A consumer’s guide to the divorced real estate commission: We’re just sitting here at the closing table, watching the money flow

Part III: The who-pays-whom of real estate is not as simple as you might have thought…

All right, let’s go buy a house. I want to talk about the flow of money in a real estate transaction, and there is no better way of understanding that flow than wading right out into the middle of it all.

So let’s buy a house for $100,000. Where I live, in Phoenix, a hundred grand will get you a grungy dump. Where I grew up, in downstate Illinois, a hundred-thousand dollar house will put you among the diamond-crusted elite. Either way, it doesn’t matter. We’re not buying this house to live in it, but just so we can see who gets paid and how.

I want for us to buy this house with 100% financing — nothing down! — even though that kind of loan isn’t as easy to get as it used to be. Even better, I want you to take 3% of the purchase price as a concession from the seller to defray your closing costs. You’re going to have to put down an earnest deposit to show that you’re serious, but I like $500 for a house this cheap. Not only that, but, since there is going to be money left over from the closing costs concession, you’re actually going to get your $500 back at Close of Escrow.

Isn’t that cool? You just took possession of a $100,000 asset for not one red cent out-of-pocket. You bought a house for nothing. This is not a fantasy. I’ve done this for dozens of clients. But before you get on the phone to all your friends, telling them about your amazing financial skills, stop and think for a minute.

Did you just buy a house for nothing, or did you buy it by promising to make monthly payments for up to thirty — or forty — or fifty — years for principle, interest, taxes, insurance, HOA fees and private mortgage insurance?

Your lender pushed $100,000 onto the closing table, but he did it on the strength of your promise to pay all that money back and then some. In essence, you pushed a hundred grand onto the table, just as much as if you had paid cash-out-of-pocket for the home.

Who else brought money to the closing table? Unless it was a short sale — the seller was “short” the amount owed on his loan for the property — the only person who brought any money to the closing table was you. You even paid that 3% “contribution” from the seller, borrowing 3% extra so you could give it to the seller so the seller could give it back to you. Everyone sitting at the closing table — including you! — is going to get paid, but every single dollar of those payments will have come from your money.

Consider just that 3% contribution for closing costs. It’s a nice solution for buyers who have no cash, but it can also be a painless way to extract an extra 3% in discounted price from a seller who refuses to go any lower on the nominal purchase price. The buyers end up borrowing more, but the incremental interest costs on a loan they may hold for less than five years can be marginal compared to the utility of having 3% of the purchase price available as cash at the time they are moving. Everything is a trade-off, and a clever buyer’s agent can structure an offer in such a way that you get the best overall value in your current financial circumstances.

But suppose you were going to pay your own closing costs out of pocket. Would you have paid the same price for the house? The seller’s “contribution” nets out to a 3% discount on the house — actually a little less than 3% allowing for other costs. If you weren’t going to take this “contribution,” you would certainly offer less for the home. So if you had taken the “contribution,” who — in reality — would have paid your closing costs?

This little pantomime — you borrow more to give more to the seller so that the seller can give it back to you — is how we get this sleight of hand trick past your lender. If you are offering $100,000 with a $3,000 seller-funded discount, what is the actual value of the home? It’s $97,000, right? So why is the lender giving you $100,000 in the form of a 100% loan? Because the lender is affecting to pretend to make-believe that your $97,000 offer on the home is actually a $100,000 offer. The actual flow of money — from lender to buyer to seller and back to buyer — has no physical reality. There is no actual cash changing hands. It’s all bookkeeping notations. But by dancing precisely the right steps in a financial rain-dance, the lender pretends that 97% equals 100%.

But, guess what? We’re not talking about seller “contributions” for closing costs. We’re talking about the exact same pantomime when it is enacted to pay the listing agent’s and buyer’s agent’s commissions.

Who brought every last dollar to the closing table? Who is paying everyone who walks away from that table with money in his or her pocket? Except in a short sale, the buyer pays for everything.

So who is paying the agents’ commissions? The seller sets the gross amount of the commissions at the time the listing contract is signed. The listing agent and the seller set the amount of the buyer’s agent’s commission — including any bonus payments. But who actually pays those commissions?

I know of three different answers to that question.

The old-line brokers would argue that the seller is paying the commissions out of the accrued equity in the home. This is the accepted interpretation, and this is how lenders are able to justify the — to me absurd — pantomime of money-shuffling that is going on at the closing table. The buyer borrows $100,000 and gives it all to the seller. The seller give $3,000 back to the buyer’s creditors in the form of closing costs. Then the seller gives $7,000 to the listing broker, who in turn gives $3,500 to the buyer’s broker.

What’s the problem?

Do you recall that the lender, in order to swallow that whopper about the seller’s “contribution” to closing costs, had to make believe that 97% equals 100%? Try this on for size:

• The buyer believes the home is worth $100,000
• The buyer’s agent writes a contract reflecting a belief that the home is worth $100,000
• The lender originates a loan predicated on the belief that the home is worth $100,000
• The appraiser writes an opinion that that the home is worth $100,000
• The loan underwriter approves a loan for $100,000
• The title company prepares documents reflecting a purchase price of $100,000

But: The seller accepts $90,000 in trade for the home.

And: The lender is affecting to pretend to make-believe that the seller’s 90% is equal to the buyer’s 100%.

The “yeah, but” argument is that the seller has to pay marketing costs to sell the home. But clearly these are parasitic costs, just as the “contribution” for closing costs is parasitic. Fully ten per cent of the purchase price of the home reflects costs that do not add any value to the home. The buyer is borrowing ten per cent more than the home is actually worth in order to pay expenses that do not and cannot accrue as equity in the home. In my view, the lender is simply pretending that a home that is understood to have an actual value of $90,000 is worth $100,000 — all effected by sleight of hand bookkeeping.

At this point, objections will swarm around the idea of “market value.” The claim is that you will be obliged to pay the prevailing market value for the home regardless of how other costs are calculated. But, as we have seen, you would certainly offer less for the home if you were not taking the seller’s “contribution” for closing costs. And, if some benevolent charity were to offer to pay both agents’ commissions outside of escrow, you would offer even less. The seller might try to insist that you pay the prevailing market value anyway — in which event we would go buy a different house from a seller who understands the difference between gross and net — and how to hang onto a bird in the hand.

In fact, “market value” is twice a fiction. The only financial value any marketable item can have is the price agreed upon by a buyer and a seller. What we call “market value” is simply an educated guess based on recent very similar transactions. There is nothing that prevents you from offering $50,000 for our house, and nothing that prevents the seller from accepting your offer. The value of a home is what it sold for. Period.

Moreover, our idea of “market value” is clouded by the complicated lies the lender is telling itself. In other words, almost all recent sales will have been inflated from 5% to 10% by the imputation that real estate commissions and seller “contributions” to closing costs are expressions of the value of the home, when in fact they are parasitic costs tacked on by sleight-of-hand bookkeeping.

Note that I am not saying that real estate agents should not be paid for their efforts. Very much the contrary. If you’ve read this far, you understand that real estate is a complicated enterprise. Navigating a real estate transaction without representation is a poor idea. What I am saying is that the method we use now to document the flow of these funds is essentially a self-deception effected by the lender. The home isn’t worth $3,000 more because the seller is allegedly paying the buyer’s closing costs, and it isn’t worth $7,000 more because the seller is allegedly paying the real estate brokers.

Another way of thinking of who pays whom in a real estate transaction is to argue that the seller pays the listing agent and the buyer pays the buyer’s agent. This might be useful as a metaphor, but it is nothing but a pleasant fiction in our current circumstances. In the way the funds are accounted for by the lender and the title company, the seller is paying the brokerage commissions.

And, of course, from my point of view, the buyer is paying for everything. If the buyer is paying his own closing costs, he should offer less than if he were asking for a seller “contribution.” But since real estate laws are written to protect real estate brokers, not consumers, an unrepresented buyer cannot expect to extract a similar discount, even though this would be entirely reasonable.

This is a knot that won’t be untied, but the good news is, it doesn’t need to be. If we divorce the real estate commissions, we can do the bookkeeping in such a way that the seller definitely does pay the listing agent, while the buyer definitely does pay the buyer’s agent.

This is from an essay I wrote on this topic earlier this year:

To effect the divorced commission in the overwhelming majority of transactions, all that is necessary is for lenders to change their underwriting guidelines, making corresponding changes in the way they illustrate the flow of funds on the HUD-1 settlement statement.

Right now, many lenders will allow up to 7% in sales commissions, to be charged against the seller’s side of the HUD-1, with up to 3% in closing costs, also charged against the seller’s side of the HUD-1.

If lenders changed their guidelines, such that no more than 3.5% could be charged against the seller for the compensation of the listing agent, with no more than 3.5% charged against the buyer for the compensation of the buyer’s agent, the commissions would be divorced.

So far, this is nothing more than a change in underwriting guidelines and HUD-1 accounting. Absolutely nothing has changed away from the paper-shuffling lender universe. The costs to the buyer and the proceeds to the seller are exactly the same.

Not to rock too many boats at once, but it would also be possible for lenders to make their internal procedures and the HUD-1 bookkeeping more honest, putting a little extra money in the pockets of both buyer and seller.

In the chart shown below, the first column illustrates the current procedure. The middle column shows how commissions can be divorced while retaining the psychotic style of accounting lenders currently deploy. The third column demonstrates how commissions can be divorced using accounting that is consonant with what is really going on.

Two points to take away:

First, divorcing the commissions will impose no new financial burdens on buyers. To the contrary, taking control of their agent’s compensation should empower them to pay less and/or get more overall value from their representation.

Second, in reality, divorcing the commissions can be effected simply and instantly, by the voluntary and unilateral action of mortgage loan underwriters. If they choose to insist on either column two or column three, as shown above, column one will be gone overnight.

And now it’s time for the lenders to issue a “yeah, but.”

“Yeah,” they will say, “but we will only loan against real property, not to pay the buyer’s agent or the buyer’s closing costs.” Which is to say the deliberately self-deceptive psycho lender math in column one is fine, but the exact same transaction expressed honestly — as a reflection of what is really and truly happening in real estate transactions all across America — is not acceptable.

This is absurd. The real estate commissions could be divorced tomorrow if lenders would insist on being told the truth instead of being willfully complicit in millions of new lies told every year.

The real estate commissions could be divorced tomorrow if the National Association of Realtors would impose a real code of ethics, one that forbade any member to participate in any real estate transaction where one party pays even one cent to the other party’s representative.

The real estate commissions could be divorced tomorrow if the Federal Department of Housing and Urban Development were to insist, via the RESPA guidelines, that the HUD-1 settlement statement reflect the actual flow of funds in a real estate transaction and not the inane lies the lenders insist on telling themselves.

In reality, the real estate commissions will be divorced when the Department of Justice, the Federal Trade Commission or a heavy-gaveled judge orders that they be divorced.

That’s a shame, because the rectitude of the matter is beyond all doubt. Some home sellers might want things to go on as they have, since sellers have such huge and unfair advantage in the present circumstance. Surely all home buyers, at least those who have read these essays, want for the commissions to be divorced at once. But we are each of us sometimes sellers and sometimes buyers, and our best long-term interests are served by creating compensation systems for real estate representation that are equitable — and that align “our” agents’ interests with our own.

This is but one of many salutary benefits that can be achieved by divorcing the real estate commissions. We will take note of some of the others in our next installment.

 
In Part IV: Not just benefits but salutary benefits…

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