Bajari and Benkard
to recover the unobserved house characteristic and buyer-specific preferences for house char-
(2005)
acteristics. We then exploit econometric matching techniques (e.g., Heckman, et al. 1997, 1998)
to recover the idiosyncratic match value that a buyer obtains from internal listings as well as from
external listings. This enables us to estimate the implicit cost that buyers incur when shopping for
agents'
external versus internal listings. To identify part of the cost that is due to agents promotion, we again
rely on the difference-in-differences strategy, exploiting variations generated by commission variables
combined with the REBBA policy, both of which are well-motivated by the theory.
buyers'
We find that about 64.3% of in-house transactions can be explained by own preference. In
agents'
this case, agents strategic promotion does not lead to a distortion in the home search process, because
buyers' agents' in-
home ez ante preference for internal listings agrees with interest. The remaining
agents'
house transactions are likely due to agents strategic promotion. For these transactions, we find that
an agent's promotion of internal listings imposes a substantial cost when a buyer searches external
listings. This cost outweighs the buyer's expected utility gains from purchasing externally versus
internally, resulting in a suboptimal match for the buyer. Consistent with the model's prediction, we
also find that such efficiency loss is larger iftransactions involve smaller brokerages, relatively distinct
houses, or hot markets. Lastly, we find that the REBBA has helped homebuyers make more informed
agents'
choices and constrained ability to strategically promote, thereby increasing aggregate buyer
welfare by $690 million in the sample market studied in this paper.
The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3
provides the institutional background and discusses theoretical predictions about strategic promotion.
Section 4 describes our data, and Section 5 presents reduced-form evidence for strategic promotion.
Section 6 further develops our structural model and presents the results to quantify the extent of
strategic promotion and its associated welfare loss. Section 7 concludes the paper. A full theoretical
4
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model that motivates our empirical strategy is laid out in the appendix.
2 Related Literature
agents' in-
Broadly speaking, our paper is informed by an important literature on the distortion of agents
centives (e.g., Gruber and Owings, 1996; Mehran and Stulz, 1997; Hubbard, 1998; Garmaise and
Moskowitz, 2004). In light of the central role of housing markets in the recent economy, there has
been substantial interest in the consequence of the misalignment between goals of real es-
examining
tate agents and those of home sellers. For example, recent work has examined the effects on selling
price and time on the market of agent-owned versus client-owned properties (Rutherford, Springer,
and Yavas, 2005; Levitt and Syverson, 2008a), MLS-listed versus FSBO properties (Hendel, Nevo,
and Ortalo-Magne, 2009), and properties sold by traditional agents versus discounted agents (Levitt
and Syverson, 2008b; Berheim and Meer, 2008). One common thread between these papers is that
agents'
the current commission arrangements have resulted in a distortion of incentives, which in turn
sell.3
affects how much a house is sold for and how long it takes to
agents'
Despite a significant interest in real estate incentive issues, their importance in the specific
context of in-house transactions has not been extensively studied. This seems surprising given the
sheer magnitude of in-house transactions and obvious incentive issues that could arise from the dual
agency representation. Gardiner, Heisler, Kallberg, and Liu (2007) are among the firstto study the
impact of dual agency in residential housing markets. They find that dual agency reduced the sales
price and the time on the market and that both effects were weaker after a law change in Hawaii
in 1984 which required full disclosure of dual agency. Using repeated sales properties, Evans and
Kolbe (2005) examine the effect of dual agency on home price appreciation. In addition, Kadiyali,
Prince, and Simon (2012) study the impact of dual agency on sales and listing price, as well as time on
the market. However, likethe previous literature on the real estate brokerage, these studies focus on
3In addition,Jiang, Nelson, and Vytlacil (2014) examine incentive issuesfor mortgage brokers; Geltner, Kluger and
Miller(1991) examine incentive issuesrelated to the finiteduration of listingcontracts forreal estate agents.
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agents'
transaction outcomes for home sellers. None of the existing work examines the consequences of
incentives on the quality of home match, which is the key transaction outcome for home buyers. The
lack of such work is in large part due to the difficulty of determining the quality of a match between
a buyer and a house.
In this paper, we marry the insights from the incentive distortion literature to the methodologies
developed in the recent structural industrial organization literature (e.g.,Bajari and Benkard, 2005;
Bajari and 2005). we a structural model of in-house transactions and pro-
Kahn, Specifically, develop
pose an approach to recover the idiosyncratic match value in home transaction process. By linking our
empirical work to agent-intermediated search theory, we are also able to distinguish between different
sources of in-house transactions - from strategic promotion to efficient matching. so
ranging Doing
allows us to evaluate the economic harm that the incentive misalignment brings to homebuyers. Such
evaluation contributes to a better understanding of market efficiency in this important industry. In
this regard, our work also complements the recent literature that examines social inefficiencies resulted
from free entry in the real estate brokerage industry (Hsieh and Moretti, 2003; Han and Hong, 2011;
Jia Barwick and Pathak, 2015).
3 In-House Transactions in the Real Estate Brokerage Industry
3.1 Institutional background
agents' buyers'
If cooperating interests are fully aligned with home interests, there should be no
loss associated with in-house transactions. However, if agents have strategic interest to
buyers'
promote internal listings, buyers benefits would be inevitably sacrificed, and a suboptimal match
would be generated. Two characteristics of the residential real estate brokerage industry make the
possible incentive issues particularly concerning for in-house transactions.
First, the agency relationship in real estate transactions does not encourage cooperating agents to
represent the best interests of their buyers. In a typical multiple listing agreement for a real estate
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transaction, the listing agent has a contractual relationship with the seller, which explicitly defines
his fiduciary obligations to the seller. The usual MLS agreement constitutes an offer of sub-agency
to all other MLS members. The cooperating agent who brings the buyer to close the deal is deemed
to have accepted the sub-agency offers and hence has fiduciary duties to the seller. Those duties
effectively preclude the cooperating agent from adequately representing the buyer, even though the
buyer.4
agent appears to work for the buyer. While the conflicting loyalty by cooperating agents for buyers
may seem obvious, many buyers are not aware of the agency relationship and rely heavily on their
agents in searching for a home and negotiating the price of a home. The incentive misalignment
problem is likely to worsen in in-house transactions, since agents from the same agency are more likely
clients'
to share the information with each other and influence their decisions from both ends.
Second, both academic researchers and market practitioners have noted that brokerage firms tend
listings.5
to offer a promotion bonus to agents who successfully sell in-house There are at least two
motivations for such promotions. in-house transactions the firm clear al-
First, help inventory faster,
lowing agents to earn commissions from existing clients sooner and hence have more time and resources
to compete for new clients. Second, by promoting in-house sales, brokerage can potentially influence
clients'
decision from both sides, making a transaction easier to go through and hence maximizing the
ends.6
chance of capturing commission income from both
For these agents promote in-house transactions. For exam-
reasons, cooperating may strategically
listings.7
ple, a cooperating agent may show her client internal listings before external listings. Alternatively,
4See Olazabal (2003) fordetailed discussion on the agency relationship.
5
For example, Gardiner, Heisler,Kallberg and Liu (2007) findthat many brokerage firms give a financialreward to
agents who successfullymatch internal clientswith internallistings.Similarly,a popular industry practicebook, Buying
a Home: The Missing Manual, reports that some agencies pay agents a bonus for sellingin-house listingsbecause the
agency makes more money in such transactions. In addition, a recent report by the Consumer Advocates in American
Real Estate explicitlypoints out thatagents who avoid in-house transactions may bear with some financialconsequences,
such as a lessfavorable commission splitwith the brokerage firm.
6To see this,note that signing a contract with a clientdoes not provide a guarantee foran agent to receive any
commission as the transaction may not occur during the agent's contract term. This is particularly a concern for
cooperating agents as they tend to have lessexclusive and shorter contracts (or even no contract) with buyers.
7Similarly, a listingagent may show his client's
house to internalbuyers before external buyers. In thispaper, we
focus our discussion on cooperating agents, but the logiccan be easily extended to listingagents.
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a cooperating agent may take her client to visit externally listed houses before visiting the internally
listed house, but these external listings would be selected to appear less attractive than the internal
listings that the agent tries to promote. These efforts are strategic and may lead to an in-house
transaction that is inconsistent with the interest of home buyers.
Of course, an in-house transaction could also occur due to spontaneous visits or information sharing.
For example, a buyer may see a for-sale sign on a property and call the listing agent whose name is
listed on the sign. Similarly, an agency may become a dual agency if a buyer who is represented by a
cooperating agent independently discovers a house where the listing agent works for the same agency
as the buyer's agent. It is not obvious whether these types of transactions would generate an efficient
matching outcome or a suboptimal choice for consumers. However, their existence makes detecting
strategic promotion empirically challenging. In what follows, we derive theoretical predictions that
underpin our empirical approach to identify strategic promotion.
3.2 Strategic and Efficient In-House Transactions
In Appendix A, we present an agent-intermediated search model that applies search diversion theory
developed in online shopping literature (Hagiu and Jullien, 2011) to the real estate brokerage industry.
The model incorporates an important feature that real estate agents receive a share of realized sales
revenues and this share is larger when a transaction occurs within the same brokerage office. The model
yields the following intuitive result: the optimal amount of strategic promotion in equilibrium increases
with the financial incentives an agent receives from promoting in-house transactions. Motivated by
the practice in the real estate brokerage industry, we argue that such financial incentives are reflected
by the amount of commission fees that agents receive in each transaction and how they split the fees
with their affiliated brokerage offices.
In a residential real estate transaction, the commission rate for a cooperating agent is typically
predetermined when the listing is posted on the MLS. While the commission rate is usually set at
2.5%, some listing agents would offer a higher or lower rate to cooperating agents. Intuitively, by
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rewarding cooperating agents a greater proportion of the commission, an external listing agent can
effectively offset the promotion bonus that the cooperating agent receives from her own firm for
promoting internal listings. Conversely, when the commission rate offered by a listing agent is low,
the cooperating agent is more likely to respond to the financial incentives offered by the brokerage
firm for promoting in-house transactions. The strategy of using substandard commission rates to
artificially increase the frequency of dual-agency transactions is discussed in Yavas, et al (2013) and
report.8
also evidenced by a recent industry report. Thus, we expect that lower commission rates offered by
listing agents are associated with a stronger presence of strategic in-house transactions.
In addition to commission fees, commission structure also matters. As noted earlier, different
brokerage office have different rules regarding how they split the commission income with their agents.
While full commission brokerage offices, such as ReMax, require agents to pay a fixed amount of
upfront fees each month, traditional firms, such as Royal LePage, split commission fees with their
agents on the per-transaction basis. Naturally, the revenues in the latter type of brokerage firms
strictly increase with the number of either end of transactions. Therefore, these brokerage firms are
more likely to reward their agents for selling internal listings. Thus, we expect that the per-transaction
split commission structure is associated with a stronger presence of strategic in-house transactions.
While agents may have financial incentives to promote in-house transactions, their ability to do
agents'
so depends on whether buyers are aware of incentives to strategically promote. In particular,
our model shows that the strength of strategic promotion would be weaker if buyers are more aware
agents'
of agents financial incentives to promote. As discussed in Section 4, our sample covers a natural
experimental permitted a legislation that required real estate agents engaged in in-
opportunity by
house transactions to disclose the possibility of strategic promotion to both buyers and sellers. This
provides an opportunity for us to empirically test this prediction.
8For example, a recent report by the Consumer Advocates in American Real Estate states that "offering lessthan
the going rate in your area willdecrease the financial attractivenessof your home [tocooperating agents]and increases
commission" Schemes"
the likelihood that your broker willcollect a double (see an article titled "Dual Agency in
http://www.caare.org/ForBuyers, accessed August 1,2014).
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In-house transactions could also occur for efficiency rather than incentive reasons. We define an
"efficient"
in-house transaction as if a buyer's net utility from purchasing an internal listing is larger
than the maximum utility she could have obtained had she purchased any of the external listings,
either ex ante or ez post. While we do not attempt to fully model the sources of efficient in-house
transactions, it can be shown that the efficiency loss associated with strategic in-house transactions
depends on the difference in the expected matching quality that a given buyer obtains from internal
and external listings. Empirically, we do not observe matching quality. However, we can proxy the
difference in the matching quality by looking at how typical a house is and how many listings the
brokerage possesses. Intuitively, ifbuyers are looking for more or less homogeneous houses (e.g.,tract
home), and if such homes are available both internally and externally, the potential loss of matching
quality associated with purchasing an internal listing should be relatively small. In addition, matching
in housing markets is typically characterized by increasing returns to scale (Ngai and Tereyro 2014;
Genesove and Han 2012b). When a brokerage firm has a larger number of listings which a buyer can
choose among, there should be less dispersion in the buyer's valuation of her most-preferred house
from the market-wide pool and from the internal listings. Although the promoted listings may not
match the buyer's preference best, the resulting efficiency loss should be smaller since these listings
are closer to the buyer's preference.
In there are a number of brokerage- and transaction-specific features that can be tied to
sum,
predictions about in-house transactions. In particular, the model laid out in Appendix A generates
the following theoretical predictions.
Prediction 1: An agent who splits commissions with the afEliated brokerage firm on the per-
transaction basis and/or receives lower commission fees from listing agents is more likely to
strategically promote internal listings.
Prediction 2: When the buyer is more aware of her agent's strategic incentives, the agent's ability
to promote internal listings will be weaker.
1
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Prediction 3: The efficiency loss associated with in-house transactions is smaller when buyers look
for typical homes and/or when the cooperating brokerage offices have a larger number of listings.
these predictions provide a basis for the difference-in-differences used in our em-
Together, strategy
pirical analysis. The model also implies that a full control of efficient matching can be obtained by
comparing a buyer's expected utility from internal and external listings, which further motivates the
structural approach that we exploit in Section 6.
4 Data
The main source of our data isthe Multiple Service in a large North American metropoli-
Listing (MLS)
tan area from January 1, 2001 to December 31, 2009. This market experienced a boom in the middle
2000s, with a peak in 2007 and the firsthalf of 2008, followed by a temporary decline in the second half
of 2008, and then an immediate strong rebound afterwards, with sales volume reaching the pre-crisis
peak level in the first half of 2009. Our sample covers 28 MLS districts which comprise a third of the
metropolitan area. There are over 200,000 transactions and about 1,500 brokerage firms. The MLS
data contain detailed information on house characteristics. Properties are identified by MLS district,
MLS number, address, and unit number (if applicable). Note that MLS districts are defined by the
local Real Estate Board and used by agents and home buyers to search for neighborhoods of their
interest. In addition, the data provide listing and transaction prices, as well as real estate brokerage
firms on both sides of a transaction. To avoid some extreme we exclude the transac-
cases, following
tions from the estimation sample: (1) transactions for which the sales price is less than $30, 000 or
more than $3, 000, 000; (2) transactions for which the cooperating commissions are less than 0.5% or
year.9
more than 5%; (3) listings that stay on the market for less than one day or more than one
We define in-house transactions as transactions for which the cooperating agent and the listing
agent are associated with the same brokerage office. In our sample, about 20% of transactions occur
9We also estimated our model using somewhat differentcutoffs(e.g. the cooperating commission ratesare lessthan
170',listings
Preview
FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 Understanding In-House Transactions in the Real Estate Industry* Brokerage Lu Han Seung-Hyun Hong Rotman School of Management Department of Economics University of Toronto University of Illinois lu.han©rotman.utoronto.ca hyunhong©illinois.edu April 8, 2016 Abstract About 20% of residential real estate transactions in North America are in-house transactions, for which buyers and sellers are represented by the same brokerage. This paper examines to what agents' extent in-house transactions are explained by agents strategic incentives as opposed to matching efficiency. Using home transaction data, we find that agents are more likelyto promote internal listings when they are financially rewarded and such effect becomes weaker when consumers are agents' more aware of incentives. We further develop a structural model and find that about agents' one third of in-house transactions are explained by agents strategic promotion, causing significant utilityloss for homebuyers. Keywords: incentive misalignment, realestate brokerage, in-house transaction, agent-intermediated search, structural estimation JEL classification: C35, C51, L85, R31 *We thank the editor,two anonymous referees,conference participants at the Stanford Institute of Theoretical Eco- nomics, Pre-WFA Summer Real Estate Symposium, Rotman Real Estate Microstructure Conference, AREUEA Meeting, IsraelReal Estate and Urban Economics Symposium, as wellas seminar participants at the Atlanta Fed, Korea Univer- sity,National Science Foundation, Penn State, Seoul National University, UC Berkeley,UIUC, University ofAmsterdam, and University ofToronto for theirhelpful comments. Contact information: Lu Han, Rotman School of Management, University of Toronto, 105 St. George Street,Toronto, Ontario, Canada M5S 3E6. Seung-Hyun Hong, 213 David Kinley Hall, 1407 West Gregory Drive, Urbana, IL 61801. FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 1 Introduction Over 80% home buyers and sellers carry out their transactions with the assistance of licensed real estate agents. Yet concerns persist that incentives between real estate agents and their clients might consumers' be misaligned, thus causing a loss in consumers welfare. A growing literature has studied such incentives issues and market efficiencies in real estate brokerage markets, focusing on home sellers and agents.1 their agents. In this paper, we aim to contribute to the literature by examining a misalignment of incentives between home buyers and their agents, particularly involving in-house transactions, that is, transactions for which buyers and sellers are represented by the same brokerage office. In-house transactions account for about 20% of transactions in North American housing markets. In theory, in-house transactions could create informational advantages and reduce transaction costs, in which case buyers may receive higher utility from internal listings than external listings, thus resulting in efficient matches. However, given that in-house transactions help clear inventories and maximize total revenues faster, brokerage firms often pay a higher commission to reward agents engaged in in-house transactions (Gardiner, et al, 2007). As a result, agents may strategically promote in-house transactions for their own financial interest. Such strategic in-house transactions, ifpresent, can entail a suboptimal choice for consumers in the search stage and an apparent conflict of interest in the negotiation stage. For this reason, many jurisdictions have now introduced disclosure requirements relationship.2 for dual agency in order to help consumers avoid unintended dual agency relationship. This paper investigates strategic in-house transactions by analyzing reduced-form evidence to test their and structural estimation to their magnitude and welfare impli- presence, by employing quantify cations. To motivate our empirical strategy, we consider a simple agent-intermediated search model and examine under which circumstances agents are more to promote in-house trans- likely strategically ¹See, e.g.,Levitt and Syverson (2008a,b), and Hendel, etal. (2009). See Section 2 formore literaturereview. 2Massachusetts, for example, requires that real estatebrokerages and agents involved in dual agency transactions obtain informed written consent from both sellersand prospective buyers before completing a transaction (254 Code of Massachusetts Regulations 3.00 13.b). Similar laws have been implemented in other states including Wisconsin (Wisconsin Statutes 452.135) and Illinois(225 Illinois Compiled Statutes 454, Article15). 1 FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 actions. The model shows that when agents are financially rewarded by their brokerage for selling internal listings, the informational advantage of agents may compound incentive conflicts, thereby buyers' enabling cooperating agents (i.e.,buyers agents) to steer buyers toward internal listings, despite the availability of better external listings. Their ability to do so, however, decreases when clients are more agents' informed about agents incentives. Furthermore, the resulting efficiency loss for homebuyers depends on the difference in the expected matching quality buyers obtain from internal and external listings. We test these implications, using a rich dataset from the Multiple Listing Service (MLS) in a large North American metropolitan area. Our empirical strategy is akin to a difference-in-differences approach. We firstexploit differences in commission structures. Specifically, agents in a traditional brokerage firm split their commission revenues with their firm on the per-transaction basis. Full commission brokerage firms, on the other hand, allow their agents to retain 100% of commission revenues but require fixed amount of upfront fees instead (Munneke and Yavas, 2001). Since the brokerages' traditional revenues strictly increase with the number of either end of transactions, these firms are more likely to offer their agents higher bonuses for promoting in-house sales (Conner, 2010). Such promotion bonus would be particularly attractive for cooperating agents ifcommission fees they receive from listing agents are lower than the market rate. these commission-related effects alone can be as the commission struc- Nevertheless, problematic, ture/rate could vary endogenously with the degree of matching efficiency in in-house transactions. we further examine differences in different commission incentives before and after the imple- Hence, "REBBA" mentation of a new legislation (Real Estate and Business Brokerages Act, or henceforth) that requires agents engaged in in-house sales to inform their clients about the dual agency relationship in writing. To the extent that the REBBA informs consumers more about the agency relationship and agents' related incentive issues, itcan constrain agents ability to promote internal listings, but it is unlikely to affect matching efficiency in in-house transactions. Thus, the identification in our model does not require the commission rates or split structure to be exogenous. Instead, it relies on the assumption FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 that no other commission-related factors, except for the REBBA, differentially affect the incidence of in-house transactions when the REBBA was implemented. To ensure our assumption, we control for a large number of time-varying house and brokerage observable characteristics. To allow for possible time-variation in unobservable house and brokerage characteristics that be correlated with com- may mission variables, we also include the interaction of the REBBA with house fixed effects as well as brokerage fixed effects. In addition, we find no systematic changes in observed attributes of houses sold under different commission structures before and after the REBBA, providing reassuring support for our identification assumption. Our reduced-form results show that cooperating agents are more likely to engage in in-house transactions when they split the commission fees with firms on the per-transaction basis. This effect is stronger when they receive less compensation from listing agents. More importantly, such effects are substantially weakened after the introduction of the REBBA. Together, these results are highly in line with the theoretical predictions, hence providing strong evidence for the presence of strategic in-house transactions. Moreover, the estimated strategic promotion effect is larger when there are bidding wars. This is consistent with the notion that in hot markets buyers have less bargaining power while agents are motivated to clear inventories faster to gain new business. In light of the reduced-form evidence for strategic promotion, we further attempt to quantify the extent of strategic versus efficient in-house and evaluate the welfare consequence of strate- transactions, gic in-house transactions before and after the REBBA. This calls for structural estimation, because matching efficiencies are generally unobserved and hard to quantify. The key idea of our structural approach is as follows. A buyer's decision to purchase an internal listing reflects the difference between the net utility from internal versus external listings and the net cost associated with searching internal versus external listings. Ifher agent promotes internal such promo- cooperating strategically listings, tion would artificially increase the buyer's cost of searching external listings. Thus, to the extent that the idiosyncratic matching values for internal and external listings can be recovered, we can estimate FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 the implicit costs that the agent may impose on the buyer for searching external listings. To that end, we first use a nonparametric hedonic approach developed by Bajari and Benkard to recover the unobserved house characteristic and buyer-specific preferences for house char- (2005) acteristics. We then exploit econometric matching techniques (e.g., Heckman, et al. 1997, 1998) to recover the idiosyncratic match value that a buyer obtains from internal listings as well as from external listings. This enables us to estimate the implicit cost that buyers incur when shopping for agents' external versus internal listings. To identify part of the cost that is due to agents promotion, we again rely on the difference-in-differences strategy, exploiting variations generated by commission variables combined with the REBBA policy, both of which are well-motivated by the theory. buyers' We find that about 64.3% of in-house transactions can be explained by own preference. In agents' this case, agents strategic promotion does not lead to a distortion in the home search process, because buyers' agents' in- home ez ante preference for internal listings agrees with interest. The remaining agents' house transactions are likely due to agents strategic promotion. For these transactions, we find that an agent's promotion of internal listings imposes a substantial cost when a buyer searches external listings. This cost outweighs the buyer's expected utility gains from purchasing externally versus internally, resulting in a suboptimal match for the buyer. Consistent with the model's prediction, we also find that such efficiency loss is larger iftransactions involve smaller brokerages, relatively distinct houses, or hot markets. Lastly, we find that the REBBA has helped homebuyers make more informed agents' choices and constrained ability to strategically promote, thereby increasing aggregate buyer welfare by $690 million in the sample market studied in this paper. The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3 provides the institutional background and discusses theoretical predictions about strategic promotion. Section 4 describes our data, and Section 5 presents reduced-form evidence for strategic promotion. Section 6 further develops our structural model and presents the results to quantify the extent of strategic promotion and its associated welfare loss. Section 7 concludes the paper. A full theoretical 4 FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 model that motivates our empirical strategy is laid out in the appendix. 2 Related Literature agents' in- Broadly speaking, our paper is informed by an important literature on the distortion of agents centives (e.g., Gruber and Owings, 1996; Mehran and Stulz, 1997; Hubbard, 1998; Garmaise and Moskowitz, 2004). In light of the central role of housing markets in the recent economy, there has been substantial interest in the consequence of the misalignment between goals of real es- examining tate agents and those of home sellers. For example, recent work has examined the effects on selling price and time on the market of agent-owned versus client-owned properties (Rutherford, Springer, and Yavas, 2005; Levitt and Syverson, 2008a), MLS-listed versus FSBO properties (Hendel, Nevo, and Ortalo-Magne, 2009), and properties sold by traditional agents versus discounted agents (Levitt and Syverson, 2008b; Berheim and Meer, 2008). One common thread between these papers is that agents' the current commission arrangements have resulted in a distortion of incentives, which in turn sell.3 affects how much a house is sold for and how long it takes to agents' Despite a significant interest in real estate incentive issues, their importance in the specific context of in-house transactions has not been extensively studied. This seems surprising given the sheer magnitude of in-house transactions and obvious incentive issues that could arise from the dual agency representation. Gardiner, Heisler, Kallberg, and Liu (2007) are among the firstto study the impact of dual agency in residential housing markets. They find that dual agency reduced the sales price and the time on the market and that both effects were weaker after a law change in Hawaii in 1984 which required full disclosure of dual agency. Using repeated sales properties, Evans and Kolbe (2005) examine the effect of dual agency on home price appreciation. In addition, Kadiyali, Prince, and Simon (2012) study the impact of dual agency on sales and listing price, as well as time on the market. However, likethe previous literature on the real estate brokerage, these studies focus on 3In addition,Jiang, Nelson, and Vytlacil (2014) examine incentive issuesfor mortgage brokers; Geltner, Kluger and Miller(1991) examine incentive issuesrelated to the finiteduration of listingcontracts forreal estate agents. FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 agents' transaction outcomes for home sellers. None of the existing work examines the consequences of incentives on the quality of home match, which is the key transaction outcome for home buyers. The lack of such work is in large part due to the difficulty of determining the quality of a match between a buyer and a house. In this paper, we marry the insights from the incentive distortion literature to the methodologies developed in the recent structural industrial organization literature (e.g.,Bajari and Benkard, 2005; Bajari and 2005). we a structural model of in-house transactions and pro- Kahn, Specifically, develop pose an approach to recover the idiosyncratic match value in home transaction process. By linking our empirical work to agent-intermediated search theory, we are also able to distinguish between different sources of in-house transactions - from strategic promotion to efficient matching. so ranging Doing allows us to evaluate the economic harm that the incentive misalignment brings to homebuyers. Such evaluation contributes to a better understanding of market efficiency in this important industry. In this regard, our work also complements the recent literature that examines social inefficiencies resulted from free entry in the real estate brokerage industry (Hsieh and Moretti, 2003; Han and Hong, 2011; Jia Barwick and Pathak, 2015). 3 In-House Transactions in the Real Estate Brokerage Industry 3.1 Institutional background agents' buyers' If cooperating interests are fully aligned with home interests, there should be no loss associated with in-house transactions. However, if agents have strategic interest to buyers' promote internal listings, buyers benefits would be inevitably sacrificed, and a suboptimal match would be generated. Two characteristics of the residential real estate brokerage industry make the possible incentive issues particularly concerning for in-house transactions. First, the agency relationship in real estate transactions does not encourage cooperating agents to represent the best interests of their buyers. In a typical multiple listing agreement for a real estate FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 transaction, the listing agent has a contractual relationship with the seller, which explicitly defines his fiduciary obligations to the seller. The usual MLS agreement constitutes an offer of sub-agency to all other MLS members. The cooperating agent who brings the buyer to close the deal is deemed to have accepted the sub-agency offers and hence has fiduciary duties to the seller. Those duties effectively preclude the cooperating agent from adequately representing the buyer, even though the buyer.4 agent appears to work for the buyer. While the conflicting loyalty by cooperating agents for buyers may seem obvious, many buyers are not aware of the agency relationship and rely heavily on their agents in searching for a home and negotiating the price of a home. The incentive misalignment problem is likely to worsen in in-house transactions, since agents from the same agency are more likely clients' to share the information with each other and influence their decisions from both ends. Second, both academic researchers and market practitioners have noted that brokerage firms tend listings.5 to offer a promotion bonus to agents who successfully sell in-house There are at least two motivations for such promotions. in-house transactions the firm clear al- First, help inventory faster, lowing agents to earn commissions from existing clients sooner and hence have more time and resources to compete for new clients. Second, by promoting in-house sales, brokerage can potentially influence clients' decision from both sides, making a transaction easier to go through and hence maximizing the ends.6 chance of capturing commission income from both For these agents promote in-house transactions. For exam- reasons, cooperating may strategically listings.7 ple, a cooperating agent may show her client internal listings before external listings. Alternatively, 4See Olazabal (2003) fordetailed discussion on the agency relationship. 5 For example, Gardiner, Heisler,Kallberg and Liu (2007) findthat many brokerage firms give a financialreward to agents who successfullymatch internal clientswith internallistings.Similarly,a popular industry practicebook, Buying a Home: The Missing Manual, reports that some agencies pay agents a bonus for sellingin-house listingsbecause the agency makes more money in such transactions. In addition, a recent report by the Consumer Advocates in American Real Estate explicitlypoints out thatagents who avoid in-house transactions may bear with some financialconsequences, such as a lessfavorable commission splitwith the brokerage firm. 6To see this,note that signing a contract with a clientdoes not provide a guarantee foran agent to receive any commission as the transaction may not occur during the agent's contract term. This is particularly a concern for cooperating agents as they tend to have lessexclusive and shorter contracts (or even no contract) with buyers. 7Similarly, a listingagent may show his client's house to internalbuyers before external buyers. In thispaper, we focus our discussion on cooperating agents, but the logiccan be easily extended to listingagents. FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 a cooperating agent may take her client to visit externally listed houses before visiting the internally listed house, but these external listings would be selected to appear less attractive than the internal listings that the agent tries to promote. These efforts are strategic and may lead to an in-house transaction that is inconsistent with the interest of home buyers. Of course, an in-house transaction could also occur due to spontaneous visits or information sharing. For example, a buyer may see a for-sale sign on a property and call the listing agent whose name is listed on the sign. Similarly, an agency may become a dual agency if a buyer who is represented by a cooperating agent independently discovers a house where the listing agent works for the same agency as the buyer's agent. It is not obvious whether these types of transactions would generate an efficient matching outcome or a suboptimal choice for consumers. However, their existence makes detecting strategic promotion empirically challenging. In what follows, we derive theoretical predictions that underpin our empirical approach to identify strategic promotion. 3.2 Strategic and Efficient In-House Transactions In Appendix A, we present an agent-intermediated search model that applies search diversion theory developed in online shopping literature (Hagiu and Jullien, 2011) to the real estate brokerage industry. The model incorporates an important feature that real estate agents receive a share of realized sales revenues and this share is larger when a transaction occurs within the same brokerage office. The model yields the following intuitive result: the optimal amount of strategic promotion in equilibrium increases with the financial incentives an agent receives from promoting in-house transactions. Motivated by the practice in the real estate brokerage industry, we argue that such financial incentives are reflected by the amount of commission fees that agents receive in each transaction and how they split the fees with their affiliated brokerage offices. In a residential real estate transaction, the commission rate for a cooperating agent is typically predetermined when the listing is posted on the MLS. While the commission rate is usually set at 2.5%, some listing agents would offer a higher or lower rate to cooperating agents. Intuitively, by FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 rewarding cooperating agents a greater proportion of the commission, an external listing agent can effectively offset the promotion bonus that the cooperating agent receives from her own firm for promoting internal listings. Conversely, when the commission rate offered by a listing agent is low, the cooperating agent is more likely to respond to the financial incentives offered by the brokerage firm for promoting in-house transactions. The strategy of using substandard commission rates to artificially increase the frequency of dual-agency transactions is discussed in Yavas, et al (2013) and report.8 also evidenced by a recent industry report. Thus, we expect that lower commission rates offered by listing agents are associated with a stronger presence of strategic in-house transactions. In addition to commission fees, commission structure also matters. As noted earlier, different brokerage office have different rules regarding how they split the commission income with their agents. While full commission brokerage offices, such as ReMax, require agents to pay a fixed amount of upfront fees each month, traditional firms, such as Royal LePage, split commission fees with their agents on the per-transaction basis. Naturally, the revenues in the latter type of brokerage firms strictly increase with the number of either end of transactions. Therefore, these brokerage firms are more likely to reward their agents for selling internal listings. Thus, we expect that the per-transaction split commission structure is associated with a stronger presence of strategic in-house transactions. While agents may have financial incentives to promote in-house transactions, their ability to do agents' so depends on whether buyers are aware of incentives to strategically promote. In particular, our model shows that the strength of strategic promotion would be weaker if buyers are more aware agents' of agents financial incentives to promote. As discussed in Section 4, our sample covers a natural experimental permitted a legislation that required real estate agents engaged in in- opportunity by house transactions to disclose the possibility of strategic promotion to both buyers and sellers. This provides an opportunity for us to empirically test this prediction. 8For example, a recent report by the Consumer Advocates in American Real Estate states that "offering lessthan the going rate in your area willdecrease the financial attractivenessof your home [tocooperating agents]and increases commission" Schemes" the likelihood that your broker willcollect a double (see an article titled "Dual Agency in http://www.caare.org/ForBuyers, accessed August 1,2014). FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 In-house transactions could also occur for efficiency rather than incentive reasons. We define an "efficient" in-house transaction as if a buyer's net utility from purchasing an internal listing is larger than the maximum utility she could have obtained had she purchased any of the external listings, either ex ante or ez post. While we do not attempt to fully model the sources of efficient in-house transactions, it can be shown that the efficiency loss associated with strategic in-house transactions depends on the difference in the expected matching quality that a given buyer obtains from internal and external listings. Empirically, we do not observe matching quality. However, we can proxy the difference in the matching quality by looking at how typical a house is and how many listings the brokerage possesses. Intuitively, ifbuyers are looking for more or less homogeneous houses (e.g.,tract home), and if such homes are available both internally and externally, the potential loss of matching quality associated with purchasing an internal listing should be relatively small. In addition, matching in housing markets is typically characterized by increasing returns to scale (Ngai and Tereyro 2014; Genesove and Han 2012b). When a brokerage firm has a larger number of listings which a buyer can choose among, there should be less dispersion in the buyer's valuation of her most-preferred house from the market-wide pool and from the internal listings. Although the promoted listings may not match the buyer's preference best, the resulting efficiency loss should be smaller since these listings are closer to the buyer's preference. In there are a number of brokerage- and transaction-specific features that can be tied to sum, predictions about in-house transactions. In particular, the model laid out in Appendix A generates the following theoretical predictions. Prediction 1: An agent who splits commissions with the afEliated brokerage firm on the per- transaction basis and/or receives lower commission fees from listing agents is more likely to strategically promote internal listings. Prediction 2: When the buyer is more aware of her agent's strategic incentives, the agent's ability to promote internal listings will be weaker. 1 FILED: WESTCHESTER COUNTY CLERK 07/14/2018 08:37 PM INDEX NO. 60767/2018 NYSCEF DOC. NO. 36 RECEIVED NYSCEF: 07/14/2018 Prediction 3: The efficiency loss associated with in-house transactions is smaller when buyers look for typical homes and/or when the cooperating brokerage offices have a larger number of listings. these predictions provide a basis for the difference-in-differences used in our em- Together, strategy pirical analysis. The model also implies that a full control of efficient matching can be obtained by comparing a buyer's expected utility from internal and external listings, which further motivates the structural approach that we exploit in Section 6. 4 Data The main source of our data isthe Multiple Service in a large North American metropoli- Listing (MLS) tan area from January 1, 2001 to December 31, 2009. This market experienced a boom in the middle 2000s, with a peak in 2007 and the firsthalf of 2008, followed by a temporary decline in the second half of 2008, and then an immediate strong rebound afterwards, with sales volume reaching the pre-crisis peak level in the first half of 2009. Our sample covers 28 MLS districts which comprise a third of the metropolitan area. There are over 200,000 transactions and about 1,500 brokerage firms. The MLS data contain detailed information on house characteristics. Properties are identified by MLS district, MLS number, address, and unit number (if applicable). Note that MLS districts are defined by the local Real Estate Board and used by agents and home buyers to search for neighborhoods of their interest. In addition, the data provide listing and transaction prices, as well as real estate brokerage firms on both sides of a transaction. To avoid some extreme we exclude the transac- cases, following tions from the estimation sample: (1) transactions for which the sales price is less than $30, 000 or more than $3, 000, 000; (2) transactions for which the cooperating commissions are less than 0.5% or year.9 more than 5%; (3) listings that stay on the market for less than one day or more than one We define in-house transactions as transactions for which the cooperating agent and the listing agent are associated with the same brokerage office. In our sample, about 20% of transactions occur 9We also estimated our model using somewhat differentcutoffs(e.g. the cooperating commission ratesare lessthan 170',listings