Compiled from news services
Bright ideas come and go in real estate. The latest bright idea, brought to the United States by the giant Foxtons firm in England, apparently has gone.
Foxtons, the innovative discount broker that set up its U.S. operation in the New York metropolitan area, is closing down and has already laid off 90 percent of its workforce.
No doubt, there will be some people within the real estate community who will cheer at the demise of Foxtons’ model. They will point out that the company’s problems in the U.S. - Foxtons actually originated in Great Britain where it’s regarded as an innovative and successful estate agent - are by-products of discount pricing, salaried real estate agents and too many distinctive Mini Coopers charging around New York.
Foxtons invested $20 million in an existing U.S. brokerage in 2001 and then began one of the most innovative and visible marketing campaigns in real estate. The company smartly captured media attention with its combination of two percent listing fees and clever marketing. The result, says the company, was that Foxtons in the U.S. “become the fastest growing real estate company in American history.”
Foxtons initially offered to sell homes with a commission schedule typically ranging from 2 percent to 4 percent, substantially less than competing firms. Not only was Foxtons charging less, it was offering a solid package of realty services including open houses, online marketing and MLS listings.
In effect, Foxtons provided a menu of services. Consumers who wanted to do much of the work on their own could hire Foxtons for the tough parts of the job. Consumers who wanted a less expensive full-service broker could also use Foxtons, but at less cost than they might have with competing brokers.
At first the idea of discounting real estate services may seem financially unworkable, but a price reduction can be economically justified if a brokerage can trade the cost of finding new listings for lower commissions. In other words, the discounted commission by itself becomes a marketing device to attract clients. The brokerage spends less money selling its services and therefore has smaller operating expenses.
But if discounting makes business sense in theory, it’s not always sensible in practice. The problem is not that brokerages are unable to function with lower commission rates, the complication is that larger brokerages cannot survive without certain levels of revenue per transaction to cover costs.
Think about steel. If you build a smelter to produce steel, the first ton is incredibly expensive. Once the smelter goes online, the cost per ton declines. This happens because fixed costs are the same regardless of whether the smelter produces one ton or 10,000. As production increases, fixed costs are divided by ever-larger productivity, thus the cost per ton falls.
In a similar sense, real estate brokerages have fixed costs. One can reduce fixed costs per transaction by having more of them, by reducing expenses or both.
Foxtons set out to be a volume brokerage and succeeded. It also set out to change real estate economics by compensating agents with salaries rather than seeking independent contractors paid on a commission basis.
You can see that the Foxtons discount model depends on volume because the company has salaried workers and those workers are a fixed expense. In a market with rising unit sales and home prices, the Foxtons approach is logical and workable - however, when unit volume falls and values stall, there are fewer opportunities to represent buyers or sellers and thus less opportunity to cover fixed costs.
Traditional brokers, in contrast, automatically have lower costs when sales slow because salespeople and associate brokers are paid only on the basis of performance.
The essential flaw in the Foxtons model is not that discounting and salaries are unworkable, rather the fallacy relates to scale: fixed costs require ongoing and predictable revenues. The bigger the company gets, the greater the necessity for more dollars. In effect, the very benefits of large scale that might attract venture capitalists is also a danger if sale volumes decline sufficiently.
Instead of a built-in need to do more volume to support expanding fixed costs - costs which are themselves created by increased sales - the alternative idea is to have smaller set expenses which require fewer transactions to support.
For instance, the menu-of-services concept can make sense for a broker who works from home, has a small service area and limited marketing costs. Without multiple offices and lots of vice presidents, shareholders and institutional advertising, the costs of being in business are minuscule. If two or three neighborhood brokers work together, then it becomes possible both to be in business and to have a personal life with vacations and time off.
Foxtons had the right idea but the wrong size. For individual brokers and modest real estate practices around the country, what Foxtons tried was neither unappealing nor without potential. Others will follow the model established by Foxtons, but the model will be smaller.