Brokering Commercial Real Estate Deals
Broker-bank relationships often make it easier to obtain financing, but despite conventional wisdom, the relationship does not increase the sale price.
Research by Mark Garmaise and Tobias Moskowitz
Professional property brokers direct business to banks in exchange for preferential access to finance for their clients. Using a broker increases a buyer's probability of receiving a bank loan from 40 percent to 58 percent.
Of course, "buyers and sellers must pay brokerage fees in order to enjoy the financing benefits arising from the close cooperation between brokers and banks," write Mark Garmaise and Tobias Moskowitz, assistant professors of finance at the University of Chicago Graduate School of Business, in their paper "Informal Financial Networks: Brokerage and the Financing of Commercial Properties." But despite what many think, hiring a broker does not increase the sale price of a property.
Garmaise and Moskowitz show that using a broker has no effect on price. "This generally negative result is striking," they note, "given that increasing the sale price is one of the primary brokerage functions described in the literature." Controlling for the fact that sellers who hire brokers may be different from other sellers, they find that brokers can greatly improve access to commercial financing. Since brokers can reward banks with future business, banks will give priority to loan applications of brokerage clients over applications of buyers without brokers.
Banks have two types of customers: individual buyers, who engage in few and isolated transactions, and buyers accompanied by brokers, since brokers complete multiple transactions each period. Banks prefer working with brokers than with individuals. Meanwhile, brokers only receive commissions for completed transactions.
According to Garmaise and Moskowitz, a broker will reward a bank that approves its customers' loans by advising its future customers to seek loans from the bank. Over time, banks in turn may offer to prioritize the applications of a broker's customers. Thus broker-bank relationships are characterized by repeated interactions rather than information acquisition, and are based on indirect cooperation rather than direct payments.
Predicting Broker-Bank Cooperation
In their paper, Garmaise and Moskowitz investigated nine predictions about broker-bank relationships:
1. Brokered deals are more likely to receive new bank financing.
To test their predictions, the authors took a sample of 36,678 commercial real estate transactions drawn from across the United States between January 1, 1992, and March 30, 1999. They obtained data from COMPS.com, a leading provider of commercial real-estate sales data in the United States. Buyers chose from among four kinds of financing: cash, VTB financing, assuming an existing mortgage on the property, or obtaining a new mortgage from a bank.
The results show that the estimated probability of a bank loan in a nonbrokered transaction is 40 percent, compared to 58 percent with a broker. In addition, Garmaise and Moskowitz found that the effect of broker presence on new bank financing is three times greater when there is no seller financing. Broker-bank cooperation, however, does not increase the size of the loans.
Next, the authors focused on brokers with at least 20 deals in the database, which covered 80 percent of all transactions. Their calculations show that brokers are much more likely to concentrate their business among a few banks. Using the measures of high concentration they developed as an indicator of the relationships' strength, the two professors demonstrate that brokers with strong bank ties increase the probability of obtaining bank debt.
"If brokers and banks develop information relationships over time," they write, "then the fraction of the broker's deals devoted to a particular bank should increase over time."
Moreover, the results show that the relationship works both ways, with a bank's deals becoming more concentrated over time among certain banks.
An even more significant impact on financial structure is evident from brokers with longer bank relationships, the authors argue. After factoring in the age of the broker, they found that longtime brokers who have cultivated bank relationships are much more likely to obtain loans for their clients than young brokers.
Testing the Alternatives
To test their theory of informal broker-bank relationships, Garmaise and Moskowitz compared it to three alternate theories. The first theory is that brokers may monitor the loan policies of banks and direct or advise their customers to seek loans from the bank most likely to provide financing. A second possibility is that brokers may certify the quality of properties and the creditworthiness of borrowers to lending institutions. Finally, liquidity-constrained sellers, anxious to complete a sale quickly, may be more likely to hire brokers and are less likely to provide seller finance.
This first alternate theory indicates that brokers may provide a financial advisory service to buyers by referring them to the places with the most favorable rates and policies. In addition to increasing the likelihood of their clients obtaining loans, this also could cause banks to prioritize brokered deals over nonbrokered deals. If this were true, however, brokers would tend to be more fickle and direct their clients toward whichever banks are most competitive, behavior the authors refer to as "herding."
They found evidence of some herding, but it was "economically insignificant." On average, a bank experiencing herding from brokers will transact only two more brokered deals out of a hundred total deals, rather than the average of 65 brokered deals. Comparing large and small banks, however, changed the situation: while herding is nonexistent among small banks, it is quite prevalent among the largest banks. This suggests that the relationship theory developed by Garmaise and Moskowitz may be most relevant to small deals.
The second theory argues that brokers serve a certification role similar to that of venture capitalists or commercial and investment banks. The analogy to investment banks is particularly apt, since neither brokers nor investment bankers have significant equity stakes in the assets they certify. The certification model, however, predicts a broker's presence will increase the size of the loan as well as increase the likelihood of obtaining financing. It also calls for properties sold through brokers to bring in higher average prices. The evidence, however, doesn't support either prediction.
Lastly, because the average time on the market is lower for brokered properties, the third theory predicts that the sellers in these deals may need money quickly and therefore be willing to pay the brokerage commission but not willing to provide vendor-to-buyer financing. Under this model, brokered deals should exhibit less VTB financing. Garmaise and Moskowitz found no evidence for brokers increasing the presence or size of VTB financing, but they did find that the probability of the buyer assuming an existing mortgage increased.
This last theory also predicts that properties sold through brokers should receive lower-than-average prices. However, Garmaise and Moskowitz's research demonstrates that use of a broker does not affect price.
According to Garmaise and Moskowitz, evidence for the alternate theories is weak. Instead, they conclude that brokers and bankers play a major role in providing clients with better access to bank financing through informal broker-bank relationships.
"The informal network of brokers and banks plays a crucial role in determining financing in the U.S. commercial real estate market," says Garmaise. "Brokers are central to providing their clients with access to finance."
Mark J. Garmaise is assistant professor of finance at the University of Chicago Graduate School of Business. Tobias J. Moskowitz is assistant professor of finance at the University of Chicago Graduate School of Business. Their research on "Informal Financial Networks: Brokerage and the Financing of Commercial Properties" was funded in part by the Center for Research in Security Prices at the University of Chicago Graduate School of Business and the Dimensional Fund Advisors Research Fund.