🏠Long Zillow. Short Real Estate Agents😔

A deep dive on Zillow's new(ish) ambitions, and what the future of real estate might look like.

👋Hello from the home office.

I spent a lot of time this week thinking about Zillow ($Z) and the future of real estate. I will update this post as time goes on and as more information comes in.

I don’t think all real estate agents will go away; just that there will be fewer of them. And the way they are compensated will change or be less than the current state (6%).

MUST-READ: CNN penned an article on why a current class-action lawsuit could do away with the 6% real estate commission. It lays out why major changes in the real estate industry are coming. And the effect it will have on agents, brokers, and consumers.

In the article, they asked Rob Hahn what would happen to the industry if the lawsuit is successful👇

It kills the industry," said Rob Hahn, a real estate marketing consultant with the firm 7DS Associates, who predicts the number of people in the profession would drop to just 200,000 if the lawsuit is successful. "A lot of things that we as consumers value go away.

Some context: There are an estimated 1.36 million real estate agents. A drop to 200,000 would be jarring.

Resources used in this article:

Important: Just because I’m bullish on Zillow's long-term potential doesn’t mean I’m bullish on its stock. Good companies can make bad investments if the price paid is too high.

I see you Zillow 👀

Fan of sports?

Imagine going from a Red Sox fan to a Yankees fan.

Or from a Celtics fan to a Lakers fan.

Or, if you're from my neck of the woods, going from a Bulldog to a Rebel😒

It’s almost unthinkable.

And that’s what Zillow is trying to do.

They’re attempting to go from a capital-light, high-margin business that makes money through advertising and marketing. To a capital-heavy, low-margin business that makes money by buying and reselling homes. Sounds great!

In fact, their new CEO said as much in his 2018 letter to shareholders.

As a shareholder, you made an investment in Zillow Group, and I know we changed some of our fundamentals in 2018 that diluted our high-margin advertising business with lower-margin, capital intensive transaction-based businesses. As your fellow shareholder, I understand this has been unsettling. It was for us as well, initially.

In addition, he pulled a sentence from Jeff Bezos’ first letter to Amazon shareholders.

From the letter:

We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages.

The truth is. I love it! I love the fact that they are going big. We’re always looking for companies with big ambitions and a realistic path to get there.


What’s their NEW, BIG ambition?

At their core, they believe the world has changed. That the world has become “uberized.” A world where consumers expect magic to happen at the push of a button (this is true👍)

They led the real estate 1.0 boom (👋Zestimate) that empowered consumers to find their dream home just by browsing an app.

They want to lead the real estate 2.0 era by taking the historical friction out of the home buying process. To help usher in this new era, they started two significant initiatives in 2018.

(1) Zillow Offers

How it works:

  • Homeowners complete a questionnaire on the Zillow site and receive an initial offer within 48 hours and a final one after an inspection.
  • Zillow charges a service fee of 7% of the purchase price on average but ranges depending on what repairs it needs to make and other factors.
  • If the seller accepts, Zillow closes the transaction within 90 days at a date of the seller’s choosing, then tries to resell the house soon after.

(2) Zillow Home Loans

Zillow acquired Mortgage Lenders of America in 2018 and rebranded it as Zillow Home Loans.

It plans to integrate Zillow Home Loans into Zillow Offers so you can sell your home to Zillow and finance your next one in one fell swoop.

Important: Its long-term goal is to create an end-to-end digital real estate transaction experience. It's integrating parts of the value chain that used to be modular (separate).

To complete a real estate transaction today, you needed an agent, bank or mortgage company, insurance, and closing attorney.

Usually, these services come from different companies. Zillow wants to integrate the whole thing into one simple, digital experience, saving us time and making it easier and cheaper to buy a house.

A few numbers to frame their ambition

  • ~180 million people visit their apps and website each month.
  • In 2018, 32 million Americans indicated they wanted to buy a home in the next twelve months.
  • Yet, only 6 million homes were purchased, and another 10 million entered into lease agreements.
  • That gap of 16 million people is what they’re going after. They believe they can take the friction and frustration out of the home buying process for millions of Americans.

At the end of his letter, he laid out their three to five-year targets (goals).

  • Purchase 5,000 homes per month through Zillow Offers. Generating revenue of approximately $20 billion. In 2018, they purchased 686 homes through Zillow Offers, generating $52 million in revenue.
  • Originate 3,000 loans per month, up from 4,000 originations in all of 2018.

Since they have released Q1 2019 earnings, we can check-in and see how their initiatives are progressing. We’ll start with Zillow Offers and finish with Mortgage origination.

Zillow Offers

  • Segment revenue: $128.5 million. This exceeded their high-end guidance by $13 million.
  • Segment loss before income tax: ($45.2) million.
  • Segment adjusted EBITDA: ($34.5) million. The losses were in line with their expectations.
  • During Q1, they received more than 35,000 seller requests in the eight markets where they were active. This amounts to more than $200 million in transactional value per day.
  • By Q1 of 2020, they expect to be in twenty markets (see below).

Unit economics

I’m impressed by how diligent Zillow is in breaking out its unit economics to give investors a sense of how profitable or unprofitable this venture will be. Most companies are not this forthcoming.

As we go through these numbers, remember, they expect to lose money in the short term. As they do more of these, gain scale, and add adjacent revenue streams (more on that below), they expect this to be a profitable business in the LONG-RUN.

As expected, they lost money in aggregate and on a per-home basis.

The following chart is what they expect to achieve in the long run.

They note two ways they can achieve profitability. One is through margin expansion. This is directly related to buying, renovating, and selling houses. The other is what they call “adjacent opportunities.”

How they can achieve margin expansion:

  • Gaining efficiencies in buying, selling, and holding costs. Caleb here: Right now, they rely on third-party data when it comes to listing prices, closing prices, etc. They are at the mercy of what each MLS (multiple listing service) will give them. Over time, they will develop their own first-party data they can use to run through their machine. This will help them get better at making offers, estimating renovations, time on the market.

Adjacent revenue opportunities:

  • Title & escrow services
  • Moving services
  • Home warranty
  • Home renovation services
  • Mortgages
  • Lead generation

In other words, they want to own the whole stack—everything from buying and selling to financing and issuing insurance.

Mortgage origination

  • Segment revenue: $27.4 million
  • Segment loss before income taxes: ($9.6) million
  • Segment adjusted EBITA: ($2.6) million
  • Grew 44% YoY and exceeded the high-end range of their estimates.

Loan unit economics

Customer acquisition costs (CAC) make up around 14% of the total cost of a loan; per industry benchmarks (see above).

Over time, Zillow believes they can achieve higher levels of profitability per loan by gaining efficiencies through their technology. And, in turn, lower customer acquisition costs.

How big is their opportunity?

In 2018, the U.S. Census Bureau estimates 212.8 million people were living in owner-occupied housing.

In 2018, approximately 5.4 million existing and over 600,000 thousand new homes were sold in the U.S. For an aggregate transaction value of $1.8 trillion.

Estimated real estate commission revenue was ~$87 billion in 2018.

Real estate agents spent ~$8.3 billion advertising in 2019 to acquire new clients and sell homes.

Zillow estimates that if Zillow Offers were in the top 200 metro areas (currently in 9), nearly half of existing homes sold in 2018, or 2.7 million, would have been eligible for Zillow Offers.

Some quick math

Ok, let’s take their three to five-year targets and estimate how much they could make, based on the unit economics they hope to achieve.

Quick refresher: They aim for a “return on homes sold before interest expense” of 4-5%. And an “adjusted EBITDA before adjacent opportunities” of 2-3%.

And: In three to five years, they hope to buy 5,000 homes per month or 60,000 per year.

Stat: In 2018, the median price for single-family homes and condos was $255,000.

The results:

Return on homes sold before interest expense (4-5% target)

  • $255,000 x 4% = $10,200 per house x 60,000 houses = $612 million.

Adjusted EBITDA before adjacent opportunities (2-3% target)

  • $255,000 x 2% = $5,100 per house x 60,000 houses = $306 million.

Note: Currently, they finance Zillow Offers through a revolving credit line with Credit Swiss. Their maximum borrowing capacity is $500 million (p. 46 in 2018 annual report).

Also: They exceeded most of their Q1 estimates. I would not be surprised if they hit their targets sooner than expected.

So, let’s talk about what could go wrong…

In simple terms, everything I wrote about above might not work.

On a granular level, we do not have enough evidence they will be good at:

  • Buying and reselling homes during up and down cycles.
  • Underwriting good mortgages.
  • Managing the hundreds of thousands of contractors they will need to conduct the necessary repairs.

In addition, will the business that pays the bills now — advertising & marketing — suffer as resources and manpower are diverted to their new initiatives?

Again, I think it’s important to reiterate this is a complete 180 from their current business. Even their CEO thinks of this as a startup.

From their 2018 investor letter:

The seeds of our new businesses we planted in 2018 are taking root. There is an energy and excitement in the halls of Zillow Group that comes from operating like a start-up again, but with the stability of size, scale and wisdom that comes with experience. I have never been more excited about our opportunities ahead and am personally energized to lead as CEO through this transformational period.

A real-life example

From the WSJ:

Matt and Diane Murphy listed their home in the Denver suburbs for $635,000 last August. They thought the five-bedroom, 3,735-square-foot home, with its wooden floors and a deck overlooking a long ridge at the fringe of the Rocky Mountains, would sell quickly. But after almost three months, they hadn’t had a single offer.

The lack of interest was particularly frustrating since the couple and their two children had already purchased a new home in Des Moines, Iowa, where they were relocating for Mrs. Murphy’s new job as a director at Mercy Medical Center, Mr. Murphy said. The last thing they needed was to start paying a double mortgage.

Editor: Eventually, they sold their home to Zillow for $605,000. Then, a few months later, Zillow relisted the house and sold it for $610,000.

It wasn’t the price they wanted, but Zillow helped them solve their problem of not paying two mortgages by providing liquidity.

🔮Magic & peering into the future

As mentioned earlier, Zillow believes that consumers expect magic to happen at the push of a button. Let’s go ten years into the future and see what that might look like…

…One rainy day, Mr. Prescott is sitting at his computer, and he gets a notification from Zillow.

😲Surprise! The house he looked at seven times on their app has just become part of Zillow’s inventory.

Since he bought his current house from Zillow (Zillow Offers), they know exactly how much he paid. In addition, they financed his existing home (Zillow Mortgage), so they know exactly how much he can afford.

Note: He wasn’t thinking about moving; he likes looking at houses, as do millions of Americans.

Their email says something like this:

Mr. Prescott,

We noticed you have looked at this house on 523 Elm St. seven times over the past month. Great news! This house just became part of our inventory😁

We are prepared to offer you $275,000 for your current house.

We will sell you 523 Elm St. for $315,000.

Since you have $100,000 of equity in your current house (they know this because they financed it), we are prepared to offer you a 15-year mortgage for $215,000 at a 3.5% interest rate.

Your TOTAL out-of-pocket expenses for this transaction will be $4,300 (people like certainty; moving will 100 dollar you to death).

In addition, here are three dates we can move you out of your current house and into your new home.

Attached are some repairs we think this house will need and what they will cost. If you choose to go forward with any of them, we will proceed with the repairs, and the costs will be rolled into your mortgage at no additional out-of-pocket cash for you.

This offer will expire in 72 hours.

Again, your total OUT-OF-POCKET cash, should you accept this offer, will be $4,300. And not a penny more.

If you would like to proceed, click “Accept this Offer,” and one of our agents will be in touch with you shortly…


Future Zillow😉

Caleb here: Maybe this scenario is a stretch. But there’s also a chance it’s not.

And if it’s not, who wins, who loses? Who captures the value in a future like this?

Just something to chew on…

The bottom line

While I am excited and bullish about their long-term potential, I also understand why other investors are put off.

It’s a risky move to go from an advertiser to what, in essence, will be a competitor to their current crop of paying customers — real estate agents!

Those 5,000 homes they plan to buy every month are homes that would have been listed with an agent.

We’ll keep tabs as the quarters go by to see how they are progressing. But in the end, they are the first stop for 180 million Americans looking to buy homes; so whatever happens with their new venture, that is worth a lot.

Again, let me stress. I don't think the agent model will completely go away. Some people, like my wife, want to be able to talk to a human when they have a problem. And she probably represents the majority.

But like any industry going through change, agents will have to learn and adapt to stay competitive and thrive.

Thanks for reading, and have a great day!

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