Journal of Real Estate Finance and Economics, Vol. 16:3, 257±267 (1998)
# 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
A Contingent Claims Analysis of Real Estate
RICHARD J. BUTTIMER, JR.
Department of Finance and Real Estate, UTA Box 19449, University of Texas at Arlington, Arlington, TX
76013, e-mail: email@example.com
This article examines real estate brokerage contracts as contingent claims. It derives terminal and boundary
conditions for this contract. A Nelson and Ramaswamy (1990) style lattice is then developed to solve the partial
differential equation for the value of the listing agreement. After identifying various parameters that determine
the contract's value, those parameters are varied to examine their relative impact on the contract.
Brokerage is perhaps the most studied area of real estate. Interest in brokerage research
originates with a variety of sources. Home sellers want to know whether brokers can raise
the sales prices of their houses. Governments and consumer groups want to know whether
brokers exercise monopoly power in the market. Brokers themselves wish to determine
their optimal pro®t maximizing behavior.
Academics tend to examine these issues in the context of market ef®ciency. The general
explanation for the existence of brokers is that they increase the ef®ciency of the market by
increasing the information available to market participants. An alternative way of saying
this is that they reduce the search costs faced by home buyers and sellers. Much of the
literature argues that there is, however, some collusion between brokers through the
Multiple Listing Services (MLS)
and that this collusion may allow brokers to extract
some rents from the market. The primary evidence normally presented is the near-
uniformity of commission rates in a given market. A common argument is that the effort
required to sell a house is not a linear function of the sales price and that if there is no
collusion among brokers, there should be, at the very least, variation in commission rates
across house price ranges within a given market.
Focusing on commission rates ignores a key aspect of the agreement: listing contracts
are contingent, not certain, claims. The broker receives a payout only if the property sells.
At the origination of the listing agreement no money changes hands, so the broker's
compensation for marketing the property is the present value of the future expected cash
¯ows. As this article shows, a number of factors in¯uence that present value. Some factors,
such as the commission rate or term of the contract, the parties can specify contractually.
Other factors, such as the rate at which the broker shows the property or the seller's
reservation price, they cannot specify contractually. Given that the homeowner controls