Profitability: Why is it so Hard?

 This is an extract from the 2004 best seller Real Estate confronts the Future by Stefan Swanepoel and Tom Dooley.  In this chapter the authors interview Dr. John Tuccillo, former chief economist of the National Association of REALTORS® and today leading consulting and author. To purchase the book click here.

Introduction

The pace of change in the real estate business the last decade has, if anything accelerated. What began as a challenge generated by the technology revolution has evolved into a world of intense competition from both familiar and new rivals. It is a world in which new business models have been warranted and explored. Now the challenge for broker-owners is to re-position their companies to survive and thrive in this new environment.

The fortunate part of this challenge is that it comes while there is time to accomplish change. The real estate market is strong and likely to remain so through the entire decade.  Prosperity may be the enemy of change, but it also goes a long way in underwriting change. That said there still remains the question of what to do? There are so many aspects of real estate today, where does one start? As with many challenges, this one is best addressed if reduced to simple elements. 

Can one make a business of real estate brokerage?

“Brokerage” means the process of serving as an authorized intermediary between principals in a transaction. The definition excludes both agency (the representation of a principal in the transaction) and the provision of ancillary services. Under this definition, the answer to the question appears to be “no.”  A moderate sized firm in which the broker is not also an agent, and no other services are offered, cannot survive on the proceeds of real estate brokerage.

The estimates are all over the lot, and any average masks a great deal of variation, but the gross brokerage commission on a transaction appears to average less than $200. This number prevails today in the best real estate market in history, where there are large numbers of transactions to share around the market. From this “company dollar,” the broker-owner who does nothing else must pay taxes, interest and overhead expenses. That leaves little for profit. The company dollar will change over time as it is subject to both cyclical and longer-term influences. Cyclically, the news is good. The strong real estate market has pushed gross returns up. Over the longer haul, the trend is flowing away from the broker-owner. For the past quarter-century the company dollar has declined as a greater share of the commission has been assigned to the agent.

There are three ways by which broker-owners have sought to overcome this trend. First, many run small shops in which they themselves are major producers.  Although brokerage income per transaction has declined, their total income has remained steady or even risen because they are acting as agents and earning commissions in a very strong market.  Second, many large firms have grown even larger, either by opening new markets or acquiring competitors. In this case, overhead is spread over a larger number of transactions and a higher transaction volume offsets the shrinking margins. This approach accounts for the dramatic consolidation of the industry, which has lost about one-third of its firms over the past fifteen years. Both of these trends account for the polarization of the industry, in which the very large and the very small are thriving at the expense of the middle.

The third approach to the declining company dollar is to expand the business into other related areas in order to increase profit margins per transaction. This process is called "remargining" and it entails devoting resources to business lines that offer the highest return.  The brokerage function may generate $200, but the title insurance on that transaction can yield $800 and the mortgage origination $1,200.  If the broker-owner becomes involved in these and other services such as new homes, home warranty, home inspection and others, profit margins can rise dramatically. Increasingly, remargining has become the strategy of choice for large companies. By increasing the number of business verticals in which they operate, they increase their income, which in turn underwrites their acquisition of other firms, which in turn drives more transactions to their ancillary businesses. Incidentally, most remargined companies report a higher than average income per transaction from their brokerage services.

So how should brokers organize their company?

Diversification and remargining may be the best model to employ in a world of shrinking brokerage income. In fact, this model is becoming dominant among larger companies. They are increasingly entering a number of verticals – mortgage, title, insurance, etc. – in addition to brokerage. They are also organizing themselves in a corporate model. A single supervisory executive oversees the entire company, with individual executives responsible for different business lines. This trend may trace back to the entrance of Cendant into real estate, generating competitive pressures that have resulted in the corporate form of business organization popping up throughout the industry.

There are, of course, other possibilities, and we are seeing examples of them all. Most companies have altered the channels they use to generate business. The Internet has allowed even the smallest companies greater direct access to the public, decreasing their reliance on agent farming as the source of new business. Other companies (Keller Williams and EXIT Realty are prime examples) seek to bind their best agents to them by offering an annuity based on their own books of business, as well as other agents they bring into the company. Still others maintain the traditional model.

All of these models work – under two conditions. First, the form of organization needs to be appropriate to the size, market position and talents of the brokerage. Before any form of organization is implemented, the broker-owner needs to conduct a thorough assessment of each of these factors and then pick the organizational form that offers the best chance for success. Few real estate firms, and virtually no small ones, do this kind of strategic thinking. However, in a more competitive and less certain market, it is absolutely necessary.

The second condition is the quality of management. No company can succeed unless its operational line management is skilled and can implement the strategies chosen by ownership. Unfortunately, the lack of good management is the Achilles heel of  this industry. Too often office managers, those with the line responsibility for implementing company policy, have been chosen from the ranks of agents and they wind up acting as shop stewards rather than representatives of management. The result is that anything ownership decides to do often runs into a wall at the office level.

The need for management expertise applies equally to both large and small companies. Even single proprietorships must be managed well in the competitive environment that permeates today’s real estate industry. Solid management training in accounting, finance, human resource management and planning, through formal business school courses or executive extension programs, are vital to the successful company. The bottom line here is that the way in which you organize your business not only must be appropriate to your market situation, talents and goals, it must also include a well-trained, business-savvy management team.

Where will brokers find the next generation of agents?

The traditional brokerage strategy of “feet on the street,” the practice of recruiting large numbers of agents in the hope that some or most of them will produce commission income, has benefited from the demographic structure in the United States. The baby boom generation has grown up to regard “total control” of their lives as a birthright. They also came of age when the women’s movement ingrained “doing it all” (motherhood and a career) as a societal value. Real estate suited both of these very well. The agent, as an independent contractor, could set her own hours, giving flexibility and work as much or as little time as she wanted, thereby generating total control. Consequently, boomers flocked into the industry. Until today’s great market, the largest membership increase in NAR came in the seventies, when waves of baby boomers signed up.

Those agents have aged in place and the time to replace them is nearing. Currently, the typical agent is in her mid-fifties. The rapid rise in the number of agent in the early years of this century has done little to affect this median age, as the bulk of new entrants are late career transfers taking either early retirement or those made redundant by recession and technological change.

There are two major implications for brokers in the industry’s demographics. First, there is a cliff looming out there. Eventually, the industry will be hit by the departure of a large number of agents. The stock market slump that began in 2000 has extended the working life of many baby boomers, but eventually, they will leave the industry. The numbers are potentially staggering, with the possibility of half the agent labor force leaving over the next eight years. Technological change has increased agent productivity so the number of agents necessary to service the market will be less. But demographic change is going to leave a large hole in the industry labor force.

The second implication stems from the growing age gap between the typical agent (mid-fifties) and the typical buyer (mid-thirties). Clearly these are two different generations with their own concepts of value, preferred channels of communications and preconceived views of how the world works. Often the sales methods most comfortable to the agent, which have worked for that agent for years, fall flat with younger buyers and sellers, who see the market and the sales process differently. Even if the boomer agents stay in the business, the broker who wants to cover the market will be wise to recruit some agents who speak the same language as the typical buyer.

This can only be done through an understanding of what attracts this age group. Unlike boomers, today’s typical buyer does not highly value independence and control. Telling them that they have the opportunity to set their own hours and generate their own income has little appeal. Rather, they seek security, predictability and the certainty of how their time will be spent. This means that to attract the younger generation of agents in any kind of numbers, brokers may have to change the way they compensate them. Younger agents will be attracted by an employment relationship that offers benefits and weekends off. They do not need to be – in fact, probably do not want to be – independent contractors. They will be happy to be employees.

These patterns reflect averages and do not imply that there will not be any younger licensees that operate in the traditional mode. Some will but most, however, will not. So the answer to the question posed above is that brokers will get new agents from the same places where all other companies recruit their workforces. They will be competing in a general labor market.

So how should brokers promote listings in the new economy?

 Real estate is an information business and it grew up around the control of information. Before the technological revolution and the ubiquity of the Internet, the agent and the office were the primary channels available for buyers to find out which properties were currently being offered for sale, and for sellers to expose their properties to all available buyers. In fact, if we ignore properties offered directly to the public by their owners (a small percentage of all offerings), they were the only channels.

The Internet has changed all that and has generated major controversies for agents. Now consumers can access and review property offerings in great detail before they ever contact a real estate professional. Additionally, other businesses such as mortgage companies, title companies and affinity groups can attract consumers and then refer them to real estate professionals for fees. Currently, NAR is attempting to implement rules that would limit the access by these third-parties to listings and thus constrain the value they offer the consumer. Finally, the Internet has increased the appeal of electronic advertising and ruptured the symbiotic relationship between real estate companies and newspapers that was developed when print advertising was the vehicle of choice for exposing real estate listings.

The dilemma facing the broker-owner in this area is how to make sense of all the channels through which listings can be exposed to the public. Fortunately, the solution is quite simple. Since the company has a fiduciary responsibility to maximize the exposure of all its listings, it must use all possible means at its disposal. The company has little control over the leakage of its listings to third-party sites. It can withhold permission for its listings to be included in any package offered by its MLS to specific sites, but that’s about the extent of it. For the most part, the third-party issue is a red herring, in that the share of the consumer’s mind dominated by agents and companies is so great that the third-party companies will never make a significant dent in the business.

It can, however, control how it exposes its own listings directly. The key to exposing listings in the electronic age is the creation and maintenance of an attractive website. If there is any investment that springs to the top of a spending list, it is this one. The company needs to develop an easily navigable, visually attractive comprehensive site that allows the consumer interested in buying property to gather all the information he needs. If the company does not offer ancillary services (mortgage, title, insurance, etc.) the site should link to companies that do. Then it should be advertised in all possible ways (print, radio and television) so that consumers are driven to the site.

The second element in exposing listings is the maintenance (or repair) of the relationship with the local newspaper. The use of print worked well in the past and it will work equally well in the future. But it must be integrated with an electronic package, preferably on the Internet. Many newspapers are working in parallel with real estate companies, attempting to create their own attractive websites to attract the public. Broker-owners need to make common cause with the newspapers and move the relationship that worked so well in print into the electronic age.

What technology do brokers need?

If this were only a $64,000 question, we’d be lucky! Technology in real estate has become an all-devouring monster that eats at budgets in a way nothing else ever has. The entry fee is high and accelerated obsolescence makes the upkeep even more burdensome. It is also a foreign country to most broker-owners, partly because it fits none of their experience and partly because their age makes it hard to climb any learning curve, much less one as difficult as technology. All this is intensified by the overblown claims of technology vendors.  The best way to address this issue is to think about what you want technology to do. Technology is a tool, nothing more. It cannot tell you what to do; it can only make easier that which you have already decided upon. If you have decided on your business goals, if you have a business plan, then you can clearly evaluate and efficiently choose the right set of tools.

Once again, the answer to this question is simple and it has two parts. The first part is to remember the simple rule that the company needs to be at least as technologically sophisticated as its most sophisticated agent and customer. This simple answer masks a large implementation challenge. Since typical buyers and sellers are getting younger, they are also becoming more sophisticated. Agents are older but they have been dragged kicking and screaming into the new world of technology and have been forced to become comfortable with large number of technology tools.

The broker-owner, to match the progress of both agents and consumers, needs to focus on the ability to communicate with, and transmit information to, both agents and consumers through the channels with which they are most comfortable. For example, consumers are increasingly comfortable screening properties electronically.

The second part of the answer is a bit more complex. It involves the use of technology to satisfy the consumer value proposition. The first thing to remember is that consumers are looking for companies that will give them back time, take away stress and offer one-stop shopping in a convenient venue. Companies have not always attempted to address this value proposition. The information monopoly that has supported the business has also blinded most participants in the industry towards the need for real customer service. Those who attempted to address the issue found that the tools available to them were inadequate for the task. The task of choosing technology to address the consumer value proposition consists of three steps:

1. Break the business down into its constituent parts: Lead generation, contact management, listing, property screening, contract, financing, settlement services and closing.
2. Evaluate your ability to provide the consumer value in each of these areas. This involves evaluating your current tools and comparing them to the tools available on the market.
3. Replace what you have and add what you need. Most important in this step is to integrate all the tools you use and create a plan to replace them. If they do not work together, your agents will be less likely to use them. If you do not improve the quality of your tools on a systematic basis, you will not be able to match your most sophisticated clients and customers.

Closing Comments

The new world of brokerage is not as complicated as it seems. If there is a theme running through the key issues, it is that at its base, the business has not changed all that much. Consumer value, wise evaluation and effective use of tools remain keys to success even if the particulars around each of them look different from what the industry is used to. The real change that has affected the real estate industry is the need to operate more skillfully as a business than was necessary in the past. New competition has placed a premium on effective management and the implementation of a thoughtful business plan. With such a plan, the answers are easy; without one, there are no answers.