Academic journal article The Journal of Real Estate Research

Franchising in Residential Brokerage

Academic journal article The Journal of Real Estate Research

Franchising in Residential Brokerage

Article excerpt

Abstract

This paper explores the profitability of real estate franchises. The database for the study consists of observations from the National Association of Realtors®' 2001 survey of real estate brokerage firms. Franchises are found to generate additional revenue for franchisees. However, net margins defined as the difference between revenues received and expenses paid (including franchise royalties) are lower for firms with franchises. The findings indicate that franchisors appear to extract the excess rents from the franchisee.

Introduction

Franchising is widespread in the real estate industry, particularly in the hotel and residential brokerage sectors. According to the National Association of Realtors® (see www.realtors.org), there are over 1 million Realtors® of which approximately one-third work for franchised residential brokerage firms. Previous research by Lewis and Anderson (1999) reveals that franchise-affiliated firms have lower costs than independent brokerage firm. Anderson, Lewis and Zumpano (2000) show that franchised firms are more efficient than their non-franchised counterparts, but they further report that franchise affiliates are not necessarily more profitable.1 The findings presented in this paper provide further insight into the relationship between franchisors and their affiliates.2

In exchange for receiving a proportion of revenue, such as the 8% charged by Cendant to Century 21 franchisees, the franchisor provides stipulated benefits by contract to the franchisee.3 A franchise offers a well-known brand name that signals information about the quality of the firm (including reliability) to new and existing clientele. Additional benefits can include marketing, training, accounting services, etc.4 Unless the franchisor controls specific customer traffic, such as a hotel reservation system, the services sold by the franchisor are general and common to all franchisees.

This paper is organized into six sections. The following section discusses prior research on franchising, both in the real estate industry and in general. Following this overview, a model of firm profitability is developed, to describe the relationship between franchise fees and expected revenue, profit and net margin. Next, the empirical model and sample data are discussed. Empirical findings and concluding remarks are presented in the last two sections.

Franchising and Residential Brokerage

Past studies support the hypothesis that franchise affiliates have higher gross revenues that allow them to pay positive fees to the franchisor. For example, Jud, Rogers and Crellin (1994) show that franchise affiliation results in a 9% increase in net revenue.5 These studies ignore whether franchises have greater profitability. Even though there is a difference in sales performance across franchisees, and within the same unit over time, the fees levied by franchisors are relatively constant and not performance-based (Lafontaine and Shaw, 1999).

Another area of academic study of franchising is marketplace signaling. Signaling information about the quality of the franchisee is not available initially, but becomes observed over time (Gallini and Lutz, 1992). Franchisees that survive have better reputations and, therefore, should qualify for lower fees (Mathewson and Winter, 1985). Lafontaine and Shaw (1999) indicate that information differences across franchisees are small and that imposing a plethora of separate fees leads to management costs. They find that the royalty, or percentage fee, and the fixed franchise fee are not negatively correlated.6

A Model of Residential Real Estate Franchising

In the conventional industrial organization analysis, franchising is a method of extracting effort by reallocating incentives. The royalty is the percentage payment from income to the franchisor, and the franchise fee is the fixed up-front cost. Let R be the percentage of revenue paid as the royalty and F be the franchise fee. …

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