Brokerage Models: A Mathematical Analysis, Part 2

In Part 1, we explored the traditional brokerage model by the numbers and found that there are significant issues with the current model as constructed.  It may be, of course, that my hypothetical numbers are just way off, and therefore, the entire analysis ought to be trashed.  I get the feeling, however, that in the main, the assumptions — and therefore the analysis — were mostly correct based on comments in the thread, as well as the simple fact that traditional brokers aren’t out buying luxury yachts and private planes by the hundreds.

But simply because “traditional” models — and please note that I exclude Keller Williams from the “traditional” model, as would Keller Williams itself — are broken does not mean that other models are sustainable.  We have had a number of discussions within the industry about how to address the flawed model for real estate brokerage, from low-overhead virtual models to heavyweight full-service/low-split models, to employee-based models.  Going forward, all of these models have to be put to the same test of (at least) hypothetical numbers.  If the hypothetical numbers don’t make sense, there’s little reason to think that the real world numbers (which are usually worse) would lead to the Promised Land.

One of the first I’d like to explore is the “brokerage as a law firm” model — simply because it was one of the first I had suggested back in the misty days of bygone memory.  The theory here is that producing agents — the rainmakers — would band together and form a partnership, much the same way that experienced lawyers get together to make a law firm, and employ associates who are on salary.  To test this, let us create another hypothetical brokerage for the purposes of discussion, debate, and comparison: TerraFirma.

Introducing… TerraFirma

TerraFirma is the name I’m picking for this model. (Get it? TerraFIRMa? Awww, okay, so I’m corny… sue me.)  Here’s the link to a simple spreadsheet online for TerraFirma.

The first thing that should jump out at even the casual observer is that the numbers look completely different for TerraFirma, as it must, since it is a firm that has no agent splits whatsoever.  The GCI = Company Dollar, period.  Put another way, this is the Zero Split model.

The concept is relatively simple and straightforward.  TerraFirma has three groups of professionals: Partners, Associates, and Support.  Partners are the rainmakers — superior agents (Tier 1 Agents in the Simulacra model) who have experience, knowledge, contacts, and a strong business development base.  They bring in leads, especially listings, which in turn generates buyer leads through the firm website and marketing efforts.  Associates are salaried real estate agents who work for the firm; various models exist for managing associates — they can be assigned to a partner, rotated within the firm, get a specialty (buyer rep, negotiator, etc.), and so on.  Support staff are just that — various individuals who do not need a real estate license, but support the partners and the associates as needed.

Actually, these Support people are extremely important to the TerraFirma model.  The idea is to create economies of scale and process efficiencies by specialization.  For example, rather than making each agent do her own marketing, TerraFirma has professional marketers (a marketing department even) who take care of all marketing on any listing.  The support team would likely include a Lead Management team that qualifies, manages, and tracks all of the leads; a Transaction Management team that performs a project management function on each and every transaction; a Marketing team that includes individuals who manages the firm-wide CRM system; Administrative staff for the partners and associates; and a IT team (or outsourced IT) that can deal with telecomm, computer, IT, and web issues so that the producers don’t have to.

The idea then is that the Partners bring in business, Associates do those pieces that requires a real estate license to do, and Support staff takes care of everything else.

The bottomline, based on these assumptions/analysis, is that TerraFirma generates the same $27M in GCI as Simulacra (back in Part 1) did, but earns a profit of almost $6.3M (versus a $2M loss for Simulacra), with a robust 23.3% profit margins.  Each of the 20 partners of TerraFirma should take home $355K in annual earnings as compared to the Tier 1 Agent at Simulacra earning $236K per year.  Sounds great, right?  Well, let’s examine the assumptions in some detail.

The Assumptions

The basic assumptions for TerraFirma are the same as those for Simulacra.  3,600 transactions per year, 2.5% BCR per side, $300K average sale price.  That results in $7,500 GCI per closed side.

One wrinkle I’ve added here is that of the 3,600 transactions, 1/3 should be Listings and 2/3 should be Buyer Rep. Based on advice and information from Sue Adler, a top producing team leader in New Jersey, it appears that a reasonable split for a company that is managing its leads and its agents is 1/3 Listings and 2/3 Buyers.  Listings generate buyer leads, and in the absence of laws or regulations prohibiting dual agency, a brokerage firm can most definitely represent both sides of the deal; TerraFirma would likely setup some Chinese walls internally to protect against conflicts of interest, if necessary.

Assumption: Rainmaking Efficiency

One of the key assumptions, then, is the number of partners required to generate 1,200 listings –> 2,400 buyer representations.  In Simulacra, it was assumed that a Tier 1 Agent’s practice was mostly focused on listings, and that each would generate 35 transactions = 35 listings.

My first assumption is that a Tier 1 Agent would nearly double his lead gen efficiency when freed up from most of the transactional, marketing, and administrative work as a partner of TerraFirma.  In the spreadsheet, I’ve reflected this by suggesting that each partner will secure 60 listings per year — slightly more than 1 per week.  Given that there are agent teams today that do hundreds of listings per year with one main rainmaker, who is doing everything else as well, this did not strike me as unreasonable.

That leads us to concluding that TerraFirma will have 20 Partners, each of whom is a strong lead generator, a strong lister, and an experienced top producing agent.

Assumption: LeadGen Bonus

I have further assumed that if a partner or an agent generates a lead, he or she will be entitled to a 10% bonus for each lead.  On the one hand, this is to incentivize partners to focus on lead generation.  On the other hand, it also incentivizes the Associate who has his/her own sphere of influence to bring business in to the Firm.

Assumption: Salaries and Headcount – Associates

The critical assumption, perhaps, is what an Associate and a Support staffperson would be paid in salary, and how many of each might be needed to conduct 3,600 transactions.

The 2009 REALTOR Member Profile revealed that the median REALTOR earns $36,700 per year in income.  For REALTORS with less than two years’ experience, the median income was actually $8,600.  Based on these numbers, I believe that if TerraFirma were to pay an annual salary of $40,000 per year, it would actually end up attracting a fairly high quality of Associates.  This number should be seen as an average; new associates with no experience might actually be paid close to the minimum wage, until they prove themselves as competent, while experienced associates who may be in line for partnership might make far more in compensation.

I have assumed that each Associate would fulfill 50 transactions per year — about one per week.  But this is not the traditional real estate agent’s work; it is literally only those activities that requires a real estate license to perform.  These might be showings, negotiations, or providing advice to clients.  Marketing, entering listings into the MLS, lead qualifications, etc. can and will be handled by the Support staff as much as possible.  Partners will, of course, get involved as needed (e.g., final negotiations, punching through difficulties, setting strategy for a particular listing, etc.), but the Associate focuses on getting the transaction done.  I felt that an organization generating 1,200 listings with 2,400 buyer transactions, with a disciplined lead management and transaction management practice, should have no problems creating enough work for Associates to do one transaction a week.

That leads to TerraFirma needing 72 Associates at $40,000 each, for a total of $2.88M in salary costs.

Assumption: Salaries and Headcount – Support

For Support, I have posited that TerraFirma requires a heavier support than a traditional brokerage.  However, recall that Simulacra was spending 5% of GCI on Salaries as well — possibly for people like Office Managers, Sales Managers, etc.  I have heard from reliable sources that some of the larger brokerages pay the managers extremely well, and that their compensation is tied to the performance of the office.  Salaries in excess of $300K per year for an Office Manager is not unheard of.  For TerraFirma, the management resides in the hands of the partners — as in any law firm — typically within an Executive Committee with a few partners who are more talented in management taking on those roles (for consideration in the profit splits, of course).

Support for TerraFirma is truly support; there may be an Office Manager, but her compensation is not tied to agent productivity.  There may be an expensive VP of Marketing, but that is a salaried position like any other in American business.

I have assumed that the average salary for Support will be $50,000 — again, an average between the highly paid professionals, and inexpensive staff such as data entry personnel or administrative assistants.  If Simulacra was spending 10% of GCI on Salaries, then TerraFirma will be spending 15% of GCI (or over $4M per year) on Support Staff salaries.  At $50K per head, this means that TerraFirma will be employing 81 support staff throughout the organization that is 173 people total (including the Support staff).  A nearly 2-to-1 ratio between producers and Support strikes me as extremely generous and backs up the theory that a real estate agent at TerraFirma focuses purely on functions requiring a real estate license.

Finally, I have assumed that payroll taxes and benefits will amount to 30% of the total salary — again, a generous estimate — on a base of roughly $6.9M, for an additional $2M or so in expenses.

Assumptions: Marketing

I believe that TerraFirma will have higher overall marketing costs, since it will take on all of the burden of marketing listings that are for sale.  Its agents are on salary (or are partners); they won’t be spending money out of their own pockets to market or promote a listing.  The Firm will.

According to Ines Hegedus-Garcia, an experienced agent in the Miami market, she spends about 25% of GCI on marketing a listing for sale.  It is not an inexpensive proposition.  I have assumed that because TerraFirma has professional marketing staff, and conducts all of the marketing out of its corporate account, there will be some economies of scale.  For example, it might purchase postcards in greater volume, resulting in discounts.  Therefore, I have set Listings Marketing at 20% of GCI, or $5.4M per year.

In addition, I have posited that TerraFirma will spend more than the traditional brokerage in corporate marketing.  As a partnership that wants to control its brand firmly, and needs to generate a strong brand for its partners to use in securing Listings, I have assumed that TerraFirma will spend double in corporate marketing as compared to a traditional brokerage: 10% of GCI vs. 5% of GCI, or $2.7M per year.

Assumptions: Occupancy and G/A

There is, however, no reason to believe that TerraFirma will spend significantly more on Occupancy or general overhead as compared to a traditional brokerage.  In fact, it is entirely possible that TerraFirma, a company of 173 people, will spend less than Simulacra, a company with 500 agents and undetermined number of support staff.  I have, therefore, set these as equivalent at 5% of GCI each.

TerraFirma Could Kick Ass

With those assumptions in place, what the numbers reveal is that TerraFirma generates $27M in GCI, keeps 100% of that as Company Dollar, then incurs expenses of $20.7M including Associate salaries.  Indeed, if you examine the numbers, it appears that Marketing will become the largest expense category for TerraFirma as it devotes fully 30% of the GCI to both corporate and listings marketing.

Let us pause and consider this factoid.  TerraFirma would spend $8.1M in marketing, both corporate and listings — and that’s assuming only a 20% economies of scale (20% of GCI vs. 25% of GCI) from concentrating all of the listings marketing spends and functions into a corporate marketing department from hundreds of agents.  With most of the advertising and marketing moving to online in real estate, and away from print/broadcast, consider what $8.1M — or even a healthy fraction like 1/4 or $2M per year — would buy you in interactive marketing.

We’re talking absolutely world-class websites, with top-notch, professionally managed SEO, social media campaigns staffed by full-time professionals, individual websites for each of the 1,200 listings, transactions management tools, etc.

If I were in charge of a $8.1M marketing budget for a brokerage company, I would probably recommend spending no less than 25% of that on CRM efforts.  Again, $2M spent on not just the technology, but also on professional CRM marketers to do client followups, engage customers and prospects, do market segmentation, leads analysis, cost-of-acquisition analyses, and the like, should yield a real competitive advantage against the Simulacra’s of the world who have none of this and couldn’t afford it with its revenue/profit profiles.

Even with spending $4M between web, social media, and CRM, TerraFirma would still have another $4.1M left for other sorts of marketing and branding activities.  Consider whether this is an advantage for a firm’s lead generation and business development efforts.

The Question of Recruiting

One of the biggest arguments against any sort of a salary-based model is that such a company won’t be able to retain top agents who would make far more money as an agent in a high-split brokerage.  The standard knock against Redfin, for example, is that its agents are newbies who don’t know what they’re doing (whether true or not).

What makes TerraFirma a viable model, in my mind, is that the top rainmakers actually stand to make more money as a partner at TerraFirma than as an individual agent at Simulacra.  Given all of the assumptions (and once again, each and every assumption could be bad — but if so, I’d like to see where the assumptions are bad, and see the resulting numbers), what falls out at bottom is that a partner at TerraFirma takes home $355K per year in partnership profits plus personal Lead-Gen bonus, while a Tier 1 Agent at Simulacra takes home $236K per year in earnings.

I know there are some individual agents who make more than $236K per year, especially in team context, but the thing to keep in mind is that these are just models.  It may be that in some high-end luxury markets, where an individual agent makes $750K per year, the partner might make $1M.  In fact, if you alter the numbers and put both Simulacra and TerraFirma into a high-end luxury market (Avg. price $1.5M), and drop the # of sides to 600, then the model suggests that the Tier 1 Agent at Simulacra makes $1.18M, while the Partner at TerraFirma takes home $2.8M.

As to recruiting Associates, one of the biggest departures between a traditional brokerage — such as Simulacra — and the employee model — such as TerraFirma — is in the function of the “agent”.  Simulacra uses the agent to generate business; TerraFirma uses the agent (aka, the associate) to execute the business under the guidance of the Partner.  One result is that TerraFirma doesn’t need to hire expensive talent — experienced agents who know what they’re doing, and want high splits or high compensation.  It can literally staff the entire Associate pool with new agents, fresh out of real estate school, as long as they know how to follow directions and are reasonably pleasant individuals.

The midlevel associate — the agents with 5-10 years of experience, who no longer need coaching, but haven’t necessarily begun to be a major rainmaker — has quite a bit of incentive to stay with TerraFirma: a steady paycheck plus benefits.

Even the ambitious ones who really want to expand their own books of business have incentive to stay at TerraFirma: they can be made partners and make more money than if they were to setup their own brokerage or to setup their own team.  Plus, TerraFirma would have all of the support, the systems, the infrastructure already built — that investment has already been sunk.  To leave and do a startup, even following the TerraFirma model, would require time and capital for the would-be entrepreneur agent.

The Way Forward?

It’s hard to say based on assumptions and fantasy numbers.  There may be real issues with this sort of a model in the real world.  Still, the numbers are promising at least for the profile as set up.

There are numerous questions and problems, of course, and this post has gone on long enough.  And there is at least one more model to examine in the next installment: the Low-Cost, Low-Services, Recruiting Model, otherwise known as the KW Special.

In any case, as usual, comments, questions, criticism, and thoughts are always welcome.  Thanks for slogging through this.

-rsh