Is Charging Large Leasing Fees Unethical?

This week I had the great pleasure of attending the NARPM Broker Owner conference in beautiful Colorado Springs Colorado. Broker Owner is the best conference of the year for residential property management company owners. In fairness I have not attended all the different conferences that touch our industry, but I’m sticking by this claim.

The conference was held at the exquisite Broadmoor hotel. It’s difficult for me to describe how enjoyable it was to stay at the Broadmoor. Everything was exceptional: from the room service to the demeanor of the bell hops, the way they answer the phone with “Mr. Brower” when I dialed zero, the art, the roses, the lake, the views, the history everywhere. Everything around was a living museum to the pinnacle of hospitality, the level which only becomes possible over 100+ years of incremental improvement. I could go on…

Several months ago Peter Lohmann and I had an exchange where I suggested we have an incentive problem in property management. His response was “I totally agree which is why I don’t charge a leasing fee.” Plus one for Peter in my book. Then he continued with something like: “You should submit for us to discuss this in a panel at Broker Owner”.

No Script

The format was live debate, which is uncommon at Broker Owner. Peter and I have argued (respectfully) about stuff before but this time it would be live without the ability to edit anything out. We knew the topic and had a few thoughts about it but left the rest up to an unscripted, live conversation—which I think frustrated some folks looking for a clear conclusion.

Incentives Matter

‘Show me the incentive and I will show you the behavior’ the saying goes. What people get paid to do, they will do more of that thing.

My position, taking the stage, was:

It’s messed up that property managers often make the most money when things go the worst for the owner.

I want to make something clear here: I lean libertarian. I am a free market guy. I think, generally, that we should let informed consenting adults trade with each other and not mess with that. Free market forces (generally) have an incredibly powerful way of directing resources into the most competent hands that can then do more good with those resources.

But, I also strongly believe in Win-Win business relationships only, and that means even if I am winning, if I know the other person is not winning, it is my obligation not to engage in that relationship. Put another way, while I am strongly in favor of businesses maximizing revenue and profits overall, I am against fee structures that create adverse incentives in an agency relationship, especially one as important as the general agency relationship property managers have with their clients.

If we get paid more for the things that hurt our client’s profitability we should take a hard look at those things. We should assess whether it is really a win for our clients regardless whether or not the court system would deem them sophisticated enough to ‘know better’.

Property managers are business managers

A rental property is not a trifle thing that needs to be occasionally poked or prodded to produce some insignificant and highly predictable outcome. A rental property is a business. Our clients own a rental business and they are hiring us as the business manager. As business managers, the scope we oversee is broad, and the weight of our responsibilities is substantial.

A great business manager can affect a seismic shift in returns. A 1-2% difference in ROI over 20 years is $200k+ for our clients. But what’s even more important—and rarely talked about—is the psychological effect. A great business manager in our field increases the odds that an owner actually stays in the game long enough to see the exponential wealth-building that only kicks in after pushing through those brutal early years.

On stage I shared this example: If our client owned a KFC franchise and they came to us to be the business manager of that store because of our 20 year experience, it would never happen that our employment contract would bonus us when the business was the least profitable. Yet, this happens all the time in property management.

“Yeah, well we’re not alone in how we charge fees…”

Todd Ortscheid took 3 shots at my arguments. A preemptive strike with this Linked-In post, a shot from the mic during the debate and a shot in this newsletter issue. I think Todd makes some compelling arguments but he is wrong on a few points but here’s where we agree: I think it is appropriate for us to be paid for our work, even when things are going badly for the owner. In fact, it’s when things are going badly that the landlord needs our help more than ever.

Todd points out that doctors and lawyers make money when things go poorly for their clients. While this is true, the comparison doesn’t hold water because doctors and lawyers are typically hired because something has already gone wrong—whereas property managers are hired to prevent things from going wrong in the first place, and if our profits spike when we fail at that, it’s a sign of an incentive problem, not just payment for hard work.

“But these people are so rich they own more houses than they can live in”

Said Peter at one point during our discussion. Yes this is true. But so was I at age 24 when I moved out of my first house and put it into service as a rental. Guess what? I was pretty dumb at 24 and I certainly was not equipped to understand fully what terms in a business manager employment relationship would best serve me in the long run.

Being ‘so rich’ you own a rental home does not automatically make you a sophisticated business person. Far from it in my experience, actually. One of the greatest liabilities our clients have is the lack of a sophisticated business owner mindset. Helping our clients move from short-term, transaction, scarcity, dollar-cost mindset to a long-term, partner, abundance, opportunity-cost mindset is the greatest value we can bring to them, but that’s a separate write-up.

I have less sympathy for “rich” people in a bind paying a business attorney $400+ per hour not getting what they are paying for than the ‘Ma and Pa’ landlord who’s overly focused on monthly cash flow with asymmetric information.

Most landlords possess neither the sophistication or the experience to properly negotiate (or choose) management terms that align with their long-term profit interests so they often choose a PM provider because of the perception of lower fees. After all, it’s the only thing they (think they) know for sure is different when shopping property management companies because everyone is pretty much promising the same thing.

Because new landlords lack business experience and sophistication they aren’t equipped to understand that the $75 per month property management fee actually still results in a $350+ RPU (a-hem) and in some cases $200/mo is coming from fees connected with tenant turnover.

Giving ourselves generous ‘bonuses’ for tenant turnover is wrong because it incentivizes turnover. You can’t convince me with your words that you don’t like turnover if a good chunk of your profits comes from turnover.

If the owner isn’t winning we shouldn’t be winning

A business manager is an executive-level hire. An executive should have a fair and reasonable base compensation but they should have a fair amount of their comp tied to business profitability. This doesn’t necessarily mean we should be engineering solutions to participate in asset and income appreciation (though I’m not entirely against the idea). It means we should be looking at maximizing the types of fees that best align with maximum profitability for the owner. To a large degree, this is the monthly property management fee.

(pssst. The higher your monthly property management fee, the more valuable your business is too… Just sayin)

I’m not crazy. I don’t think we should eradicate all leasing fees, late fee revenue and ‘maintenance oversight’ fees. I have participated in these categories at Mark Brower Properties. I do think there is an incentive problem in making 5x the monthly profit on the door that paid late this month. If it really costs you $100 in resources to collect that late rent and $150 late fee on average call me, I may have some ideas on how to drop that to $20 or so. Don’t tell me you hate late-paying tenants if your unit profit that month quadruples every time it happens.

Just like the business manager running a KFC franchise, PM’s should be paid the equivalent of a base level ‘salary’ no matter what. This can and should include conditional fees to address certain things that come up periodically. I don’t take issue with this. It’s the proportion of this ‘base compensation’ to ‘bonus’ that matters more in driving the right behaviors I think. Lower level employees make most of their money in their hourly wage or salary, executives often make a significant amount of their annual compensation from performance bonuses and those bonuses are often tied to company performance.

What bonuses are we giving ourselves in our property management? What should those bonuses be?

The fees we make when things go wrong should be a reasonable compensation for resources expended, like the base salary of my KFC franchise business manager. The high monthly management fee is the bonus for achieving maximum stability and consequently, profitability for the owner.

We exist in the space between general partner and your typical professional services provider

Property management is unique. We are dealing with unsophisticated business owners often operating with the mis-perception they are consuming a commoditized service. Really they are hiring a business manager who controls the feedback loop and the profitability of the owner’s ‘rental business’. Many landlords unwittingly jump headlong into adverse-incentivized relationships enriching their PM for poor performance (yes, you can make a difference in placing on-time versus late-paying tenants, let’s not pretend otherwise).

The fees are not the problem, the profits are. Where are your biggest margins coming from? Manage those, and you manage your conflict of interest with the client.

Designing a fee structure that clearly aligns with the owner’s best interests isn’t just smart business—it’s our best defense against the most damaging forces to our industry: opportunistic politicians, aggressive litigators, and overreaching regulators.

Now that I have had time to unpack this a bit more, my clarified position is:

It’s messed up when PM companies profit on turnover, late paying tenants and maintenance.

The more our profits come from the ‘bonus’ of a healthy monthly property management fee, the better off the owner, the PM and the industry. Make lots of profits but attach them to the right behaviors.

I’m still thinking through this one. Email me your thoughts. My goal is to aim at the very highest good we can do in the industry. To that end, what else should we be talking about that matters?