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Friday, February 23, 2007

Research Note: A Fable of Competing for Context

Buying a flat in London is a pain. A pain of epic, cosmic magnitude. Not only does the UK government impose a lengthy and absurd set of taxes, but, mystifyingly, even factoring in a good amount of scarcity, it's difficult to even find a flat to buy.

How is it possible that between the ten estate agents (aka realtors) I'm listed with, alert me to only 2-3 new properties in total per week? This is isn’t just irrational – it’s impossible.

In Central London, home to 2-3 million people, simple intuition tells us the market must be thicker than 150-300 flats per year.

It's a hugely interesting problem, from a strategic and economic point of view.

Estate agents are intermediaries who stand to benefit if the prices of flats rise. So why are they deliberately holding listings back?

The answer, it turns out, is fascinatingly simple. Let me illustrate what's happening.

With the rise of numerous property aggregators and search engines, context for real estate in London became cheap, abundant, and ubiquitous. Prices and relative values became relatively easy to ascertain – almost.

Estate agents retaliated by amplifying the artificial scarcity of context - by not publishing new listings on their websites for weeks.

But the game didn't end there.

These days, estate agents are requiring side payments in exchange for preferential access to listings. Pay your estate agent a grand or two, and he will alert you to new properties well before anyone else.

Now, to a degree, this has always been the way business has been done - but it used to be confined to very small segments of the market.

Now, the question again is – why? Why are estate agents radically altering their own business models by shifting to side payments?

After all, surely, more liquidity should benefit estate agents. More context – a more liquid market for real estate – should drive prices up, benefiting estate agents, who stand to earn fatter fees.

The answer is, of course, that estate agents aren't worried about short-term increases in margins as prices go up. They're worried about market power. And that's what this game is really about – holding on to decaying market power any way you can.

In fact, from the estate agent's point of view, side payments are probably, given the current industry structure, a rational response. If they simply release their information, market power shifts to property aggregators and search engines, who will ultimately put a downstream squeeze on their margins.

So until and unless there is a credible commitment from aggregators and search engines not to squeeze estate agents later - we’re stuck.

So, as things stand, this is a classic, textbook case of moral hazard - of an agent reneging on his contract. Sound familiar? It should - it is the story of intermediaries at the core. Think record labels, film studios, travel agents, etc.

Now, are estate agents right to be worried? Certainly. Other naive intermediaries like them have been utterly wiped out – travel agents, for example.

This alone reinforces a vital strategic lesson: naive intermediaries – players rich in information, but poor in knowledge – are skating on the edge of a precipice in the post-network economy. The next wave of mediation is going to be about transmediation – but more about that later.

Another way to look at it is this: the present value of the side payments – bribes for context – estate agents are getting must be greater than the present value of any short term increase in cashflows plus the opportunity cost of foregone cashflows from lost market power. That, in turn, implies, that side payments are a relatively stable solution – they are an equilibrium in this game

In other words, bribing your estate agent is fast becoming the only way to play the game – it's becoming a structural change to how estate agents in London create and capture value (and, I’d bet, other places with strong economies of density).

What does this really mean? Well, that the strategies and business model of estate agents (realtors) is altering radically. They are shifting from intermediaries hired by a principal – the seller – to becoming pure providers of context. That's really what the side payments mean from an economic point of view.

That is, strategically, estate agents are putting themselves in direct competition with property search engines, who are also pure providers of context. But their business models are polar opposites: one charges directly for information (side payments to estate agents), whereas one charges indirectly for it (search engines harnessing ad and transaction based revenue streams).

This is a relatively stable equilibrium – a war of attrition - but it's a bad one. Value creation is minimized for everyone – estate agents, search engines, and (especially) buyers and sellers.

This (finally) brings us to the heart of the problem: all these players are applying the tired logic of the industrial era to context-based competition. The result is a value chain in agony. None of these players understand how, when, or why context revolutionizes value creation - they are all seeing it context as simply amplifying the risk attached to a pie whose size never expands.

More simply, none of these players – property aggregators, search engines, or estate agents – are pursuing the set of strategies which must dominate the economics of context: those built around markets, networks, and communities.

Markets, networks, and communities are the natural chokepoints of the post-network economy: they are the most efficient ways to structure interaction.

It's economically inevitable that a radical innovator will utilize one to redefine interaction in the real estate market – and end the stalemate that property aggregators and estate agents have, ultimately, reached.

The moral of this story is simple: competing for context isn't as simple as you think. The games firms play in the post-network economy are just as intense – if not more intense – than in an industrial economy.

In the Valley, we have begun thinking that context will change the world. It will. But getting there requires deeper insights into business models and strategies – especially those built on markets, networks, and communities.

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-- umair // 12:54 PM //




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