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Brokerage Commissions, a direct cost: In the United States, if a house is sold, the seller’s broker typically receives six percent of the value of the house as commission (and splits this commission with the buyer’s agent). Thus, if a real estate agent manages to sell a house for $300,000, the commission is $18,000. Put differently, without an agent, the buyer and seller could have split the $18,000 between them. (Of course, brokers do many useful things, such as matching buyers and sellers, shepherding the selling process, etc., so the $18,000 may just be the intrinsic transaction cost to selling a house. However, inconsistent with this view, real estate commissions are much lower in other countries, and it is difficult to see why the cost of selling houses would be exactly 6% in practically all markets in the United States.)
Although only the seller pays the broker’s cost, it makes sense to think of transaction costs in terms of round-trip costs—how much worse you are off if you buy and then immediately sell an asset. You would mislead yourself if you thought that when you buy a house, you have not incurred any transaction costs because the seller had to pay them—you have incurred an implicit transaction cost in the future when you need to resell your investment. Of course, you usually do not immediately sell assets, so you should not forget about the timing of your future selling transaction costs in your NPV calculations.
Housing transaction costs are so high and so important that they are worth a digression. If you borrow to finance the investment, transaction may be higher than you think. The real estate agent earns 6% of the value of the house, not of the amount of money you put into the house. On a house purchase of $500,000, the typical loan is 80% of the purchase price, or $400,000, leaving you to put in $100,000 in equity. Selling the house the day after the purchase reduces the owner’s wealth of $100,000 by the commission of $30,000—for an investment rate of return of –30%. This is not a risk component; it is a pure and certain transaction cost.
Let us briefly consider what happens if the house price decreases or increases by 10%. If house prices decline by 10%, or the buyer overpays by 10%, the house can only be resold for $450,000, which leaves $423,000 after agent commissions. The house owner is left with $23,000 on a $100,000 investment. A 10% decline in real estate values has reduced the home owner’s net worth by 77%! In comparison, a 10% increase in real estate values increases the value of the house to $550,000, which means that $517,000 is left after real estate commissions. The house owner’s rate of return for the same up movement is thus only 17%.
With the tools you already know, you can even estimate how the value of a typical house might change if the Internet could instantly and perfectly replace real estate agents. You cannot be too accurate—you can only obtain a back-of-the-envelope estimate. A typical house in the United States sells every seven years or so. Work with a $1,000,000 house, and assume that the expected house capital-gain appreciation is 0%—you consume all gains as rental enjoyment. In this case, the house will stay at $1,000,000 in value, the commission will stay constant at$60,000 and will be paid every 7 years. If the appropriate 7-year interest rate were 40% (around 5% per annum), then the value of the brokerage fees would be a perpetuity of $60, 000/40% = $150, 000. The capitalized transaction cost would therefore have lowered the value of the $1,000,000 house by $150,000. If you could eliminate all commissions, e.g., by selling equally efficiently over the Internet, such a house would increase in value by about 15%. However, if you believed that the brokerage commission were to go up by the inflation rate (2% per annum, or 15% per 7-years), the friction would not be $150,000 but $240,000—more like 25% of the value of the house, not just 15%.
Other direct costs: In addition to direct agent commissions, there are also many other direct transaction costs. These can range from advertising, to insurance company payments, to house inspectors, to the local land registry, to postage—all of which cost the parties money.
Indirect and opportunity costs: Then there is the seller’s own time required to learn as much . about the value of the house as possible, and the effort involved to help the agent sell the house. These may be significant costs, even if they involve no cash outlay. After all, the seller could spend this time working or playing instead. Furthermore, not every house is suitable for every house buyer, and the seller has to find the right buyer. If the house cannot be sold immediately but stays empty for a while, the foregone rent is part of the transaction cost. The implicit cost of not having the house be put to its best alternative use is called an opportunity cost. Opportunity costs are just as real as direct cash costs.

So, if you are an entrepreneur who wants to start a company, what can you do to reduce the expected cost of capital? The answer is that it is in your interest to disclose to the lender all the information you can, provided you are the type of entrepreneur who is likely to pay back the loan. You want to reduce the lender’s doubt about future repayment. Unfortunately, this can be very difficult. The lender can neither peer into your brain, nor give you a good lie detector test. Attempts to convey information credibly in the real world are many, but there will always be residual information differences—they are just a fact of life. Still, if you can reduce the information differences, your firm will be able to enjoy lower costs of capital. Also, if you as borrower fail to give your best try to convince the lender of your quality, then the lender should not only assume that you are an average company, but instead assume you are the very worst—or else you would have tried to communicate as much as possible.
There are at least three important mechanisms that have evolved to alleviate such information differences. The first mechanism is covenants, which specify upfront what a debtor must do to maintain credit. This can include such requirements as the maintenance of insurance or a minimum corporate value. The second mechanism is collateral—something that the creditor can repossess if payments are not made. But anything that inflicts pain on the debtor will do. For example, if defaulting debtors were thrown into debtor’s prison (as they often were until the 19th century), the promise to repay would be more credible and lenders would be more inclined to provide funding at lower rates. Of course, for the unlucky few who just happened to suffer incredibly bad luck ex-post, debtors’ prison has some definite drawbacks.
The third mechanism to alleviate repayment uncertainty are credit rating agencies, which keep a history of past payments to help assess the probability of future default. This is why you need to give your social security number if you want to take out a substantial personal loan—the lender will check up on you. The same is true for large corporations. It may be easier to judge corporate default risk for large companies than personal default risk, but it is still not easy and it costs both time and money. The two biggest bond credit rating agencies for corporations are Moody’s and Standard&Poors. (The other two are Duff and Phelps and Fitch.) For a fee that the corporate borrower pays, they will rate the bond’s quality, which reflects the issuer’s probability that the bonds will default. This fee depends on a number of factors, such as the identity of the issuer, the desired detail in the agencies’ investigations and descriptions, and the features of the bond (e.g., a bond that will pay off within one year is usually less likely to default before maturity than a bond that will pay off in thirty years; thus, the former is easier to grade). The credit rating agencies ultimately do not provide a whole set of default probabilities (e.g., 1% chance of 100% loss, 1.2% chance of 99% loss, etc.), but just an overall rating grade. It is up to the ratings’ reader to translate the rating into an appropriate compensation for default risk. The top rating grades are called investment grade, while the bottom grade are called speculative grade (or junk).
There is often a sharp difference in quoted interest rates between the worst investment grade bond and the best speculative grade bond, partly also because many investing institutions are allowed to hold only investment grade bonds.
So, is there a difference between bonds of different rating quality? Yes! Altman studied corporate bonds from 1971 to 2003 and reported default and recovery rates. Very few investment grade bonds default—and especially right after issue when they would have still carried the original credit rating. However, many speculative bonds will eventually miss at least one coupon payment (which is considered default). Upon default, an AAA or AA bond price was worth about 75 cents on the dollar; an A bond price was worth about 50 cents on the dollar; and lower rated bonds were worth about 30 cents on the dollar.
Unfortunately, although bond rating agencies will update their rating if the condition of the firm changes, the empirical evidence suggests that these bond ratings are not very good in helping an investor earn superior rates of returns. In fact, the ratings seem to respond more to drops in the value of the underlying bonds than vice-versa. The bond rating agencies seem to be more reactive than proactive.
How do bond ratings translate into differences in promised (quoted) bond yields? lists the borrowing rates of various issuers in May 2002. (Many other current interest rates can be found at www.bloomberg.com/markets/rates/index.html and bonds.yahoo.com/rates.html.) Most of the differences between these borrowers’ promised interest rates and Treasury interest rates are due to default risk, which compensates lenders for differential default probabilities.

Where do such market imperfections apply? In the world of large corporations, the interest rate spread between similarly risky borrowing and lending rates is often mild, so they can pretend they live in a “perfect” market in which they can separate the project choice from their financial situation. Their promised borrowing interest rates would still be higher than what they can receive investing their money in Treasury bonds—but, given that these large firms still have some possibility of going bankrupt, their expected borrowing cost of capital would probably be fairly similar to the expected rate of return that they could earn if they invested money into bonds with characteristics similar to those that they themselves issued.
In the world of individuals, entrepreneurs, and small companies, however, expected borrowing interest rates are often higher than expected saving interest rates. In fact, this issue of an extraordinarily high differential between expected borrowing and lending rates—and with it the role of cash-on-hand—is one important difference between “ordinary corporate finance” and “entrepreneurial finance.” Entrepreneurs find it very difficult to convey credibly their intent and ability to pay back their loans. As a consequence, many entrepreneurs even resort to financing projects with credit cards, which may charge a thousand basis points above Treasury bonds. These high borrowing costs can thus prevent rational entrepreneurs from taking many projects that they would undertake if they had the money on hand. It also means that more established firms or richer entrepreneurs should optimally take more projects than poorer entrepreneurs.
But be careful in the real world before you conclude this to be the case: Entrepreneurs tend to have notoriously over-optimistic views of their prospects. (Even venture capitalists, the financing vehicle for many high-tech entrepreneurial ventures, which advertise returns of 30%/year or more seem to have managed to return only a couple of percentage points above the riskfree rate over the last thirty years.) This may actually mean that entrepreneurs face only high promised borrowing costs, not high expected borrowing costs. Thus, the quoted spread between their borrowing and lending rates, which is really all that you can easily observe, likelyhas a large component that is due not to information disagreements but simply due to credit risk.