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Are markets efficient? - A look into the NYC 'broker fee ban.'

Remember this chart from macroeconomics?

The details don't matter. The key is the conclusion. When a tax is assessed, the buyer pays a higher price, the seller receives a lower revenue, both relative to equilibrium. Both the buyer and the seller end up incurring a portion of this cost, irrespective of who pays the government. What portion each party incurs depends on something else you might remember called elasticity.

Let us consider this first-year economics theory in light of the recent "Broker Fee Ban." Who pays broker fees? Is it the landlord? Is it the tenant? Does it matter who writes out the check to the broker at closing?

For those that are not aware, here is a quick primer on recent events:
1/31/20: The Department of State issues guidance stating that a Landlord's Agent (an agent representing the interests of the landlord) can no longer collect a broker fee from a tenant. A Landlord's Agent can still collect a fee from the landlord, and a Tenant's Agent can still collect a fee from tenants.

2/5/20: Even though the focus of the guidance is narrow, multiple publications pick up on this guidance and lead with headlines reading "Broker Fees are Banned in NYC", leading to tenant, landlord, and broker confusion.

2/10/20: After a lawsuit is brought on by various real estate groups, a judge issues a temporary restraining order on this guidance, bringing us back to square one, for now.

Why do broker fees exist?
When a landlord has a vacancy in their portfolio, they must fill that vacancy. Their goal is to fill the vacancy quickly and for a fair market price. The landlord incurs transaction costs to fill the vacancy. These costs include:
1. Spending time and money marketing the unit on popular tenant facing websites like StreetEasy.
2. Spending time communicating with, responding to, answering questions from, and coordinating appointments with the people that inquire about the unit.
3. Spending time showing the unit to the people that inquired.
4. Spending time collecting paperwork, running background reports, and reviewing the qualifications of applicants.
5. Spending time preparing the leases, riders, and disclosures at the lease signing.
6. Lost rent while the unit sits unoccupied.

What does all of this add up to? They may spend $500 and 3 hours marketing the unit, 6 hours communicating with 40 leads, another 8 hours showing the apartment to 14 people, another 2 hours collecting and reviewing 2 applications, and finally 2 more hours preparing and signing the lease. In total, they have spent $500 and 21 hours to fill their vacancy in our fictional example, while incurring four weeks of vacancy loss. And this only makes up a portion of the landlord's "Transaction Cost" (other indirect costs include office space to house their leasing staff, computers, software, etc.). Many (but not all) landlords in NYC outsource this work to a third-party broker. They outsource because they cannot handle the leasing internally, they don't want to handle it internally, or because they may feel the broker can reduce their vacancy loss. A broker fee is a combination of the "Cost" and the broker's profit margin.

Who pays for this "Transaction Cost"?

Let's go back to our first-year economics problem. When it comes to Transaction Fees and Broker Fees, both parties incur a portion of this cost. But because short term housing demand is inelastic and NYC has low vacancy rates, a larger share of this burden is borne by renters. Whether the landlord writes out a check to the broker or the tenant writes out the check does not matter and is unlikely to change this basic economic rule.
- Landlords Revenue = Rent they collect - Transaction/Broker costs at vacancy
- Tenants Price = Rent they pay + Transaction/Broker costs at vacancy

Assume there are two identical apartments (space, layout, finishes, amenities, location, etc.). Two separate landlords own these apartments.
- Landlord A decides to pay a broker's fee out of their pocket.
- Landlord B asks the broker to make the tenant pay.
The forces of supply and demand will allow Landlord A to increase the rent above a hypothetical equilibrium where "Transaction Costs" do not exist while forcing Landlord B to decrease the rent. Ever noticed how "No Fee" apartments often seem expensive while "Broker Fee" apartments seem like a better deal?

How does the new guidance impact tenants?

Is forcing landlords to write out a check to the broker better for tenants?
- Better: Tenants have lower out of pocket costs at lease signing.
- Worst: Tenants will have to pay higher rent.

This is not a theory. We analyzed how prices moved during the five days when the "Broker Fee Ban" was in effect. We found 101 apartments that shifted from "Broker Fee" to "No Fee". These apartments saw an average rent increase of 5.7% over this same five-day period. These 101 apartments also included 10 apartments where the rent dropped, which we concluded was unrelated to the DOS guidance (the units were initially overpriced and had been sitting on the market). If we exclude the 10 price drops, the average rent increase was 6.8% over the five days. The median rent increase was 5.8% (including rent drops) and 6.7% (excluding rent drops).

Assume a renter is renting out a $2,500 apartment. A 6% rent increase is equal to $150 per month, which the tenant would pay for as long as they live in the apartment.

Length of Tenant StayThe additional cost in rent
1 Year$1,800
2 Year$3,600
3 Year$5,400
4 Year$7,200
5 Year$9,000
6 Year$10,800

The typical tenant will stay in the same apartment for 4-5 years. The broker fee ban causes the typical tenant to spend more over the life of their tenancy, while the tenants that stay only one year will save some money.

Many savvy landlords in NYC understand this concept, which is why "No Fee" apartments have become more common in NYC in the last five years. Approximately 50% of the inventory in Manhattan was marketed as "No Fee" before the DOS guidance. Landlords are not doing this because they are charitable, but because they can demand higher rent for these apartments. This leads to an increase in revenue for them in the long run as tenants continue to pay the higher rent for many years.

How does the new guidance impact landlords?
If landlords can simply increase the rent of their apartment to cover the cost of the broker's fees, then the guidance should not matter to them, right? Not necessarily. For landlords that own many buildings, have leasing infrastructure, and already offer to pay broker fees, it will be business as usual. It is the smaller mom-and-pop landlords that will be impacted.

These mom-and-pop landlords hire brokers because they do not have the time or infrastructure to lease their units and because they would incur significantly more vacancy loss if they tried renting their units internally. They ask brokers to get paid by tenants because the short term out of pocket costs at lease signing matter to them. These landlords essentially give tenants a discounted monthly rent, which costs them more if the tenant stays longer because they do not want to pay the broker fee at lease signing.

Perhaps we should trust the forces of the market.
- Some landlords already offer to pay broker fees so they can demand a higher monthly rent.
- Some landlords are forced to offer discounted monthly rents because they do not want to pay the broker fee.
- Some tenants don't want to pay a broker fee and so they rent more expensive "No Fee" apartments.
- Some tenants end up paying the broker fee because the best deal they found has a broker fee.

This is how we are taught the free market should work. People will act based on their circumstances and decide if they want to compromise on short term savings versus long term cost, or vice versa. When all people act in this way, the markets reach an efficient state. The DOS guidance shifts costs from certain tenants to other tenants and certain landlords to other landlords, and in the process potentially creates inefficiencies in how the market works, increasing overall costs for everyone.

How do we bring down housing costs in NYC?
To bring down housing costs, we should again look at the forces of supply and demand. Housing costs are high in NYC because housing is scarce and vacancy rates are low. For those of us not blessed with a below-market rent-stabilized apartment, the rent we pay is based on these forces of supply and demand.

How can the state help? By encouraging development, either through financial incentives or through the intelligent use of zoning laws (while making sure the city infrastructure is maintained and upgraded to handle higher density zoning). How else can the state help? By not scaring developers away from NYC due to regulatory uncertainty. More housing and more competition will bring down our housing costs.

The nefariousness of the "Broker Fee Ban" is not in the fact that it does not save consumers money, but in the fact that people may believe it saves them money. This gives our legislators an excuse to ignore effective policy suggestions that will bring our housing costs down.

Are you a landlord or a tenant confused about how to handle these new guidelines. Contact us for a free consultation.