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Broker Commissions--A changing pie

Commercial real estate brokerage has been infused with a change of ingredients in recent years. Specifically, the traditional method of compensating brokers by commissions has begun to weaken. Other methods of compensation - such as retainers, hourly fees and bonuses - now supplement and sometimes replace the traditional commissions.

The reasons for this change include the decline of proprietary real estate listings due to the Internet and different client expectations about the nature of the value received from a broker's services.

Michael Zugsmith, chairman of NAI/Capital Commercial, an Encino, Calif.-based brokerage firm, believes changing compensation structures stem from the arrival of the Internet. "Historically, brokers have earned commissions in part by serving as repositories of proprietary information about available space," he says. "To get information, a client had to hire a broker. Today, much of this data is publicly available on one or another Internet database. Brokers can no longer sell services based upon the fact that they - and they alone - know where the buildings for sale and lease are located. Everyone has access to this information."

According to Zugsmith and other industry observers, brokers today must sell creative ability and strategic ideas. Brokers must prove to clients that they can mold this freely available information in a way that will benefit a client's business.

"Today, we must add some kind of hard value to a transaction," says Zugsmith. "We have to sell what we can do with information. This is a fundamental shift in the business."

For many brokers, including NAI/Capital Commercial, this change in brokering responsibilities has led to changes in compensation structure. Transactions have become less important, and continuing client relationships has become more so.

While commissions have always proven negotiable to some extent, brokers today report wild plunges in what owners are willing to pay. In the past, says Zugsmith, representing the owner of a major property might have garnered a 5% commission worth $500,000. Today, however, that same owner might contend that the value brought by the broker to the transaction is closer to $100,000 than $500,000.

For boutique brokerages reliant on income produced by several major transactions per year, such a reassessment of transactional value has been devastating. Regional companies in some cases have been unable to compete. "I believe that there will be a real shake out in the years to come," says Zugsmith.

Network benefits Zugsmith has moved to protect his company. A strong regional competitor, the company boasts annual transaction volumes in excess of $1 billion and maintains 10 full-service commercial real estate brokerage offices in the greater Los Angeles area. It has consistently ranked as one of the top brokerage firms in the region.

Despite its size, Zugsmith's company began to suffer losses when battling competitors with national reach. "We were not the safe choice," he says. "Maybe we were the better choice, maybe not. But we were certainly not the safer choice."

Potential clients evaluating brokers for national breadth might include REIT owners with properties located across the country and national companies with vast real estate needs for leases on new space or the disposition of leases on existing space.

Joining a network is one option available to regional brokers today. Capital Commercial recently joined the NAI network.

NAI differs from other networks because its members do not own the network. As for benefits, NAI operates its own corporate services department and makes the capabilities of this department available to its members. By joining the NAI network, NAI/Capital Commercial has developed the ability to serve national clients, albeit by using alternative forms of compensation.

As commissions paid by owners have grown more negotiable, brokers have moved into the arena of corporate services - providing retainer-, fee- and hourly-based services for large tenants who require brokers capable of performing nationally and internationally.

"When you represent a corporation, you are looking at an overall compensation package," says Zugsmith. "Instead of earning commissions on transactions, you earn money within a relationship based on what feels fair based upon the value you bring to a process.

"Historically, for example, you might put a tenant into a space in a single building and earn a commission of $5,000. Today, a brokerage that has built national corporate relationships might do 10 transactions with that client.

"But instead of earning $5,000 for each transaction or $50,000 total, the brokerage may have a retainer or fee contract with the client that includes a provision to rebate a certain percentage of commissions," adds Zugsmith. As a result, you may earn $30,000 instead of $50,000."

Larger companies have also responded to the downward pressure on broker commissions by selling other services more aggressively.

A wide range of services David Binswanger, president of Philadelphia-based Binswanger Realty Group, calls the evolving compensation structure a hybrid that involves reduced commissions plus fees for increasingly important ancillary services. Binswanger Realty, which has offices internationally, offers a host of services, from brokering to finance to construction.

Binswanger recently found a 30,000 sq. ft. building for a Philadelphia-based insurance agency. Under the traditional brokerage structure, Binswanger would have provided the tenant with a list of buildings, the tenant would have picked one and the company would have earned a relatively predictable commission.

Not in this case, however. "To handle this client's needs, we provided a team of people," says Binswanger. "Our analysts ran comparative financial analyses on various properties that the client might decide to lease or to own. Our finance people provided resources to obtain financing if the client decided to buy. We also provided construction estimates related to fitting out new properties and renovating old ones."

The company's marketing and government affairs employees were also involved in the project.

How did the insurance agency compensate Binswanger for all of its work? "In our original agreement, we capped the commission at a dollar amount significantly below the market level," says Binswanger. "Under a conventional commission structure, we might have received $150,000. With the commission cap, we ended up with just under $100,000.

"But the ancillary services that we provided beyond brokerage probably added another $150,000 to the transaction. In addition - and this is important - the construction services we provided saved our client about $500,000."

The new model has also begun to change the make up of companies. According to Binswanger, five years ago about 85% of Binswanger Realty Group's non-clerical employees were paid under a brokerage commission structure. Today, about 50% of Binswanger's non-clerical employees provide brokerage services. The other half focuses on professional services such as finance, construction, and marketing, and earns compensation based on the value delivered outside of the pure property deal.

Los Angeles-based CB Richard Ellis Inc. has also seen its employee mix change, as professionals skilled in other fields begin to complement brokers. "Today's business model has definitely reduced the number of brokers we employ and raised the number of other professionals in our group," says Anthony Buono, managing director of retail services for CB Richard Ellis.

He agrees that the reason for this shift is the increasing accessibility of proprietary information. "Today's broker is a problem-solver who evaluates information and creates solutions," says Buono.

As an example, Buono offers CB Richard Ellis' efforts on behalf of Grossmont Center, a 1 million sq. ft. open-air regional mall located in eastern San Diego County. Built in 1961, the mall suffered a major drop in sales revenue when two neighboring regional malls undertook renovations.

Two of Grossmont's mid-to-high end anchors, Bullock's and Buffums, pulled out of the center, leaving Macy's and Wards as the department store anchors. CB Richard Ellis, which was serving as the property manager for Grossmont, pitched the expertise of its retail services group.

Grossmont accepted, offering the group a hybrid compensation package of retainer fees and transaction fees to design and implement a repositioning plan for the mall that would include new lifestyle and entertainment tenants.

The group led off with a surprising recommendation: a Target Store for one of the vacant anchors. "Combining a Target with a Macy's and a Wards might seem questionable," says Buono. "But the two have turned out to fit perfectly in the overall repositioning of the property."

The new leasing strategy also included major remodeling efforts by Macy's and Wards, plus a new stadium-seating Pacific Theatres facility, which is the largest auditorium in San Diego County. But the big news is the value added to the performance of the mall by the CB Richard Ellis plan.

"We took net operating income from $8.4 million to $11.8 million over a five-year period, from 1996 to 2000," says Buono. "Currently the property is 99% leased and has enjoyed a 10% sales increase over last year. Cash flow to the partnership has increased by approximately $1.8 million per year."

Who works for whom? When information remained in the proprietary hands of brokers, owners as well as tenants could not expect a reasonable answer to the question: For whom does a broker work?

An owner who listed exclusively with a broker might expect a certain level of service. A tenant with a need who listed exclusively with a broker might expect the same. Both sides suspected, probably with some justification, that the result of an eventual transaction generally produced the most value for the broker collecting a commission on a transaction.

That is how a traditional brokerage system structures incentives. The building with the higher rent and longer-term lease receives the most attention. Lower-value buildings receive less attention. Clients with needs that might be well served by lower-cost space and shorter-term leases learn about space that stretches their resources.

As listing information becomes less proprietary, owners and tenants alike can generate their own lists of leads, while setting service requirements for brokers.

"Tenants studying this commission structure have seen that the more rent they pay, the more space they take, and the less flexible the lease they sign, the more the broker earns," says Peter Roberts, managing director and co-president of tenant representation for Chicago-based Jones Lang LaSalle Inc. "They can see that the system does not align interests, but creates a divergence of interests."

In the 1970s, Jones Lang LaSalle restructured its approach to compensation to address the problem of conflicting incentives. Today, the company finds itself well-positioned to deal with the changing shape of commercial real estate brokering.

"In our company, everyone is paid based on a salary and bonus," says Roberts. "No one works on commission. In addition, all our work on corporate accounts on the occupancy side is considered a single profit center. The client pays Jones Lang LaSalle, and the revenues fund a single profit center and a single bonus pool nationwide."

The approach aims to align the interests of the company with those of its clients. Jones Lang LaSalle professionals receive bonuses based on an assessment of their client's satisfaction. The higher a client's satisfaction, the higher the bonus.

A changing view Another explanation for the sea of change in broker compensation plans involves the changing view of real estate within corporations. At one time, real estate simply meant a place to do business or to house offices. Over time, however, large corporations have developed major real estate assets that in and of themselves represent significant profit and loss potential.

In a Fortune 500 company, real estate must perform just as any other company asset. This mandate has brought the consulting arms of major accounting firms to real estate.

"The consulting companies approach the issue of real estate from the perspective of shareholder value," says Gene Wright, senior managing director of retail services for CB Richard Ellis in Chicago. "Consultants will look at an asset base and a corporation's need for capital, and say that real estate carries a cost for funds similar to other forms of debt and equity.

A former consultant with Andersen Consulting, Wright came to CB Richard Ellis to add this form of expertise to the company's portfolio of retail services. Among his challenges is the need for a corporation to manage multiple properties in multiple locations simultaneously. He describes the process as identifying a real estate strategy, building decision support tools with technology, and creating a war room to monitor and evaluate what is happening in the 40 or 50 real estate markets in which a client may operate.

These are today's real estate management challenges. They are not local and are not tied to any proprietary knowledge of property location.

These challenges have everything to do with turning information into appropriate strategies and creating value for clients. Conventional commissions continue to play some role in this mix. But it is a declining one that may one day disappear altogether.

While brokers must negotiate commissions and create compensation structures for value-added services on more and more deals, the old-fashioned commission structure is still used in many deals.

Traditionally, brokers have charged commissions on lease and purchase transactions. Commissions for lease transactions usually involve a percentage of the total dollar value or consideration of a lease over its term. This percentage varies according to lease type.

"In a leasing transaction, you will see rates as high as a fee and a half or about 9% paid to listing brokers," says Mark Fitkin, managing director in the Portland, Ore., office of Los Angeles-based CB Richard Ellis. "Generally speaking, the standard fee, depending upon the lease, ranges from 5% to 6%." This range generally covers all property types: office, industrial, and retail, he adds.

However, nothing is written in stone about rates. Owners always try to negotiate lower rates, and brokers try to negotiate higher rates. A deal depends on how much an owner will pay and how much a broker will take, in light of the prevailing regional market conditions.

Rate variations are also due to the lease type, says Fitkin. Triple-net leases, in which the lessor pays all expenses, generally carry a lower rent than full-service leases, in which owners pay all expenses and therefore charge higher rents. So, a certain building may yield a lower commission for a full-service lease than for a triple-net lease.

In some markets, fees are based on an amount per square foot of space leased. For example, a lease on a 60,000 sq. ft. grocery store may yield a commission of $2 per sq. ft., or $120,000. These markets also tend to use sliding scales for differences between large and small properties. A 2,000 sq. ft. store in this market may produce a commission of $5 per sq. ft.

Sales commissions often vary according to the buyer's plans. "For a building a buyer intends to occupy and use, the commission might be 5%," says Fitkin. "For an investment sale to an institutional owner who plans to lease the property, the fees generally move up and down in direct correlation to the value of the asset. For example, a $100 million asset might bring a commission of 1.5%, while a $5 million building might produce a commission of 5%.

"Is a $100 million asset harder to sell than a $5 million asset?" asks Fitkin. "Not always. There are some differences and a little more complexity. But the process for each asset is similar, and so the rate is discounted as the value of the asset goes up."

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