Does Size Matter? (Part 2)

In Part 1 of this series, I examined a scholarly paper by one Glenn Reynolds(aka, Instapundit, who is a law professor, the author of Army of Davids, and one of the most important and influential bloggers in the United States today) about the future of big law firms and drew some lessons about how big law firms and big real estate brokerages are similar.

In this part, we focus on how they’re different.  And before you say, “Duh, Rob” (or since you’ve probably already said that, before you say it again), of course lawyers are not realtors, and law firms are not brokerages.  But there are lessons to be drawn from some of the fundamental differences as they go to issues of business models.

The Importance of Brand

I wrote in Part 1 that the focus on the value of brokerage brand is in some ways deeply irrelevant: “It would be more accurate to say that whether brand matters or not to the consumer is almost entirely incidental.”  The reason is that real estate brands are, for the most part, bear no relationship to professional quality.  We see this clearly when contrasting real estate brokerages to law firms.

As Reynolds wrote, big prestigious law firms provide a sort of filtering mechanism for excellence, at least in theory:

The lawyers they hire, you can assume, will be first class, and if you’re like most clients, you can figure that the folks at Sullivan and Cromwell or other top law firms know more about picking top lawyers than you do. It’s more efficient to let them do it.

Having been through the ringer a couple of times myself during law school recruiting, I can personally attest to some of the (ridiculous) considerations.

There are law firms who simply do not bother recruiting at the so-called “second tier” law schools.  You show up at first day of the summer associate orientation and realize that 46 of the 50 fellow summer associates went to the same five schools: Yale, Harvard, Columbia, NYU, and Stanford.  There are firms who discourage students even from these elite law schools from interviewing with them if they have less than a A- average… after only one year of law school, this is.  If you’re not on Law Review, some firms become a long shot.  Keep in mind that these are students from a top five law school, which meant that every single one of them excelled in college — usually an elite institution with single-digit admit rates themselves — and did well enough on the LSATs just to get admitted to the law school.

In this and other ways, the big law firms send the message loud and clear that they’re interested only in the best of the best of the best, in the smartest, most motivated, most ambitious scholar-warriors that the country (and the world!) has produced.

It turns out that such careful screening doesn’t necessarily lead to the best legal work, as longtime practitioners could tell you in unguarded moments, but the effect of such recruiting process builds the value of the brand.  As Reynolds said, if you hire Sullivan & Cromwell, chances are that they’ve done the hard work of finding the best attorneys (or at least, the best law students) so that you don’t have to.  Whether true or not, the brand promise of big law firms is one of quality professionals.

Real estate, however, simply doesn’t have the infrastructure that the legal industry has.  Real estate school is a far cry from law school.  Few large brokerages (if any) have any sort of a degree requirement for entry.  This sentence is seldom uttered by brokers: “I’d love to hire you to come be an agent at my firm, but I see you have a B in advanced econometric techniques, so we’ll have to pass.”

Much attention is paid to the low standard of entry to become a real estate agent, focusing on the state real estate boards which set the educational and testing requirements to become licensed, or alternatively, on the National Association of REALTORS, which grants the REALTOR designation to anyone who pays the dues.  But that is the wrong focus.  It isn’t difficult to pass the Bar Exam (no matter what lawyers tell you), and once you’ve passed it, you’re automatically granted membership in the lawyer trade association (the State and Local Bar Association).  But getting hired by Cravath is another story altogether.

As a result, even if deeply flawed, a customer looking for a top-notch attorney could reasonably rely on someone having “Cravath Swaine & Moore” on her resume; the same does not hold true for a top-notch realtor.

One might reasonably ask, given that both law and real estate are seen by their respective practitioners as professions requiring fiduciary duty to clients, why is there such a huge difference?

The Answer: Compensation

It cannot be stressed enough that at the root of the difference lies money.  (Isn’t money at the root of all evil?)

First, clients pay their attorneys for their effort, rather than for the result.  This is especially true in the case of big law firms that typically do not take on contingency cases.  (When I say “typically do not”, I mean “never”.)  In contrast, real estate brokers are paid for the result (commission on a successful transaction), rather than for the effort.

Second, law firms pay their associates a salary.  They are an asset of the firm, human capital, whose costs are paid in advance of revenues.  Apart from a couple of recent efforts, such as Redfin and ZipRealty, the vast bulk of real estate brokerages do not pay their agents a salary of any kind — not even a “draw against commission” as is commonplace in other sales organizations.

Third, given the way that real estate has evolved historically, there is no price difference between brokerages (or agents) based on “quality”.  Whether you use the best, most experienced, most motivated, top performing realtor in the whole country, or an incompetent, ethically questionable agent, as the consumer, you pay the same 5% in commissions.

The combination of these compensation-related factors has the following consequences:

1. There is no advantage to using a big brokerage firm.  At the same time, there is no disadvantage either.  Unlike law, where hiring Cravath might mean $1000 per hour billing rates vs. $100 per hour from the small one-man shop down the street, in real estate there is no benefit and no cost to hiring the biggest and most prestigious firm in town.  In fact, one might reasonably ask, since price is a signal to buyers, what “prestigious” even means in real estate.
2. There is no difference in the transaction cost whether you use a top-notch REALTOR or a bottom-crawling licensee.  There may be financial consequences as the result of selecting a competent vs. an incompetent agent, as the price of the home may be impacted (though there is precious little research to support a conclusion one way or the other), or the time on market might be extended resulting in more mortgage payments, more taxes, or more carrying costs, but the commission you pay will be the same.
3. There is no incentive for brokerages to do any kind of screening in hiring.  Law firms have an incentive to hire the best lawyers, because they can charge a premium for their services.  Brokers have no such incentive, since the price of service is more or less fixed.  Furthermore, since agents are not paid even a draw against commission, there is no cost to the broker in advance of revenues.  A brokerage could literally have 10,000 non-producing agents on its “payroll” and not care as none of them are paid until a transaction closes.  At that point, however, payment comes after revenues such that each transaction equals a profit for the broker.  As long as fixed overhead costs are kept low, a brokerage could be very successful indeed simply by lowering its standards to the legal minimum (e.g., not currently serving prison time, etc.).

It is hard to overestimate the impact of compensation, which goes far beyond simply branding.  But the ultimate effect on brand is that big law firms serve as signifiers of professional quality, while big brokerages do not.  For the consumer, then, big brokers might have brand awareness (“Oh, I’ve heard of that company”) but do not have brand promise (“I know you only hire the best”).

I conclude that the value of the brand for big law firms (assuming there is any) accrues to the client, whereas the value of the brand for big real estate brokerage (assuming there is any) accrues to its agents.  Put another way, law firm brands are about helping clients select top-notch attorneys without extensive and costly interviewing of every single attorney; real estate brands are about lead generation to the realtor.

[Sidebar: A frequent debate I have with my friend Marc Davison of 1000watt Consulting could be characterized as a chicken-or-egg problem.  I think it’s fair to say that Marc believes that big brokerages could adopt a strong brand promise, including one of professional quality, and thereby create a business advantage (which may ultimately lead to changing the compensation structure of real estate brokerage).  I feel that as long as the fundamental issue of compensation remains unchanged, no amount of branding could be successful.  It’s an interesting debate if you’re a real estate marketing junkie like the two of us, I suppose.  Horribly boring otherwise.]

So What’s This Got to Do With Size?

Whether a law firm or a brokerage, we have already granted that size does mean more ancillary resources: paralegals, secretaries, marketing assistants, transaction coordinators, technology systems, and so on.  The question isn’t whether bigness offers additional resources, but whether those additional resources (a) require size and scale to provide, and (b) are valuable to the customer.

Reynolds’s point is that at least for big law firms, those resources are not valuable enough to warrant the additional cost of big law firms.

My view is that for big brokerage, those resources (a) do not require size and scale, and (b) are of marginal utility to the customer.

Any agent can hire her own transaction coordinator.  It might be more efficient if the broker hired the coordinator then spread the cost out over a group of agents, but given the business model of brokerages (there goes that compensation issue again), it is entirely unclear whether brokerages can take on such overhead in advance of revenues consistently.  It is clear that big broker can not charge the customer more money as the big law firm can.

Advances in technology means that there is a very flat curve of diminishing returns for systems.  Microsoft Exchange might be awesome, but Google Apps gets 90% of the way there at a tiny fraction of the cost.  A multi-million dollar customized enterprise CRM yields benefits, but an off-the-shelf $99 program achieves much of the benefits.  (There are important exceptions, which we’ll cover in Part 3.)

Furthermore, it is a truism that such resources are of marginal utility to the customer, because those services are included in the price of brokerage (the commission).  If a different business model evolves, and the brokerages who offer such support services can charge a premium to the consumer, perhaps we can discover whether customers really value them or not.

Size Is A Disadvantage

Given these realities, big brokerages face a major challenge.  Size in real estate turns out to be a disadvantage one must overcome.

Any organization above a certain size must have overhead — even the CEO is administrative overhead if you think about it.  A small broker-owner with ten agents could reasonably manage all ten people effectively; no human being alive can manage 1,000 agents.

For big law firms, size grants certain advantages like reputation and resources that creates differentiation that clients are willing to pay for.  (Although, that is rapidly changing.)  Big brokerages do not have that luxury, because of the fundamental compensation models in real estate.  When advertising power was tied to size in the pre-Internet era, size did grant a certain advantage in brand awareness.  It still does, but that advantage is disappearing quickly.  And since real estate brands were never about the consumer’s benefit but about lead generation for the agent’s benefit, information technology has had a disproportionate impact on big brokerages.

So we have a situation where big brokerages have all of the negatives of large organizations (bureaucracy, expensive overhead, inefficiency) and none of the positives (higher price, greater efficiency for large-scale production).

Making Size Relevant

The challenge for real estate brokerages, then, is to make size relevant again.  As we’ll see in the next part, there are still areas where size does matter a great deal.  And if the experience of the real estate industry holds true for legal industry, the big law firms will also find out that the competition isn’t between Big Law vs. Independent Law.  It’s between Big Law and Big Technology, as it is in real estate between Big Brokerage and Big Technology.

-rsh