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So if you’ve been following my little series here on commissions, you can find installments one, two, and three here. I started by asking five question about the real estate sales process and associated costs and premiums.

     1.    What are the standard elements to the real estate process
     2.    Can a baseline cost be applied to each of these elements
     3.    How does “service level” impact the premium placed on the baseline cost
     4.    What effect does the market have on the costs
     5.    What other factors would affect the premium calculation

Before we put all of this together, I want to make sure we’ve property put the concept of “Risk” in the perspective of other types of businesses.

The graph below is an illustration of the “Risk Profile” of a real estate sales transaction from the perspective of the “Vendor and Vendee” or “Real Estate Profession and the Seller” Its at the point where the two lines intersect that risk is passed from the Real Estate Professional to the Home Seller. However, while the risk has decreased substantially, it should also be noted that it’s unusual that no money has changed hands at this point. The real estate professional has delivered a ready buyer of the seller’s home, but has yet to receive any compensation for this work.

Note: 1 is where the consumer engages the vendor, and 2 is where the vendor is paid

Contrast the real estate professionals risk profile with the risk profile of a retailer, or a service provider like an auto mechanic. All of them have some upfront risk, associated with attracting clients; however, the retailers risk is slightly lower, because it’s mitigated by the salvage cost of the merchandise. As you see their risk transfers to the customer as soon as the customer purchases goods or engages them for services. It is at that point when a “revenue event” occurs and the vendor can record a receivable.

Note: 1 is where the consumer engages the vendor, and 2 is where the vendor is paid

When the Vendor and a Vendee engage in a “meeting of the minds” regarding the purchase of goods or services, the transaction is complete. Compare that with the real estate industry, when a seller engages a real estate professional’s services, no revenue event occurs, it is not until a third event the “closing” occurs when the real estate professional can record a receivable.I know you must be say “duh” this is all common sense stuff, true, but I don’t think most of us think of it as a reason for why commissions are constructed the way they are. Our commissions are based on a “contingency” that the house is sold. This contingency can be influenced by several outside factors, the market, the seller, the availability of capital. Not too many other service professions have such “contingencies” that can be influenced by third parties, except maybe trial lawyers that work on contingencies, and their fees are steep, up to one-half of your award.We can now begin to answer my original questions:

1. What are the standard elements to the real estate process?
    a. Lead Generation
    b. Sales
    c. Listing Management
    d. Offer Management
    e. Transaction Management
    f. Closing

2. Can a baseline cost be applied to each of these elements?
a. No, there is no guarantee of success in a given transaction a real estate professional cannot make a forecast regarding costs.

3. How does “service level” impact the premium placed on the baseline cost?
a. Since you can’t standardize costs, the addition of “premium service” can only drive up costs, in a given transaction. However, over a series of transactions it may actually drive down the cost of lead generation, further lower a real estate professional “risked capital” and creating higher profit margins.

4. What effect does the market have on the costs?
a. If there is a “hot” real estate market, meaning short “on-market” times for a given property, then costs associated with a transaction are lowered, and vicea versa.

5. What other factors would affect the premium calculation?
a. Risk is the primary factor which effects any premium above the costs of doing business, in this profession.

While many complain that real estate commissions are high, an opinion I share, but not because of the “greedy” real estate professional, but rather the consumer’s aversion to risk.

It’s the home seller that must assume some of the risk if they want to change the industry, and the cost of commissions. In the current environment where the home seller wants the real estate professional to tie up his capital, time, and resources selling their house, for an unspecified time, with an undetermined outcome, the real estate professional needs to have some sort of reward that is inline with that risk.

Yes, the real estate model is broken, it is inefficient, and the barrier to entry of new participants is low. However, it is only when we present a model to the consumer where some of the risk in the transaction is shifted to the home seller, that we can offer a “low fee” for our services.

I believe it is for this reason, that history has seen the loss of market share by the “flat fee” providers during down markets, as they just haven’t built up adequate reserves and their revenues are not high enough to sustain their model when the entire market shrinks.

There are some popular companies out there charging lower fees and giving rebates, but at a time when cash is needed to drive the marketing engines of what is essentially a marketing business, they will only last so long before they fold, unless they can achieve enough market share that they can basically bring their lead generation costs close to zero.

If you know me, you know I’m a 9 year veteran of the discount wars, I’ve founded and run my own “flat fee” company that had offices in several states, and have been the Chief Technology Officer of one of the nations’ major discount brands. I do truly believe commissions are not inline with costs incurred. However, as I’ve come to see now, when many of the “non-venture” funded discount brands struggle to grow and their offices are closing their doors, it is because our margins were too low. In a robust market, you can lower your margins because your risk/reward profile is shorter and your carry costs are lower, but when the market turns, as it has now, those companies, and real estate professionals, can’t simply survive on thin margins.

I hope traditional real estate doesn’t read this a “defense” of the 6% commission, it’s NOT. It’s an explanation of why it is what it is. The system is broken, but consumer education on shared risk is the only way to create change. If I were at the helm of a “big brand” I would start charging up front fees! The reward for both the consumer and the company are huge.