Risk Management

Divided Loyalties

Companies are starting to look twice at their real estate brokers' business relationships.
Don DurfeeDecember 29, 2005

Brace yourself for a shock: your company’s real estate broker may not always have your best interests at heart.

True, this is probably about as stunning as, say, the revelation that securities analysts once wrote flattering things about banking clients. But, like the complex relationships of the pre–Eliot Spitzer banking industry, conflicts of interest in the real estate business are pervasive and costly, say experts.

Many of these conflicts are well known. For example, it’s common for a brokerage firm helping a company find office space to also work for landlords in the same market. This shouldn’t be surprising: the largest real estate services firms — a group that includes Trammell Crow Co., Jones Lang LaSalle Inc., and CB Richard Ellis Group Inc., among others — derive about two-thirds of their revenues from owners and investors and the other third from occupiers.

Other times, problems can be more obscure — when, for example, a real estate company recommends a vendor in which it has an undisclosed investment. Or when, in a sale-leaseback, a broker’s desire to earn a commission or win business from one of the investors calls the outcome of the auction into question.

Such problems are commonplace and will only become more so as the industry consolidates, claims Michael Silver, president of Equis Corp., a tenant-only real estate services firm based in Chicago (and a competitor of the larger real estate companies). In New York, for example, consolidation has created a situation where general brokers are representing many of the big landlords as well as tenants, says Silver. “There are sweetheart business relationships that companies never see,” he asserts.

Tainted Deals

Many companies now want to uncover those relationships. In the age of Sarbanes-Oxley, companies are less willing to tolerate murkiness in their financials, and this caution extends to corporate real estate. As more CFOs assume oversight of real estate decisions, some are examining their companies’ provider relationships.

One is John N. Spinney Jr., senior vice president and CFO of Investors Financial Services Corp., which provides custody and asset-administration services to financial services companies through its subsidiaries. A couple of years ago, the company’s CEO handed Spinney responsibility for the company’s real estate relationships. When Spinney’s team considered whether to renew the company’s lease in Boston’s John Hancock Tower, it decided that the company’s longtime broker had a conflict: because the firm also represented the landlord, it had little incentive to get the best deal for the company.

Spinney conducted due diligence on other brokerage firms, and chose one whose interests were more closely aligned with the company’s. In the end, Investors Financial Services did obtain more-favorable lease terms than what the previous broker had presented. “People may say that the conflict of interest isn’t a big deal, but I saw it in black and white,” says Spinney.

The problem that Investors Financial Services faced — dual representation by a single brokerage — is not new, of course. The reason it can work against the tenant’s interest is that the local broker may think that keeping the landlord happy is more important than trying to get the best deal for the client.

“People in the industry will say, ‘Hey, there’s no conflict. Show it to me,’” says Tom Gibson, a veteran of several brokerage firms who now has his own real estate services firm in Newport Beach, California. “But whether [brokers] admit it or not, what usually happens is that you make sure the guy giving you the ongoing business — probably the property owner — gets the benefit of the deal as opposed to the tenant, who you’ll probably never see again.”

Sale-leasebacks might be tainted, too. In the winter of 1999, Bank One (now part of JPMorgan Chase & Co.) hired Texas-based real estate company Trammell Crow to advise it on whether to execute a sale-leaseback on a large office tower in Oklahoma City. According to lawsuit documents filed in 2002, Bank One accuses its adviser not only of deliberately skewing its analysis to make the leaseback appear more attractive than continued ownership, but also of falsely convincing the bank to sell the property for far less than it was worth, and then securing a lease for the bank at above-market rates.

Why would the broker have done that? Allegedly so that Trammell Crow could collect the $400,000 fee for a completed transaction and win favor with the new owner, who hired the company to manage the property. (After making some improvements, the new owner sold the $14.5 million property for $27.9 million three and a half years later.) Representatives of JPMorgan Chase and Trammell Crow declined to comment on the case, which is still pending, but elsewhere Trammell Crow has denied all of Bank One’s charges.

Raising the Issue

How concerned should companies be about such problems? Real estate services firms argue that they manage conflicts diligently. “We are vigilant about fulfilling our fiduciary duties,” says Christopher Ludeman, president of CB Richard Ellis U.S. Brokerage. “We train our professionals relentlessly to identify potential conflicts from the moment they join us.”

Similarly, Richard McBlaine, who is president of strategic consulting for Jones Lang LaSalle, says that his company discloses any conflicts and has a code of ethics its employees must sign annually. “The real estate industry is too small,” he says. “There’s no amount of win that one could achieve on an individual transaction that would cover the damage to our reputation.”

But Equis’s Silver argues that even if a general broker is acting ethically, the results will still be unfavorable for the tenant, because many landlords won’t bother to bid. “It’s like what was happening in the insurance industry,” he says. “Insurers would say, ‘Why should I even bother bidding on this insurance contract when I know Marsh & McLennan has a deal with this insurance provider?’”

And while many companies engaging in a sale-leaseback will be sophisticated enough to know what their property is worth, others that may be doing such a transaction for the first time — or that, like Bank One, have outsourced all of their real estate expertise — may be vulnerable to misleading advice.

So what should you do? One step is simply to raise the issue with the broker. Many companies now require prospective real estate providers to disclose any potential conflicts in their RFPs (some states also require such disclosure). “In my experience, brokers are pretty good about fessing up to their conflicts, if only because the conflicts are so obvious that to deny them would take away credibility,” says Peter Linneman, professor of real estate at The Wharton School of the University of Pennsylvania.

Companies could also hire tenant-only firms, which is what Velocity Sports Performance, a sports-training franchise, has done. According to Kevin G. Keegan, head of operations (and a licensed real estate broker), the company did this to help ensure that its franchisees get the best deals on leases.

Caution is in order here, too. “The ability of tenant representatives to get deals done also depends on good relationships with landlords,” says Keith M. Pattiz, a partner with McDermott Will & Emery in New York. John Spinney’s approach was to hire a tenant-only representative, but then negotiate a fee arrangement that aligned the broker’s interests with those of the company. In addition to a flat fee, the broker was paid a commission based on the cost of the company’s final net rent. Spinney paid an additional bonus once he was satisfied that the broker had run a thorough process.

Such caution is a good idea. Just as it was unsophisticated investors who were swayed by stock analysts’ happy talk, so in real estate it’s not the seasoned professionals who should worry, but ordinary companies with other things to think about.

Don Durfee is research editor at CFO.