MDU Access in a Nonexclusive World, Part 3: Evolving Economic Models

In a world of nonexclusive access, owners may gain more by forgoing ancillary revenues and maximizing rents. Of course, they'll have to find new ways to compensate ancillary managers.  November 2010

In this third installment of our series on building access in a nonexclusive world, we consider some economic issues that multiple-dwelling unit (MDU) owners will confront as the market settles and relationships between owners and providers begin to conform to predictable patterns.

Over the long term, nonexclusive property access will likely require both MDU owners and broadband service providers to adjust their traditional business models. Some of this adjustment will probably occur in the area of ancillary income, or revenue other than rental revenue – for example, broadband providers' door fees or revenue-share payments.

Broadband providers typically offer door fees or monthly revenue-share payments in exchange for exclusive access rights of some kind. Notwithstanding the Federal Communications Commission's (FCC) 2007 prohibition on exclusive video service contracts for MDU buildings, service providers are still willing to pay property owners for exclusive marketing rights and exclusive use of in-building wiring infrastructure controlled by the building owner.

Exclusive marketing and wiring usage rights are valuable to a provider because they often convey de facto exclusivity – a second provider is less likely to invest in a building without at least some marketing rights and access to existing wiring infrastructure.

It is easy to imagine a not-too-distant future in which such exclusive arrangements become less viable – not because of any FCC regulatory action, but because entering into these arrangements will no longer be in a property owner's interest. The principal source of ancillary income is the owner's preferential treatment of one service provider over all others. However, owners have an incentive to maximize rents by encouraging multiple service providers. In a nonexclusive world, property owners must confront the question of whether the value of ancillary income outweighs the value of rent increases attributable to tenants' having a full range of choices among service providers. In fact, this question is already upon us.

To illustrate this point, let us consider several examples based on a hypothetical apartment community with 350 units, each rented at $800 per month.

Example 1: Single Provider – Exclusivity Model

In the traditional model of exclusive access, one provider is given exclusive rights (marketing and/or use of wiring infrastructure) in exchange for revenue share paid on a sliding scale where the percentage of revenue paid is based on the provider's subscriber penetration rate at the property. To illustrate, assume the following:

Provider Revenue:

• Term of agreement: 7 years
• Average monthly revenue per unit: $65 from video services, $35 from data services
• Average penetration: 60 percent for video services, 30 percent for data services
• Average monthly gross revenue: id="mce_marker"7,325
• Average yearly gross revenue: $207,900

Owner Revenue:

In exchange for the grant of exclusive marketing rights and/or the exclusive use of inside wiring, the cable company pays the owner a door fee of $150 per unit, as well as a share of its monthly revenue, in amounts based on those typically found in cable right-of-entry agreements:

This looks pretty good until we consider how much potential rent is lost due to prospective tenants' being stuck with no choice among service providers. Remember our assumption that the average monthly rental income from one unit is $800, or $9,600 yearly. How does that value compare with the cable company's payments to the owner?

The door fee consists of an upfront payment of $52,500, with an annual amortized (at 6%) value of about $9,200 or $767 per month over the seven-year term. Unless the owner gets more than 6 percent of the cable provider's monthly revenue (at 60 percent penetration for video and 30 percent for data), the owner is better off renting two extra units (worth id="mce_marker"9,200 per year). So how many potential rents are lost by an exclusive provider arrangement that denies tenants choice?

One way for the apartment owner to rent those two extra units is to offer the prospective tenant a choice among broadband providers. If the owner can rent three additional units by offering prospective tenants a choice of providers, the cable company would have to pay a revenue share of more than 10 percent in order to justify the owner's forgoing those three additional rentals. It is highly unlikely that any provider will agree to pay a 10 percent share of revenue based on video service penetration of 60 percent and data penetration of 30 percent.

Example 2: Multiple Providers – Limited Competition

In the emerging nonexclusivity model, two or more providers compete for subscribers on a unit-by-unit basis. Each provider is given nonexclusive marketing rights. With two providers – the franchised cable operator and the local ILEC – on the property, generating ancillary income is still possible. However, the revenue share available from each provider is significantly lower than under the exclusive access model, and the door fee is greatly diminished.

Moreover, in a competitive environment, subscriber penetration for each provider will be reduced – and therefore the revenue share percentages based on those penetration rates are also reduced. With two providers,

Provider Revenue (for each of two providers):

• Average monthly revenue per unit: $65 from video services, $35 from data services
• Average penetration: 30 percent for video services, 15 percent for data services
• Average monthly gross revenue: $9,800
• Average yearly gross revenue: $117,600

Owner Revenue:

Because the door fee paid by a provider for nonexclusive marketing rights is likely to be negligible, we will assume for the sake of simplicity that no door fee is paid.

In exchange for nonexclusive marketing rights and nonexclusive use of wiring infrastructure, each provider will pay a revenue share that is somewhat reduced relative to what an exclusive provider would pay.

Again, in our hypothetical example, the average monthly rental income from one unit is $800, or $9,600 yearly. Based on these revenue and penetration assumptions, the value of the owner's combined revenue share payments (assuming a 4 percent revenue share for a combined total of 60 percent/30 percent penetration) will approximately equal the value ($9,600) of renting one unit under a one-year lease.

Example 3: Multiple Providers – Open Competition

In this scenario, three providers – a cable company, a telephone company and a satellite distributor – serve and compete for subscribers on the property. Each has nonexclusive and equal marketing rights along with shared use of wiring infrastructure, and no provider pays any door fee or revenue share. Although we lack data to determine the increase in rental income that results from offering a full array of service providers, the younger, more technologically sophisticated and mobile demographic appears to place a high value on this option. If this is true, and if our economic assumptions are relatively accurate, then the open-competition model is likely to replace the exclusivity and limited-competition models, at least for MDU properties marketed to demographics for whom broadband choice is an important consideration in choosing a rental home.

Conclusion

Over time, as the exclusivity model for building access in MDU markets is eclipsed by provider choice, the value of ancillary revenue paid by providers will be outweighed by the value of incremental rental revenue attributable to competition. This will require adjusting the business model based on traditional sources of ancillary revenue – including the compensation paid to ancillary managers who are compensated based on door fees and revenue-share payments.

This is not to say that revenue-share payments and door fees are about to cease tomorrow or any time soon. They won't, for several reasons. First, as the limited-competition model illustrates, there are and will remain provider combinations that justify the payment of ancillary compensation to property owners based on the allocation of access rights in ways that enhance rather than suppress provider competition and do not negatively impact the owner's rental income. Second, there are and will remain certain renter demographics – for example, the elderly and transient student populations – for whom broadband provider choice is less crucial. In properties that cater to these demographics, bulk or exclusive agreements will likely remain appropriate options.

MDU owners ought to look closely at their portfolios to identify assets in which the value of resident choice outweighs the value of ancillary revenue paid in exchange for exclusive rights. Unfortunately, we lack hard data on the precise value of choice – that is, how much rental revenue may be increased by two or more providers' competing at a property relative to how much ancillary revenue is sacrificed. However, even in the absence of hard data, it is very likely that among the younger, educated and tech-savvy demographic in and around urban centers, the value of choice is relatively high, and that properties catering to that demographic benefit from the existence of multiprovider competition.