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In this third installment of how and why real estate commissions are constructed, and why consumers and industry outsiders have the perception that real estate professional fees are so high. I’ll talk about just when the home seller starts to share the risk and how real estate professionals mitigate that risk.

It’s interesting that once I begin to discuss risk with most people in the context of a real estate professionals’ commission, I can see little light bulbs going off over their heads. For consumers who are perplexed by the real estate professionals’ commission, they don’t see how that commission relates to costs the real estate professional incurred in the sales process, but then, they begin to see how there is a lot of capital tied up in that sale and that the time/value of money equation begins to make sense. Simply put, the real estate professional doesn’t make money unless the house sells. Sooo whats so hard about that?

4. Offer Management (Risk ~ 90% Real Estate Professional / 10% Home Seller) Here is really where the rubber meets the road. Real estate professionals and home sellers evaluate incoming offers to determine the following:

1. Which offer nets the seller the most
2. Which offer meets the sellers closing time frame
3. Which offer is most likely to close

Basically they are looking for the offer that has the most reward for the lowest risk. This is NOT a straightforward computation of facts. There are several factors that can effect the sale and this is where an real estate professional’s experience can play a valuable role. A real estate professional must properly weigh the offer against several given situational facts, such as:

1. Market conditions
2. Lending environment
3. Seller’s requirements
4. Buyer strength (credit, down payment, source of funds, etc)

Any one of these factors could have many facets and the balance of those factors can be thrown askew by many external forces.

Now, before I go making this sound like a tricky technical skill that can take years to master, you should understand in a good market, good offers are not hard to find; large down payment from a buyer with good credit and pre-qualification letter from a major lender. However, in a slow market, good offers are harder to find, and that makes the real estate professional’s skills and abilities all the more important. If there is a single process where great real estate professionals differentiate themselves from the pack it’s in “deal mechanics” or understanding the value of the offers, their associated risk and matching that to the seller’s needs/wants.

While this is not a practically risky activity for either real estate professional or home seller, the risk a home seller takes when selecting an “inexperienced” real estate professional is great, as they may not have the knowledge to identify the best offer in a handful of offers. Additionally, real estate professional’s motivation can play a role, because real estate professionals can “steer” a seller to an offer which may not be the “best” offer because it could mean a “double-sided” or faster payday, this is a ethics violation, but very hard to prove and even harder to enforce.

5. Transaction Management (Risk ~ 95% Home Seller / 5% Real Estate Professional) This is the phase of the sales process in which the house is, essentially “off the market” the property is under a sales contract and the parties should be working in good faith to complete the transaction. For the real estate professional, if they have done their work in the previous four phases, this phase carries little risk and the task work can be passed to an assistant or transaction coordinator to complete the sales process and close.

However, for the homeowner, the house being “off-market” means they are committed to the deal, and must use best efforts to complete the sale. Should a better offer come, they are precluded from accepting it. An unqualified or lazy and indecisive buyer can tie up a house for months, while they try to find a mortgage or come up with additional funds. Liquated damages, the practice of keeping the buyer’s deposit, may be hard to enforce, tied up by the escrow company, or little compensation for the period that house is off the market.

If all goes well, the transaction will close, and the home seller will receive the value of his equity, minus any fees due to the respective parties. It’s at this point much consternation is directed at the large sums the real estate professional has earned.

Many times consumers retroactively apply the outcome from a given transaction to a lower cost method of selling their homes without using the same inputs. Their $300,000 house sold for $310,000 in 60 days, it closed on time and with all of their conditions met. It’s at this time they say, if I would have used “so & so” to sell my house, I would have saved $5,000. It’s always interesting to say “what if”?

• What if the house sold for $320,000?
• What if the house closed in 10 days?
• What if the could have kept the appliances?

All of those could have added the extra $5,000 to the deal and may have been well within their control.

If a real estate professional, meets or exceeds expectations, he/she is met with malaise. It’s just hard for the public to get excited over such a long process with so many moving parts. It’s easy to lose perspective of the real estate professional’s contribution.

Friday, I’ll end this series with part four where, were we solve the Commission Paradox and show the holes in this model and how it can be improved for both real estate professional and consumer.

Men get a bad rap in the media these days, but here is to all you dads that love your kids…

HAPPY FATHERS DAY.

Spawn of Agent X

Here in part 2 of this series we begin to evaluate the question of whether the current commission structure is equitable for consumer and real estate professionals.

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward. However, there is doctrine of “diminishing returns” where at a certain point in a given transaction, the amount of new risk does not have a corresponding increase in reward.

 It’s important to understand these concepts as we go thru the next parts of this discussion, because much of what I believe, is that the current commission structure was designed to reward real estate professionals for assuming almost 100% of risk in the real estate sales process.One of the questions I asked yesterday was “what are the standard elements of the real estate sales process”.  In the graphic below, I’ve outlined the process from both the real estate professional’s and consumers perspective, with the consumer having the more simplistic view, thus more likley to have a view that real estate agents do very little, and risk very little.

 As we examine the process from the real estate professional’s perspective, I’ll assign the level of risk and to what party that level is assigned.

1. Lead Generation (Risk ~ 100% Real Estate Professional) The traditional lead generation and distribution model is inherently flawed. In fact I believe that it may be one of the most inefficient systems in American business. This phase of the process is the most likely culprit in the perception that commissions are over priced. Consider the following scenario:

 

Broker X has 100 agents in his office, and his office serves approximately 10 zip codes with about 200,000 households. Only about 3 of the 10 zip codes have more than 4% annual turnover and are the target market of more than 30% of the offices agents. Each of the 30 agents that markets to those zip codes spends about $300 a month on marketing to those zip codes. Total markets spend $9,000. Lets assume that each agent generates 10 leads from their marketing efforts. That is a cost of about $30 a lead. If you apply the doctrine of diminishing returns, after a certain point, say mailing #10, any additional spend doesn’t have a corresponding increase in return. You could spend only a 1/3 of what was spent by the competing agents and still generated the same amount of leads.  Combined per lead cost, $10. Consider further that agents in that office only convert 1 in 10 leads to a listing, in the current model the cost is about $300 per listing, vs. $100 per listing in the combined model.

NOTE: Mary Jane has a better marketing piece and generates more leads than average and has a higher conversion rate from leads to listings. This effect can be incorporated into the model over time by applying best practices to marketing and lead distribution based on conversion rates. We learn from our mistakes.

This lead generation phase is where the Zillow’s and Trulia’s of the world are going to work on you. They know that there is an economy of scale to lead generation and by having brands generate leads instead of individual agents, the brands can maintain brand integrity, have better control of the customer experience, and mitigate the “top producer” effect.

This phase of the process is one of the most risk intensive parts of the process for the real estate professional. They must extend capital in the hope that they can generate enough leads, that conversion is just a mathematical certainty, without going broke.

2. Sales (Risk ~ 100% Real Estate Professional) The sales phase is the process of which the Real Estate Professional develops property specific proposals and invests mostly time and shared resources in an attempt to convert leads generated in the previous phase.  This is “time intensive” in the extreme. The risk here is mostly the value of the agents time.

The “risk” involved is almost entirely the agents to mitigate.

For example, should an agent not do his due diligence on the property or the sellers, or is “forced” to list the house at a price he knows it won’t sell, the agent is risking, not only his time, but his reputation and possibility a significant amount of money.

3. Listing Management (Risk ~ 100% Real Estate Professional) There is a common misperception that because the homeowner has entered into a contact with the agent he is somehow sharing the risk with the agent. Not True. The homeowner still has very little to lose if an agent’s marketing campaign is unsuccessful. Provided that the house is occupied, or rentable, the sellers risk is almost zero. This phase is typically the entry point for a consumer relationship. From a consumer’s perspective this would be the “Property Marketing” phase of the process. They would define it as the period at which they work with their agent to stage and show the house in a manner conducive to a sale.

Much of the “work” that agents do is in this phase. They must conduct an inspection; stage the home, setup marketing for the property, property photos, MLS entries, yard signs, flyers, postcards, mailers, open houses, etc. These activities too, must take place without any guarantee of compensation by the agent.

Tomorrow I’ll talk about Offer and Transaction Management phases and how agents mitigate risk for their clients. This is also important to understand from a communication phase with your clients.

I’m a big fan of facts and proof. Last night I was watching the Science Channel about how there is some disagreement in the scientific community about how best to get humans to Mars. It caused me to think about the real estate community’s disagreement about commissions.

I think people generally believe that the following statement is true: “Real estate commissions are too high, and real estate services are overpriced”

I began to think where is the proof of that? How do we know it is true? It seems to me that we would need some supporting facts, to be able to confirm that statement applies in all situations. We need to know the following:

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

Over the next couple of days I’ll examine those questions and how the commission argument has developed among our community.

If you’re thinking your going to read a scathing rebuke of Redfin… you can bounce out right now.

I was trolling the real estate blogsphere over the weekend and was shocked by the absolute hate that Redfin receives from the real estate community. Its really more sad than anything. When an industry attacks innovation it is a sure sign of that industry’s impending death.

The major airlines attacked Southwest when it started, and left a lasting scar which is still visible to this day, (you can’t fly into Texas on Southwest from any state that doesn’t touch Texas, so no direct flights from LA to Dallas) They almost killed them. However, today, Southwest is one of the few airlines that can turn a profit, all of its attacker have long since gone or are now emerging from bankruptcy, realizing the status quo can no longer be maintained.  They fought their competitors, unions, and the airports, built systems that save consumers money and time and most of all made the short air travel enjoyable and affordable.

Redfin could be the next Southwest.

One thing is a sure bet, if we are attacking innovation, especially consumer centric innovation, we are losing the consumers hearts and minds. A battle we should and NEED to be winning.

What are we telling the consumer? We don’t care about you? We care more about protecting our tuff than helping you keep more of your money?

I’m embarrassed by the cheers that went up when Redfin got hit with a $50,000 fine for posting reviews of homes for sale? Can you imagine? What if Roger Ebert got hit with a fine for being critical of a current movie? What was even more galling, was the fact that were Redfin simply a consumer, instead of a licensed brokerage, posting those reviews nothing would have happened.

We ultimately make it harder for us all, when we poop on the consumer, we are lumped into the heap of deplorable professions like “used car salesman” or “blog operator”.

 Let’s elevate the discussion… if you’re better than Redfin, why?