Home sellers should offer price protection the way many electronic retailers do.

The conventional wisdom debunked.
June 1 2009 6:54 AM

Crazy Eddie's House Sale

Home sellers should offer price protection the way many electronic retailers do.

Illustration by Mark Alan Stamaty. Click image to expand.

The housing market now faces a dilemma long familiar to makers of computers or flat-screen TVs: Prices are dropping so fast that many buyers may be scared off. Home prices have fallen by more than 30 percent since their peak in mid-2006, and although the decline is slowing, they continue to fall. Why buy a house now, many buyers think, if they can get the same house in six months or a year for substantially less? No one wants to catch a falling knife.

Above all, the market needs stability. And stability can be achieved—without adding a penny to the ballooning federal deficit. Like their counterparts in the consumer electronics industry, home sellers can reassure skittish buyers by offering a price guarantee: If this house is worth less than you paid for it in a year, I'll refund the difference.

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Why would sellers ever agree to such an arrangement? For starters, it may help them sell their homes. And it wouldn't necessarily cost them very much. Sellers could commit to reimbursing their buyers for any fall in the average value of homes in their area in the year following a sale. Such price protection would give buyers confidence that they won't regret their purchases even if the market does fall further and cheaper houses come on offer—confidence that they need in order to buy now. And if buyers gain confidence, prices won't fall, so sellers won't have to pay. In order to bolster this confidence, the government should make it easier for sellers to set up price-protection-escrow accounts, which would allow sellers to retain the risk that housing prices might fall after a sale is made.

Here's how it would work. At the time of closing, 10 percent of the purchase price might be placed in escrow for 12 months (with the remaining 90 percent going to the seller). If the median sales price in the city falls in the 12 months after the sale, then the drop in value would be returned from the escrow account to the buyer—with any remainder in the account being released to the seller. If housing prices don't fall (or go up), the seller would recover all of the escrow. The buyer in this case will take comfort in the knowledge that he did not overpay.

Escrow agreements aren't free, because escrow agents (the third parties that hold the money during the escrow period) need to be compensated for their trouble. But a standardized, plain-vanilla price protection escrow should not cost more than a few hundred dollars—a small price to pay for inducing buyers to re-enter the housing market. And it's natural for sellers to provide the insurance that price protection involves. If they can't sell their houses, they're going to end up bearing the house price risk anyway. Price protection escrow can also provide buyers with much needed insurance without having to face the difficult question of how to measure and price housing market risk.

The key to price protection is to agree on a definitive, nondiscretionary real estate index that the escrow agent can look to in divvying up the escrow cash after 12 months. The escrow formula doesn't need to take on the difficult task of assessing the value of the particular property. The new buyer should retain incentives to maintain and improve her own house's value. All that's needed is a measure of how housing prices in the area are faring. The measure needn't be perfect in order to work, and if there are too few sales on a particular block or street, the price benchmark might refer to a ZIP code or even a whole town. In most cases, the median sale price or even the Zillow.com estimate of house value (which similarly turns on comparable sales in the area) will be more than sufficient.

Finally, price protection escrows need not cost the general public a penny. They can be adopted by private parties by themselves. Of course, a gentle government nudge might help private parties take advantage of the benefits that these arrangements provide and in this way try to bring stability to the broader housing market. To this end, the government might develop standardized escrow forms or require real estate agents to offer buyers and sellers the option of including price protection in their contracts.

To be sure, price protection escrows aren't feasible for all sales. If the sellers don't have much equity built up in their homes, they will need all of the buyer's money at closing merely to pay off their existing mortgages. And some sellers will need the equity to make the down payment on their next house.

But these are details that could easily be worked out between buyer and seller. In most cases, with price protection escrow everybody wins. Buyers get to move in, sellers get to move on, and the rest of us benefit from a more stable housing market—and maybe a more stable economy, too.

Ian Ayres, author of Super Crunchers: Why Thinking-By-Numbers Is the New Way To Be Smart, and Daniel Markovits, author of A Modern Legal Ethics: Adversary Advocacy in a Democratic Age, are professors at Yale Law School, where they both teach contracts.