The real estate business model, part 2: let's see that again in slow motion.

The real estate business model, part 2: let’s see that train wreck again, in slow motion.

The four consumer interviews you just read in The real estate business model, part 1 are real interviews, done by extra-terrestrials posing as Assignment 7 reporters, and charged by their Grand Council with studying the galactically-famous American real estate industry.

I'm told that these extra-terrestrials returned home burning to reconstruct our real estate business model based on their interviews. I obtained these transcriptions, at great cost and by means I can't reveal, because I recognized their remarkable scientific value.

After all, who could be more impartial and objective about the way we buy and sell real estate than extra-terrestrials? Admittedly, most economists write about real estate as if they were from another planet, but in reality they bring their own baggage and preconceptions.

So let’s see what these ETs learned from their interviews. Sellers pay full commission, except when they don’t. Buyers don’t pay a commission, but they do. Agents give it away, but not always. (This part always reminds me of Kafka’s The Trial.)

It gets better: The interviews indicate that the amount of time and other resources an agent invests in a client has absolutely no relationship to the amount of compensation he or she gets.

That’s right, they've discovered that the agent gets nothing—not even a little something to cover direct overhead—until, and if, the client buys or sells using that agent. If the client doesn’t buy or sell, our agent ends up with nothing to show for the resources she's invested. If the client does buy or sell, but uses another agent, our agent gets nothing except a hollow feeling in the pit of her stomach.

So it was with a strong sense of foreboding that our extra-terrestrials PowerPointed their presentation before a silent Grand Council. The Grand Council adjourned briefly, then returned to announce that the real estate model as presented had too many inefficiencies and contradictions to serve as the basis for their planet's industry, but showed promise as a somewhat more humane alternative to share-cropping.

Our ETs were taken out and shot.

So what’s in this for you?

You’ll notice a recurring theme throughout these interviews: the client least likely to pay an agent is the one who takes the most time.

That’s unfortunate, because time is, ultimately, what the agent sells. Yet every agent spends significant time working with clients who never pay for it. That’s just a hidden reality of the real estate business, one that always trips up the new agent who, mistaking every putz for a prospect, dashes off in several directions at once to give him the best service he’s ever had and far better service than he needs or deserves. A big part of the new agent’s learning curve consists of learning to recognize the giant sucking sound that identifies one of these bottomless pits.

But sometimes the giant sucking sound goes ignored because it’s an unwelcome intrusion on an agent’s illusions. Agents like to stay busy, or at least think they’re busy, or at least look like they're busy to other agents and to their broker, even as doubt gnaws away in the background like a hungry beaver on a wooden bridge. Then there’s the agent who, having spent hundreds of hours with a client, is even more determined to throw good time after bad: “I have to sell him a house. I have too much time invested in him to walk away.”

Or perhaps the bottomless pit has been referred to the agent by a client, friend, relative or neighbor. In that case, the agent can’t walk away without alienating both the referral and the referrer. That’s burning your bridges at both ends, something no one in a business so dependant on referrals can do casually.

Not all dead-end prospects turn into bottomless pits, of course. A smart agent soon learns to cut them loose before they waste much time. But even dead-end prospects take valuable time to identify.

By far the majority of these bottomless pits are buyer prospects. I should clarify that I've enjoyed working with real buyers, particularly first-time buyers. First-timers are often extremely rewarding, not because they lead to big commission checks—usually they buy inexpensive starter housing—but because their overwhelming gratitude reaffirms the agent's belief that he does something useful.

But agents have a pithy expression about buyer prospects that neatly sums up their cynicism: “Buyers are liars”. Like all bumper-sticker truths, this one is emotional and simplistic and, even better, concisely expresses the viewpoint. Sometimes “buyers are liars” is pc-ed up to real estate's version of “what we have here is a failure to communicate”. Variants of this are “buyers don’t know how to communicate” and “agents don’t know how to listen”. I might add another: “buyers don’t always want to hear what their agents tell them.” There’s truth in all of this, but it’s a fact that buyers are the hardest to pin down and the most likely to casually waste an agent’s time and their own.

I’ll illustrate this point with an interesting and telling analysis I did a few years ago, of 156 buyer prospects I collected from 2000 to 2002 who turned out to be dead-ends. Yes, that's 156 buyer prospects over a mere two-year span who weren't and didn't. I met these buyer prospects almost entirely through open houses and floor calls. These contacts occurred early in my career, when I was holding at least one open house every week-end and took hours of floor time every week. I don’t do that now. You’ll understand why in a moment.

When I did this analysis in 2004, these 156 dead-end contacts were from two to four years old. Of them, only 82 (just over half) bought a house in one of the two counties in which I work. That's right, only about half the people who gave me their names and contact information and encouraged me to devote hours of my time to their housing needs actually bought a house in an area where I had even a remote chance of making a sale. That’s a mighty high flake-out ratio. That’s an awful lot of wheel spinning. And this was when the market was booming, people were buying and, apparently, wishful thinking was running rampant.

I guess the good news for the real estate industry is that over half those 156 buyer prospects bought. I'm happy for the industry, but the bad news for me is that they bought using another agent, and more than a year on average after I’d met them—13 months, to be exact. And that 13 months almost certainly doesn’t represent the entire time they spent in the market, because it's unlikely that I was always the first agent they gave their contact information to—and obviously I wasn’t the last.

To get an idea of my conversion rate from 2000 to 2002, let’s add to the 156 dead-ends the 13 prospects I met through open houses and floor calls during this period who did buy using me. That’s 169 total prospects. Divide the 13 real prospects by 169 contacts and (drum roll please) just 8% actually led to a commission check made payable to me.

Or, to put it another way, 92% didn’t. That’s shooting a lot of blanks, partner. I wouldn't have gotten through that period without my newsletter, my sphere of influence and referrals from other agents. And fortunately, the average home price in my area is well over a million dollars, so you don’t need to sell fifty homes a year to make a living. But it’s a wonder I had the time back then to handle any real business, because every one of those 156 dead-enders got at least a few hours from me, long enough to determine whether they were “real” enough to return my phone calls and e-mails. And those who cleared that very low hurdle got considerably more attention. None led to a commission check, at least for me. Almost half led to a commission check for no one.

Sure, you could look at these numbers and say, John, you must be a whole lot better at getting leads than at following up on them. You must be hell on wheels at an open house. You must be on them like a cheap suit. Actually, it’s the opposite. When you walk into my open house, I greet you and then leave you alone. I treat you as I’d want to be treated at an open house. I do have a few print-outs on the kitchen counter, like recent sales, that have been known to start a productive conversation. But you have to initiate the conversation. (Come to think of it, maybe that’s the appeal.) If you show signs that you’d like to work with me, that’s when I get animated.

I can hear you agents saying, John, that’s pathetic. I have a much better conversion rate than that. Well, hotshots, keep the records and do the research like I did, and then tell me what a converting fool you are. Because I’ll bet that 99.999% of you don’t have any data and don’t really know what your conversion rate is. I thought I did, and the numbers shocked the heck out of me. They also changed the way I prospect.

Would the 82 prospects who did buy but with another agent have used me if I’d stayed in touch? That’s a fair and tantalizing question, one that most sales trainers would answer with an emphatic “yes”. “Put them on your B list, bombard them with useless information and refrigerator magnets and watch the money roll in. Just sign up for my seminar—only $299—and I'll tell you how.” You betcha. The reason I dropped these prospects, sooner or later, is the same reason every agent not abusing illegal stimulants would drop them: the time required is prohibitive, not just to relentlessly call or e-mail, but also to go out and stay on top of whatever market they said they were in so that what I sent them would be relevant enough to matter. Besides, how do you "close" on someone whose given you only their email address? Bombard them with "Importance: high" emails?

And it wasn’t just a matter of the time and gas money I was wasting. Something far more precious was at stake: my enthusiasm for mankind in general and real estate clients in particular. It’s easy to lose that enthusiasm, and fatal if you do, because then you’re just a used-up burned-out husk of a used-car salesman. And every week these prospects didn’t buy with me was another week they could be seduced by an agent standing there with the unfair advantage of being in the right place at the right time when each one of those 82 prospects turned into a buyer.

Okay, you willing to admit this isn't good. But you’re a “real” buyer or seller, easy to work with and profitable. Shouldn’t you get a discount?

Wonk!!! Penalty buzzer! The model doesn’t work that way. Yes, someone will get a discount—and “free” is a mighty steep discount—but it ain’t you.

Let’s do the math. To stay in real estate, an agent needs a certain income to pay the bills and make the daily grind worthwhile. Let’s say he has to gross $100 an hour. The amount varies from agent to agent, depending on area and overhead. In some places, an agent grossing $100 hourly might be a venerated top producer. In others, one hundred bucks an hour might barely pay his desk rent. And remember, most agents share a substantial portion of their gross with their broker, and those who don't have additional overhead. The minimum acceptable gross also depends on an agent's options outside real estate. At some point selling tech, big-ticket appliances or even magazine subscriptions door-to-door starts looking more compelling.

But whatever the hourly gross required is, it’s not an arbitrary number. If the agent makes less, either because the market is slumping or because he doesn’t have the ability to capture and convert clients, he’ll have to, or want to, leave real estate. Many do. It's commonly believed in the industry that 80% of the people who enter it leave within two years. I don't know if this washout rate has ever been documented, but it's certainly credible.

Okay, you figure, $100 an hour is a fair deal. It's about what your plumber charges. You’re willing to pay your real estate agent that.

Sorry, the model doesn’t work that way. If your agent spends a quarter of his time working with clients who eventually pay him $0 per hour, he’ll need you to pay him $133 an hour to compensate and keep him in business.

Of course, it isn’t this straightforward. You don’t pay your agent an hourly wage, and neither does his broker. I’ve used this example just to illustrate a complex but very important point:

1. agents sell time

2. not everyone pays for that time, so

3. the people who do pay, also pay for the deadbeats, which

4. raises the cost to those who pay.

Here are a few examples from other industries or from government of deadbeats raising the costs of the people who do pay:

1. The Uninsured Motorist (UM) part of your auto insurance premium helps reimburse your insurance company for the damage done to their insureds’ autos by uninsured drivers.

2. One of the reasons healthcare costs are skyrocketing is that emergency rooms have to provide medical services even to those who can’t pay for them.

3. California’s “Prop 13” freezes property taxes at a level based either on the home's purchase price or what they were in 1978, whichever is earlier, plus a miniscule annual increase. Yet the costs to run the state continue to increase. This means that the property taxes of those who bought in 2007 are subsidizing the property taxes of those who bought in 1997 or 1987. Of course, everyone pays something—there aren’t any deadbeats in this example—but it does lead to higher property taxes for recent homebuyers and fewer services for everyone.

In real estate, the people who consume real estate services without paying for them are just like uninsured drivers, the poor and other uninsureds who land in ER, and the long-time California homeowners who have their property taxes virtually fixed. All of them create a significant burden on a vital system, intentionally or otherwise, that has to be shouldered by others to keep that system running.

I’m going to speculate that this is a cost of doing business in every industry, but that it’s a bigger factor in some than in others. Say you’re in a service business where 1% of your receivables (income earned but not received) is routinely uncollectible. Say your average receivables runs about $100,000 at any point in time, and of that amount, about $1000 will prove uncollectible. That raises the cost of your services to the 99% of your customers who do pay by slightly over 1%, a negligible amount. Maybe it’s even 2%, because someone has to pay for the extra attention uncollectible accounts get. But the total cost to your business, and therefore to your customers, is so small as to be unnoticeable. It doesn’t create a gross inequity in the system. It’s simply a small and standard cost of doing business.

But as we’ve seen, real estate’s deadbeats can be a much larger percentage of the total, so they’re a much bigger cost of doing business. Unfortunately, my analysis of prospects can’t give us even a hint as to what deadbeats cost the real consumer. It gives us just the percentage of deadbeats, not the time I spent on them, and it’s the agent’s time that has economic value. But just based on the staggering proportion of deadbeats, it's obvious that they create a gross inequity in the system.

In other words, you, the bona fide buyer or seller, subsidize the flakes. Eureka! It’s that's simple. You pay an indirect subsidy—no one shakes a can in your face and says, “I’m collecting for the flakes”—but it’s a subsidy nonetheless.

Because of that subsidy, you pay more for the services of your agent than you should. No, this isn’t a pitch for the discounters. They’re using the same dysfunctional model, just a down-market version of it. And yes, we’ll get into that later.

Wait a second, you say. I’m a buyer. Buyers don’t pay commission. How am I paying for anything, let along paying more because of the flakes? Realize that the listing and selling (buyer's) agents' commissions are tacked onto the price of the house you buy. All the seller does is give the listing agent a percentage of the sales price, say 6%, as a lump sum. The listing agent then gives the buyer's agent half. You the buyer reimburse the seller for this cost of sale: with 20% down, you end up financing 80% of the commission for thirty years.

Okay, you say. But the guy who sold me my car also works on straight commission. Money doesn’t change hands every time someone walks onto his car lot. Are you saying that I paid too much for my car just because my salesperson doesn’t sell something to every customer he shakes hands with?

Or what about the contractor who gives me a free estimate? That took his time. Are you saying he has to mark up his prices just to compensate for all the free estimates he gives that go nowhere?

Great questions! Here’s my answer: If you’re having a deck built, you don’t decide to switch contractors in the middle of the project, even though the deck is half-built and even though the first contractor did everything he said he’d do. And if you did change horses in mid stream, he’d have legal recourse against you to recover his costs. If you’re replacing your roof, you don’t have three different contractors doing the job at the same time, then pull them off and tell them you’ve decided not to re-roof.

Okay, how about the car salesperson? It’s a comparison that’s frequently made, and not usually in a way that’s flattering to the real estate professional, but there’s a fundamental difference between the two, in theory if not always in practice.

Both car sales and real estate sales are sales professions, but the real estate salesperson provides professional services. The car salesperson doesn’t. That’s a huge and meaningful distinction because it gives the real estate professional the roles of advisor and advocate as well as sales professional. That’s usually been true to some extent, depending on the times and on local peculiarities such as sub-agency, but now your agent is held to an ever-higher standard of care as the real estate transaction becomes more complex and more charged with legal risk.

Now we’ve come to the fundamental problems with the current real estate services delivery system: perception, performance and reality. What an agent should do, what the typical agent does, and what the typical consumer thinks the agent does are like three circles that intersect but don’t completely overlap.

Not every agent knows or cares about the new, sterner reality of his profession or is up to the task. That’s a real problem for the industry and the consumer, and a real bonanza for the lawyers. Meanwhile, the perception of the profession among consumers, academics, journalists and the people who do ad campaigns for real estate brokerages doesn't seem to have changed much since 1950: nothing more than sell sell sell.

But the reality is that today’s competent, diligent agent dwells in a gray area that includes sales but goes well beyond that to take in elements of law, negotiation, home improvement and psychiatry.

Yet she almost never has the advanced education in these fields that, in a society impressed with advanced education, would enhance her recognition and perceived value. Instead, she’s jack of all trades and master of none, of necessity an expert at turning prospects into successful transactions—she wouldn't stay in business if she wasn't—but also as much facilitator and coordinator as salesperson. In this, she’s like a general contractor, or at least the generals I’ve known. That’s why the public has a hard time pigeon-holing the agent. She’s neither fish nor fowl: she claims to deliver professional services, but her minimal training and licensing requirements would seem to put her on the level of contractor.

Most important, her business model and reputation are more like that of the car salesperson. So let’s explore the differences between these two professions more closely.

The relationship of the car salesperson to his or her customer is like that of the retail clerk: light, casual and brief. (Light? Okay, sometimes it gets heavy, but we won’t go there now.) On the other hand, the relationship of the real estate agent to his or her client is intense, complex and typically lengthy.

Note that I’ve distinguished between customer and client. This distinction may seem esoteric, but it’s not to the courts. There’s a legal difference between the two categories that raises the risk to the agent and should therefore raise the reward she gets. The salesperson simply owes the customer a certain degree of honesty and good service. The consequences to the salesperson who fails that modest goal usually aren’t that great: the loss of a sale, an angry phone call, maybe a complaint to 7 On Your Side and a moment of televised humiliation.

The real estae agent, on the other hand, owes the client the highest, most squeakily honest form of business relationship. The agent owes the client a fiduciary duty of utmost care, integrity, honesty and loyalty. In other words, your agent is on your side, period, no ifs ands or buts. In fact, your agent is you, according to the law, in the sense that your agent must act as if he or she were standing in your shoes. Any deviation from this strict, unyielding standard, whether triggered by incompetence, low cunning or just plain goofiness, can put your agent out of business, temporarily or permanently, and land her in court.

I’ll admit that not every agent understands the agent relationship as well as they should. Agency law is complex and not well explained in licensing classes. It was only after taking a two-day class for the Accredited Buyer Representative designation, and after several years in the business, that I really understood the ins and outs of agency. And it was obvious from the blank looks on the thirty or so other agents who took the class that I wasn’t alone. At least one of them, an old-timer, failed the test. Surprised? I’ve often said that the easiest money in real estate is in real estate law.

In any case, if the agent is held to a higher standard (and invariably sells a more expensive product) than the salesperson, the rules regarding compensation should be different too. We’ll get into this more later on.

But by far the biggest, most practical, most rubber-meets-the-road difference between a salesperson and a real estate agent is the additional intensity, complexity and, often, time, inherent in selling real estate. To illustrate this point, let’s exhume those extra-terrestrial interviewers and send them out to do three more interviews.

“And this time get it right!”

Next, Part 3: tragedy and farce in three acts.