Realigning Profits

How brokers and their clients can profit by realigning the commission structure

Industrywide, commercial real estate brokers are compensated by commission, usually based on a percentage of the sales price or a percentage of the base rent for the initial term of the lease. Of course, variations on these models exist. For example, brokers sometimes receive per square foot compensation for the initial term of a lease.

However, many of these variations represent a distinction without a difference, with millions of brokered transactions essentially based on the same model. Although characterized as incentive-based compensation, how does the prevailing commission structure adequately align the interests of brokers with their clients?

Calculating Commissions

The customary commission model rewards brokers equally for the first and last $100,000 of a sale or lease. Although there are an almost infinite number of ways to calculate brokerage commissions, compensation is typically based on a static percentage of the sales price or an unwavering percentage of the minimum rent payable during the initial term of the lease.

The words “static” and “unwavering” are meant to convey that the broker receives the same percentage for the first and last $100,000 in value negotiated for the client. So, for example, although a property may be worth $10 million dollars, the selling broker receives the same commission for the first $100,000 as for the much more demanding task of convincing the buyer to boost an offer from $9,900,000 to $10 million.

Unfortunately, this model does not accurately reflect the disparate degrees in difficulty a broker must overcome to achieve these fundamentally different $100,000 increments.

When a property is sold, the listing broker receives a commission, often split with the buyer's broker. Frequently, the commission is then split again, with the agent(s) for the seller's broker and the agent(s) for the buyer's broker each receiving a share. For purposes of this hypothetical, each of the four intermediaries receives an equal 25-percent share of the commission.

If this model is applied to the sale of a $10 million grocery-anchored neighborhood shopping center on a percentage-based commission, each of the buyer's and seller's broker and their respective agents would earn the same amount. Based on such a model, the commission on the first $1 million is compensable as though it bears the same merit as the last $1 million.

Changing the Paradigm

If brokers received higher percentages for more challenging tasks, it would help align brokers' and clients' interests. A weighted commission structure serves to promote a closer relationship between the interests of listing brokers and their clients. By weighing the last increment of the sales price or rent more heavily than earlier, more readily attainable pieces, the listing broker has a much stronger incentive to uncompromisingly pursue the full market rent or sales price.

This differs from the current model, in which the broker receives incentives to complete the transaction more quickly, potentially leaving money on the table. This statement is not meant to question the ethics or integrity of commercial real estate brokers, who do fulfill their fiduciary duties, but just to present the reality of the current process.

Let's examine the initial five-year term of a 20-year retail lease, illustrating how the traditional static model leaves a gaping void between the interests of the broker and the landlord client. Assume, for example, that the market rent for a 25,000 sf space in a grocery-anchored neighborhood shopping center is $10 psf, but negotiations drag on with the tenant resisting the listing broker's efforts to increase the offer. The additional $1 per square foot means $125,000 to the landlord during the initial term alone. However, the total loss to each of the brokers is only 25 percent of the agreed upon commission percentage of that amount, a substantially smaller amount.

Consequently, with the current commission model, the loss of the $1 per square foot detrimentally affects the landlord a great deal more than it impacts the landlord's broker. Brokers have an incentive to complete the transaction early, while the landlord has an incentive to invest more time and pursue the full market rental rate.

Part of the problem can be addressed by rewarding brokers for more challenging tasks. Unquestionably, the landlord's broker deserves weightier compensation for bridging the gap between minimum rent of $9 and $10 psf, than for the first $1 psf.

How could this broker compensation system work on a practical level? On a landlord representation assignment, the first $1 psf might yield a modest commission, say just for example, 2 percent, with the $1 between $9 and 10 per psf yielding a significantly higher commission of, for example, 8 percent. Through its network, Exceedant has used this system for the benefit of clients.

Encompassing More Criteria

The goal is to alter commission structures to more closely align the interests of brokers and principals. Currently, commissions run from the seller's broker and the landlord's broker to the buyer's broker and the tenants' broker. This only serves to create significant fissures between the interests of the buyer's broker and the tenant's broker and those of the client.

For example, buyers and tenants benefit from lower costs, whether the cost is the purchase price or rent. Under the prevailing model, the compensation awarded to the buyer's broker and the tenant's broker increases as the purchase price or rental rate escalates.

To accomplish this objective on co-brokered transactions, for example, the landlord might open escrow, depositing funds for use by buyers or tenants to compensate their brokers. Buyer and tenant brokers would then be rewarded for negotiating buyer and tenant-friendly terms, such as lower purchase prices and reduced rental rates. This is more conductive to aligning the interests of tenants and buyers with their brokers.

The commercial real estate industry can do still more to closely align the interests of brokers and clients, for example, by including a broader range of criteria to determine broker compensation. Also, commercial real estate principals and their brokers are frequently engaged in forcefully negotiating a broad range of terms by performance across an appropriate cross-section of contractual provisions.

How could this broker compensation system work on a practical level? When negotiating the listing, the landlord and tenant and their respective brokers would agree on specific criteria and benchmark compensation for each of those criteria. So, for example, tenant allowances lower than the norm would result in higher compensation for the landlord's broker. Individual numbers could be rolled into an overall Lease Score, with higher scores meriting greater compensation.

Computing Results Achieved

CCIMs are recognized as exceedingly skilled commercial real estate professionals. Why shouldn't their compensation reflect a more thorough measure of performance? Why should the computation of the brokerage commission be based solely on a single barometer of performance?

For example, what about the length of time it takes to go from a listing agreement to a fully executed lease agreement? Wouldn't it be useful to reward the broker for leasing the space more quickly than absorption rates would suggest? This is certainly important to the landlord, who not only earns nothing while the space remains vacant, but bears responsibility for various expenses on the unoccupied premises.

Under this proposed model, higher compensation will be based on more precise measurement across a broad spectrum of criteria. Like all industries, commercial real estate is undergoing rapid changes and exists in a fluid economy where innovative companies such as Uber and WeWork go from startups to firms worth billions of dollars in only a few years.

Creativity and adding value count. How long will it be before a commercial real estate broker guarantees a lease or sale on specified minimum terms by a specific date? It is already happening in residential real estate.

A commercial broker may opt to agree to lease space as a sub-landlord if a third-party lease is not signed by a specified date. In other instances, the broker may agree to purchase the property if a sale, on predetermined terms, is not completed by a certain date. Such a broker adds substantial value, and may become a formidable competitor. Moreover, such a model may help commercial real estate brokers continue to thrive and leverage online resources.

Adhering to the Bottom Line

The more sophisticated the brokers, the greater their ability to figure out how to add value for their clients, then pursue a piece of that value by personalizing the commission to the transaction at hand.

Routinely, CCIMs solve complex site-specific problems for their owner and occupier clients. With a more powerful commission structure, these same skills can be applied to carefully calibrating the interests of brokers and their clients, optimizing results for both.

Preplanning Deal Cash Flows

Splitting Profi ts is a CCIM Institute Ward Center course to help CCIMs determine the best way to carve up profits from the transaction once it is done. This profit planning, however, has to be decided at the beginning, when brokers are putting the deal together.

Who gets what? CCIMs put the deal together, using their expertise and market knowledge, but they could not have completed it without equity partners. How should they split the cash flows? What about the sale?

Often an equity investor will be offered a preferred return to make the deal more appealing. The developer or CCIM designee may also use different structures to achieve a greater share of profits if the deal performs better than pro-forma or is a home run.

It is vital for a CCIM to be able to discuss and model varied methods of sharing the wealth. Developing Excel models for many different structures, such as Traditional Split, The Rake, The Pref, Carried Interest, Subordinated Interest and Waterfall, will help CCIMs to structure investment distributions to gain the confidence of potential equity investors and to earn a better share of the incremental return once the equity investor is satisfied.

Developed by CCIM Senior Instructor Jeff Engelstad, PhD, CCIM, FRICS, Splitting Profits explores Preference Splits and Waterfall structures, as well as Pari-passu splits and Reversionary Interests. Upon completion, CCIMs can describe different structures and model them using Excel. Also, Excel templates and models are provided as an immediate tool for applying these splitting profit techniques.

In addition to teaching for CCIM Institute, Engelstad is a professor at the University of Denver and consults nationally on financial and partnership-related issues. To register for Splitting Profits, go to www.ccim.com/splitting-profits/.

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Randall Airst, Esq., LLM

Randall Airst, Esq., LLM, is managing partner and co-founder of Exceedant with offices in New York City and south Florida. Contact him at airstr@exceedant.com.

Susan Stann Airst, JD

Susan Stann Airst, JD, is managing partner and co-founder of Exceedant with offices in New York City and south Florida. Contact her at airsts@exceedant.com.

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