In the coming weeks, you will be reading a lot about our specific ideas on the Next Generation Brokerage.  It’s important to explain why we believe this is necessary.  In our view, this comes down to a matter of necessity.  Simply put, the status quo is not an option.  The numbers won’t fly.

Every brokerage has four basic revenue drivers:

1. The number of homes sold (with each sale having two “sides”),
2. The average price of the sales,
3. The brokerage’s take after the agents’ commission splits (“percent retained”),
4. The amount (in percentage) received per transaction (“average broker commission rate” or ABCR).

While times were good earlier this decade, the average broker was making a solid living while, for the most part, three of their four drivers were headed in the wrong direction.  For the vast majority of brokerages, only average sales price, the driver they had least control over, was increasing.  Despite a market that was churning out more sides, the number of agents and brokerages in the marketplace increased dramatically so that the pie was split ever more; because of this, most brokerages were barely able to keep sides steady during the upswing.  At the same time, competitive and consumer pressures were driving percent retained and ABCR down.  But price kept saving the day so the good times rolled.

Sides were the first to fall in the correction, but price increases kept sales volume (the combined impact of multiplying sides with average sales price) propped up, so very few noticed.  When price turned, the average broker’s P&L very quickly fell apart.  This is because the other revenue drivers weren’t balancing the equation.  Percent retained and ABCR didn’t reverse course as the market turned; these drivers have been either flat or only modestly better since market peak.

Since the shift, the average broker has cut and cut but there simply hasn’t been enough to eliminate to offset the revenue crash and get to profitability.

Let’s look ahead now.

According to Fannie Mae, we should expect sales volume to bottom out this year, improve only marginally next year, and grow at an increasing rate from 2011 through 2013.  Overall, FNMA is projecting that sales volume in 2013 will be 33{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} better than 2008 levels.

Wait a second – that sounds wonderful!  We’ll be back to good times, right?

Not necessarily.  In fact, without fundamental changes, we believe there’s a good chance that, despite improved price and sides, the return to profitability for most brokers will be at best delayed for many years after the market improves and at worst always beyond reach.

In order to answer why we believe this, we have to go back to our revenue drivers and predict how they might fare (these are, of course, hypothetical projections and are not to be misconstrued as representing the views of our parent company, Realogy Corporation).  By assuming FNMA is right (NAR‘s predictions are a bit too optimistic for my tastes), we’ve addressed two of the four drivers.  But what about percent retained and ABCR?

Let history guide us.  While the market was good, percent retained declined steadily (according to a REAL Trends survey, from 2004 to 2008 percent retained decreased from 27.8{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} to 25.7{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c}, or an average of 0.5{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} per year).  Even when the market turned, this didn’t improve as some might have expected; it merely held its ground.  ABCR, on the other hand, has actually improved marginally over the same time period (from 2.54{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} per side to 2.61{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c}, according to REAL Trends), but much of this improvement has likely been skewed by the high level of recent foreclosure sales.  Most brokers would tell you that ABCR on non-distressed properties has not improved during the downturn.

So it seems logical to assume then that when sales volume improves (likely next year) and foreclosures return to normal levels (perhaps a couple years away), ABCR should do no better than remain flat while percent retained will break from its holding pattern and continue along its historical trend line.

Working that into our figures, if percent retained continues to drop at the 0.5{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} per year rate we’ve recently experienced, then the average percent retained in 2013 would be 23.2{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} (or 10{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} worse then 2008).

If these assumptions are right (and some would argue that they’re in fact optimistic) then the average broker will have lost a third of the gains the market will have provided.  Keep in mind that we’re assuming ABCR will hold steady, despite the likely unrelenting pressures from competitive models both known and unknown.

A one-third drop may be bearable, but that’s not all there is to it.  To take it to the final step and predict the bottom line impact, we need to take into account operating expenses (rent, payroll, marketing, supplies, etc.).  Assuming the model doesn’t change, expenses remain the same and we simply apply an inflationary index of 3{0a8e414e4f0423ce9f97e7209435b0fa449e6cffaf599cce0c556757c159a30c} per year and compound that over the same time period.  That alone wipes out half the sales volume gains!

Since very few brokers are making money now, the combined impact of these two factors (erosion in percent retained and inflation) would very likely eliminate most of the predicted improvements in the market, thereby preventing a return to profitability.  And, to repeat, this assumes that ABCR holds steady.

Does this view seem plausible?  We think so.  In fact, it’s not too hard to envision less pleasant outcomes that would make this analysis seem hopeful.

We believe there’s support to argue that the model as it exists today simply must change, that the average broker can not just wait this market out.  The status quo is not an option.

Looking ahead, then, we must address each of the basic revenue drivers as well as new revenue streams and take a good hard look at the existing expense structure.  Nothing should go unchallenged when thinking up the new model.

As you read our posts on this topic, think about how the proposed idea improves either one of the revenue drivers or operating expenses (or, in some cases, both).  Specifically, consider how it fits into the financial keys to the Next Generation Brokerage, which I believe will be:

1. Maintaining ABCR by constantly updating and improving the value proposition to consumers,
2. Increasing average agent productivity,
3. Increasing percent retained through brokerage-generated business,
4. Generating a far higher output per square foot of office space.

Let the ideas flow.

View Nicolai Kolding’s Inman Presentation: New Real Estate Math: How to Slash, Burn, and Rebuild Your P&L