Notorious R.O.B.

One of the more insightful posts on the industry came earlier this week from one of the more insightful people in the industry: Nicolai Kolding, COO of Better Homes & Gardens Real Estate, and former head of M&A for Realogy. This is a man who knows what he’s talking about.

He gave a presentation (PDF) at Inman Connect in San Francisco that I unfortunately missed due to meetings and such but I think his blogpost covers most of his basic points:

- The current business model for real estate brokerage is unsustainable.

- There are four financial factors that drive revenues:

1. The number of homes sold (with each sale having two “sides”),
2. The average price of the sales,
3. The brokerage’s take after the agents’ commission splits (”percent retained”),
4. The amount (in percentage) received per transaction (”average broker commission rate” or ABCR).

- Three of these four factors have been going in the wrong direction over the past decade or so. The deterioration was covered by rising home prices during the Bubble, but sides, percent retained, and ABCR have all been headed down.

- Even if home prices recover, without changing these fundamental dynamics, the current brokerage model is unsustainable.

- The sustainable model of the future will, in Nicolai’s view, do four things:

1. Maintain (or increase) ABCR by constantly updating and improving the value proposition to consumers;
2. Increase average agent productivity;
3. Increase percent retained through brokerage-generated business;
4. Generate a far higher output per square foot of office space.

Nicolai recommends a bunch of action items in his presentation.  For example, he talks about reducing office space to 50 sq.ft. per agent, restructuring commission plans and compensation plans, consolidating certain functions such as accounting and marketing, and eliminating technology/office items such as printing, copying, extra landlines, etc.

As it happens, I think Nicolai is right on target in many many respects.  In the comments to his blogpost, there are some heavy duty thinkers weighing in on how to fix the status quo and structure a business model for brokerage that makes sense going forward.

One of the things I wanted to do — and I’ve asked Nicolai for some help on this, which he was kind enough to supply as he could — was to contextualize the discussion by looking at the numbers involved.  A lot of the talk about business models feels to me like a bunch of hot air unless we can start looking at numbers, even if manufactured/fake, just to have some basis for discussion.

Introducing… Simulacra

Let me introduce Simulacra, a “traditional” brokerage with some numbers for the purposes of discussion.  Here’s the link to a simple spreadsheet.

As you can see, this is a brokerage with 500 agents divided into four quartiles, with varying splits, varying production levels, and the like.  The end result is that this brokerage does 3,600 transactions, with 2.5% commission rate per side in a market with the avg. home price of $300K — sort of vanilla really.  That means $7,500 is the GCI per transaction.

Again, look at the spreadsheet for some of the analytics, but bottomline is that when the top split is 80% for Tier 1, Simulacra ends up with $7.425M in company dollar against $27M in GCI, or a company dollar % rate of 27.5%.  That keeps Simulacra in line with the RealTrends study of a couple of years back showing that the average retained company dollar was about 26.7% among respondents.

With the expenses set at Nicolai Kolding’s estimates of about 5% of GCI for Occupancy (office leasing), 5% for Marketing, 10% for Salary, and 5% for G/A (general overhead), the end result is that Simulacra makes $7.425M in revenues, incurs $6.75M in expenses, for a profit of $675K — a profit margin of 2.5%, which is in line with the reported average of 3% for real estate brokerages.

Now, here’s the thing.  From what I’ve heard from realtors and brokers, managers and franchise people, 80% is hardly the top rate for a Tier 1 producer.  It’s closer to 90% for the top agents, and in the case of some brokerages (e.g., Keller Williams), there are models offering 100% splits (after a cap, or with transaction fees or some such).

If you reset the splits to reflect 90% as the Tier 1 rate (and cascading down — 80% for Tier 2, 70% for Tier 3, 60% for Tier 4), the results are on Sheet2 in the link above.  Bottomline is that our little brokerage, Simulacra, goes from making $675K for a 2.5% profit margin to losing about $2M per year.  Could this be what’s going on at brokerages around the country?

Cost-saving measures — such as reducing office space, laying off staff, etc. — have an impact of course.  I wanted to see what that was.  In Sheet2, you see that I reduce Occupancy costs by 50%, Salary by 25%, and G&A by 50%.  Result?  Instead of losing $2M a year, Simulacra now breaks even.  But think about that: our profit for the year is zero from all those dramatic cost reductions.  If you go all-virtual, and simply eliminate the Occupancy cost altogether, then Simulacra will make a profit of $675K — the same anemic 2.5% profit margin of the “Top Split 80%” version.

Implications and Inferences

Let me grant at the outset that the data for Simulacra is entirely made up, although I have tried to keep them “reasonable” and based on what I’ve seen and heard.  Nonetheless, the numbers strongly imply that cost-cutting measures simply are not the way forward.  Since “expenses” for a brokerage operation apply to Company Dollar, they leave out the single biggest expense line: Cost of Sales.  That strikes me as a simply insane way to run a business.

Charging various fees to the agent to try and recapture more dollars don’t strike me as a particularly wise way of going about things if for no other reason than the psychological.  Even if it amounts to the same thing, getting paid $1,000 less vs paying the broker a $1,000 fee seem to me to be in two totally different psychological dimensions.

Nonetheless, if the Cost-Cutting scenario above addresses the fourth of Nicolai Kolding’s Four Recommendations (“Generate a far higher output per square foot of office space”), let us address the other three.

Increase ABCR

First up is “Increase Average Broker Commission Rate by constantly updating and improving the value proposition to consumers”.

If you take the second spreadsheet (the “Bad Scenario”) and increase the Commission Rate to 3% per side from 2.5% per side, Simulacra’s losses widen to $2.43M from $2.0M.  Part of it is that expenses are tied to GCI as a % of GCI, and increasing ABCR merely increases GCI.  Perhaps the real model is to hold expenses steady, rather than as a % of GCI.  Doing it that way for Simulacra, what I find is that to increase GCI to a point of break-even — while holding expenses steady at $6.75M — the ABCR has to increase to 3.6% per side: an astronomical 7.2% commission rate for the buyer/seller.

In an environment where consumers think realtors already don’t deserve their 5% (the 6% commission is a historical artifact I think by this point) for the work they do, I can’t imagine a brokerage being able to charge 7.2% in commissions.  If anything, rational projections would think that ABCR is headed towards 2% per side.

Increase Productivity

Second up is “Increase average agent productivity”.  This one is a bit more challenging to analyze, because the “average agent productivity” is generated by the activity of all of the agents, and which group does more deals impacts revenues.

Simulacra boasts an average agent productivity of 7.2 sides per agent, with Tier 1 agents doing 35 transactions, Tier 2 agents doing 12 transactions, Tier 3 agents doing 3, and Tier 4 agents doing 1 transaction every year.  What’s a reasonable increase in productivity?  25%?

Increasing productivity (defined as transactions/agent) by 25% across all four tiers, while holding expenses steady (rather than as % of GCI) results in losing $843K instead of $2M.

So it’s an improvement, but hardly a solution unless there’s some sort of reason to expect that agent productivity would increase dramatically through the application of hitherto unknown techniques.  200% or 300% increases in productivity are irrational to assume absent some sort of major technology change — which requires investment in said major technology, of course.

Increase Percent Retained

The third (and final for us, since we covered the Office Space one above) recommendation is to increase percent of GCI retained through brokerage-generated business.  I have heard that brokers often charge between 20 – 30% of the GCI if the lead is originated by the broker (e.g., through the broker website).

Let’s think through how such a scheme would work.  Presumably, it would be entirely concentrated on buy-side, since I’m not sure what a “brokerage generated listing” looks like under the traditional model where agents are encouraged to work their individual sphere of influence to get listings.

One of the prevailing wisdoms is that the higher-tier, more productive agents, derive more of their business from listings than they do from buyers.  Indeed, the trend towards Agent Teams is the result of the main rainmaker agent wanting to focus on the listings business and hiring a number of buyer agents under him to work with buyers.  For our Simulacra model, then we have to assume that the brokerage-generated business will be focused disproportionately on the lower tiers.

For our purposes, then, I’m going to exempt Tier 1 agents entirely from a ‘brokerage-generated business’ deal — they’re busy enough and won’t want to pay the internal referral fee that the broker will charge.  So for Simulacra, of the 3600 total sides, 1750 sides simply won’t be affected.  That leaves 1850 sides from the Tier 2 – 4 agents.  Some % of that 1850 will be listings business, especially from the competent Tier 2 agents.  So let’s assume that 50% of Tier 2, 25% of tier 3, and 10% of Tier 4 transactions will be listings.  The pool of buyer transactions, then, is (1200 * .5 = 600) + (450 * .75 = 338) + (200 * .9 = 180) = 1,118.

Let us now assume that the brokerage, through increasing its efforts, will drive a large percentage of leads, resulting in some significant percentage of these 1,118 buyer transactions to be “brokerage-generated”.  Say that number is 30% — the remaining 70% will come from agent websites, Zillow, etc. — and that Simulacra will collect an additional 25% referral fee from those transactions.

The end result is an additional $628,125 in company dollar, as those referral fees kick in on 335 transactions.  That moves the company dollar percentage from 17.5% to 20%.  The net of all that is, rather than losing $2m per year, Simulacra will only lose $1.4M.

The Combo

Perhaps the answer is to combine all four approaches, as Nicolai would probably recommend: reduce expenses, increase/maintain ABCR, increase productivity, and increase percent retained through referrals.  So let’s combine all four things:

• Reduce Occupancy by 50%, Salary by 25%, G/A by 50%
• Maintain ABCR at 2.5% per side
• Increase agent productivity by 25%
• 30% of buyer transactions are broker-generated, with 25% referral fee

The net result of all four things is $33.75M in GCI, 20% retained for Company Dollar of $6,626,250 vs. Expenses of $5,906,250 for a net profit of $720K or 2.1% profit margin.

Considering that Bank of America is offering a CD at a fixed rate of 2.50%… I’m not sure that 2.1% profit margins are the future of the industry.

Reducing the Cost of Revenue

As I see it, if the analysis is not enormously flawed, any new model that will rescue the brokerage industry from its current morass will need to address the single biggest expense item: Cost of Revenue.  This is a tricky proposition, of course, since commission splits are being forced upwards, not downwards today — and since those are variable, dependent costs.  Until there’s a transaction, the broker has no expense — even if giving away 90% of the revenues to the agent, at least he’s not sinking in money in the absence of revenues.

At the same time, however, the numbers strongly suggest that the single biggest contributor to financial success or failure is the split percentage.  At 80% as the top split, Simulacra was making money, even loaded down with huge expenses; at 90% as the top split, Simulacra has to do all kinds of things, make all sorts of changes, in order to make less money (2.1% profit margin vs. 2.5% profit margin).  The implication then is that whatever model the future has in store must somehow figure a way to recruit, retain, and make productive agents at lower splits.

Take the original 80% as top split model for Simulacra; if I do nothing else but move my Tier 1 Agents from an 80% split to a 75% split, I double my profits from $675K to $1.33M.  Put everyone on 60% splits and Simulacra is now pumping out $4M in profits, a 15% margin — which is more than enough extra money to double the marketing spend and increase Salary by 50% (e.g., add support headcount), and still net more money than the old model.

In a sense, this is truly obvious; it’s so obvious that it oughta be an uninteresting truism.  If you keep more of what you make, then your profits are higher.  Like, DUH!  Yet, this is the sacred cow that can’t be touched in real estate brokerage today.  All the talk, all the dancing around issues of value, independent contractor vs. employee, profit sharing, etc. etc. are all attempts not to address the central issue of agent splits.

If, as Nicolai suggested in his original post, the status quo cannot hold… then I dare say that whatever replaces the status quo will be one where the brokerage is able to reduce the cost of revenue: the agent split.  In upcoming parts, I hope to examine a couple of those models to see how they work out numerically.

As always, criticism, comments, error correction, and reasoned debate are welcome.

-rsh

Related posts:

1. Repositioning vs. Reengineering: Real Estate Brokerage
2. Imagining the Future: Part 3 — Shifting the Grounds of Competition