Answering Our Brokerage Clients’ Most Commonly Asked Questions: How Do Pro Investors Pay Commissions and Manage Risk?

August 15, 2024
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How Do Pro Commercial Investors Pay Commissions and Manage Risk - MDL Group

Our ongoing blog series answers our clients’ most pressing questions about commercial real estate. In our previous blog, we defined the parties in a commercial real estate transaction and outlined factors affecting the amount and timing of commissions. In this blog, we will take a look at how professional owners pay commissions and how these commissions fit into their risk management strategy.  

Many practices around paying commissions in the commercial real estate industry are established by “institutional owners” such as Real Estate Investment Trusts (REITs), pension funds, insurance companies, and private equity firms. The broker commission practices of these institutional owners, which aim to effectively manage risk, can contribute to property value and overall investment success. 

Established practices include:

Bonus Commissions for Tenant Agents

Institutional owners often offer bonus commissions to tenant agents, typically around 4% to 5% rather than 2.5% or 3%. This incentive is strategically designed to attract a higher volume of tenants, better quality tenants, and secure long-term leases that enhance the property’s value. By compensating tenant agents for successful lease agreements, institutional owners win deals over competing properties. This maximizes occupancy rates and stabilizes income streams.

Impact on Property Value

When a new lease is signed, the increase in income can significantly boost the property’s overall value making the commission investment worthwhile. The additional income generated directly affects the property’s net operating income (NOI), which, in turn, influences its capitalization rate (cap rate)—a key metric for determining its market value. For example, the 15,000 square foot lease mentioned in our previous blog adds $270,000 of net income to the property (15,000 x $18 per square foot = $270,000). Applying a 7.5% cap rate to this income calculates to $3.6M of value ($270,000 / 7.5% = $3.6M). Paying a commission of $67,500, along with a bonus commission totaling $108,000 (5% to the tenant’s agent), is a worthwhile investment to secure this income stream and boost property value. Institutional owners recognize that the financial benefits from increased property value significantly outweigh the costs of broker commissions.

Risk Management in Commission Payments

Institutional owners understand that once they agree to a lease, they are accepting the financial risk of the tenant. They do not expect brokers to refund commissions or lease the space to a new tenant for free if the original tenant defaults. Instead, these owners focus on other risk mitigation strategies, such as thoroughly assessing a tenant’s creditworthiness and financial strength during the underwriting process. By accepting a tenant, they also acknowledge that commissions are a fixed economic cost of the deal. Additionally, while the landlord has legal recourse in the event of a default, the broker does not—further emphasizing why commissions are treated as a necessary and justified expense in securing high-quality tenants.

Excitement to Pay Broker Commissions

Institutional owners view paying broker commissions as an investment in their success. They understand that the value brokers bring—by sourcing high-quality tenants and securing favorable lease agreements—far outweighs the cost of commissions. These payments are a small price to pay compared to the significant profits generated from a successful deal. Institutional owners treat brokers as indispensable partners in identifying lucrative opportunities.

By building strong relationships with brokers, institutional owners ensure a steady flow of high-quality deals. Their established best practices for commission payments incentivize brokers while enhancing property values. Let’s look at the example of Panattoni, a global leader in industrial real estate development. They developed a widely known program called the “Triple Play”. If a broker brings them land to develop they get to stay with the deal for the lease listing and the disposition once it’s stabilized. This gives the broker three opportunities to earn commissions.

If a broker learns about an opportunity, they are more likely to bring it to an institutional owner like Panattoni who recognizes the broker’s value and treats them like a partner, vs. a property owner who undervalues the broker’s role, offers minimal commission or restrictive terms. Brokers are more likely to bring prime opportunities to owners like Panattoni, who foster loyalty and trust, ultimately driving better property performance and long-term profitability. 

Now that you know how the pros do it, check back here for our next blog to learn how the Sale or Leasing of Commercial Property is governed in Nevada.

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