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Action Plan : Competing with New Business Models

Jun 4, 2018 1:24:06 PM

New business models will keep you on your toes, but complaining won't get you anywhere

The onslaught on new venture-backed realty firms entering the industry is somewhat breathtaking. Along with Redfin, Compass, and eXp, we have Open Door, Offer Pad, Knock.com, Purple Bricks and others not so well known. Zillow, Realtor.com, Homes.com and myriad other real estate tech firms have also had an impact. What is less known is that there are at least four private equity firms—that we are aware of—carefully examining investment options in brokerage and real estate tech.

It’s not so much that there are so many new entries that are causing angina among incumbent realty firms. It’s that they compete by offering lower costs to consumers, higher costs to recruit and retain agents or both. In fact, it’s not just one that keeps us on our toes; it’s the totality them all. Many of them raise enormous amounts of capital with which to enter markets and compete with incumbents. It is also that their backers don’t seem to require any earnings potential for the foreseeable future with these new companies. Zillow and Redfin have been out over ten years, and neither has produced annual earnings—yet. Indeed, this is a new form of competition for the residential realty industry.

However, is it all that different than what brokerage firms faced in the past? Merrill Lynch and Sears entered the business from 1977 to 1982 buying brokerage firms.  Their size and scale scared everyone back then. At just the same time, RE/MAX gained strength and raised the cost of recruiting and retaining agents. Don't forget this was also when savings and loans started buying brokerage firms and entering the business.

Brokers detested all of them. They saved their particular dislike for RE/MAX because the cost of keeping top producers soared while the others played by the incumbent’s rules. At the time, brokers felt they wouldn’t know how to compete should gross margins fall below 30 percent. Many of those brokers today are healthy and growing.

Later in the early to mid-2000s, after an initial wave of real estate tech firms entered the market, there was fear that opening up the MLS to public access would wreck the industry. Keller Williams gained share and again raised the cost to brokerage firms for recruiting and retention of agents. Brokers shifted their dislike from RE/MAX to Keller Williams and Zillow. Brokers felt like there was little hope that they could remain viable when gross margins fell below 20 percent (see a pattern here?). Traditional brokerage firms continue to find ways to compete and to stay profitable.

What can we learn from history?

First, don’t waste any time complaining about today’s villains. It won’t make a difference. Redfin, Compass, Zillow, and others are likely here to stay. Years ago, incumbent independent brokerage firms complained about RE/MAX and franchised brokers in general. It didn’t stop them, and it didn’t change anything on the ground. Later, incumbents (now including RE/MAX firms) complained about Keller Williams and Zillow. It didn’t stop them, and it didn’t change anything. Currently, incumbents (now including Keller Williams) are complaining about eXp, Redfin, and Compass. It won’t help.

Brokerage firms are remarkably resilient and adaptive. With average gross margins now at 18 percent and falling, nationally, the business will be tougher, both regarding how to grow and how to maintain margins—but not impossible.  When once it was thought that there was no way to make money with gross margins under 30 percent, then 20 percent, now lower than 18 percent for most brokerage firms, we find that there are numerous companies still making 4 to 6 percent pretax on their gross revenues.

Where is it headed?

Many years ago, we commented that the residential brokerage might well evolve as other retailing industries had—a few large-market-share participants, with low costs and low margins along with a few more niche players who specialize in specific segments of the market, generally with smaller market shares, but with higher margins. The key is not to get caught between these two models.

The value proposition guides decisions for all consumers. Its parts are price, convenience, and trust. If you’re not focusing your conversation with your agents and critical employees on convenience and trust, then the discussion will be about the price (agent splits for instance).

We do believe one key point. If the choice of the brokerage firm is always and only about money, then every brokerage today of any size would be out of business. Quite a few agents and teams value more than just their commission plan. The key is in finding the right blend that gets you the right type of agent and builds the kind of company that you most want.  It may be different than where you started.

Commission rate pressure

In addition to the downward pressure on gross margins at the brokerage level, we have been watching national average commission rates decline steadily since 2011 when the market indeed began to recover. As we published in our book, Game Changers in 2014, there is a remarkable correlation between the average number of listings available in the market and the number of Realtors® serving the market. It turns out that over the last six years or so, the average number of listings per Realtor at any given time has dropped by nearly 50 percent—from 2.9 to 1.4.  While that happened, the national average commission declined from 5.4 percent to 5.08 percent. There is no end in sight for tight inventory conditions. Realtor membership is climbing. We expect that the downward trend in national average commission rate will likely continue.

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