What analysts don’t understand about Zillow Instant Offers
Zillow announced yesterday that Spencer Rascoff will be stepping down and replaced by co-founder and former CEO Rich Barton. As a Realtor, Premier Agent and an investor, I’d like to offer up a few rebuttals to all the hysterical analysts and skeptics levying criticism. The gist of the rebuke condemns Zillow for acquiring Mortgage Lenders of America and entering the instant offers space as it is perceived to be a distraction from their core business, too much work relative to the payoff and creates a conflict of interest with their Realtor customers. I feel this perspective is uninformed, reflexive and myopic, but it mostly underestimates the extraordinary perspicacity of Rascoff and others.
Analysts have been slashing price targets and Zillow’s stock has been plunging ever since they made the announcement to enter into the iBuyer space in April 2018, and acquire Mortgage Lenders of America in November.
With all due respect to analysts, they don’t always understand the businesses they cover.
In an interview, Chris Camillo, the author of Laughing at Wall Street, recounts a conversation he had with a Kate Spade analyst. It was 2016, Anna Kendrick’s (Pitch Perfect) popularity was skyrocketing. He says to the analyst,
“Hey, we’re just taking casually — have you been tracking this Anna Kendrick video?”
The analyst says, “Who’s Anna Kendrick?”
Chris: “You cover Kate Spade as an analyst — she’s the spokesperson for the brand. She has the biggest viral video of the year, you don’t even know who she is?!”
I don’t think analysts or even hedge fund managers fully understand the instant offers business; the difference between flipping and wholesaling, trade-ins and what Zillow makes on mortgage origination fees, how much more Premier Agents are willing to pay for guaranteed referral leads, and how any of this ties together.
There’s also much, much more going on in the residential real estate industry than what meets the eye.
Instant Offers disruption is just the tip of the iceberg. The astrophysicists of venture capital believe there is a giant asteroid headed toward traditional 5–6% real estate commissions in the shape of fair and equity-conscious alternative brokerages. 5–6% commissions and traditional brokerages and Realtors are inextricably linked, the extinction of these fees would devastate the real estate agent population. Over a hundred million dollars has been invested in these next-generation brokerages, also referred to as alt-brokers, to lower the cost of selling commissions. Rexhomes.com, for example, recently raised $45 million in their series C round of financing. They charge 2%, all-in, and pay no buyer’s agent commissions whatsoever. They bypass the Realtor MLS (Multiple Listings Service) altogether. They are growing and scaling at an incredible pace and have nothing in common with the “discount brokerages” of yesterday. These firms pose a serious threat to traditional fees and Zillow’s Premier Agent revenues by extension. I don’t hear analysts grappling with any of this, so it leads me to believe they are unaware of what’s underway and its implications. Zillow’s decision to enter the iBuyer space and acquire a lender is an ulterior motive, one in which they must keep concealed because of the precarious position they are in: If the smartest people believe commission constraints are on the horizon, Rascoff cant just come out and say “If national average commissions come down just 1.5% our economists predict a 3rd of all agents will vanish. We aren't going to rely on a dying 5–6% industry, we’re getting ahead of that now. ” The statement might be effective in relieving the concerns of analysts that all this is just some harebrained scheme, but it would also seriously jeopardize relationships with their Realtor base.
Instant Offers and alt-brokerages are two new categories carved out of the residential resales pie. They will reduce the market share for traditional 5–6% brokerages while simultaneously applying pressure on Realtors to reduce their fees to compete. If we project the results these nascent firms have had in just a handful of markets onto the rest of the country, there will be fewer Realtors selling less homes and making less commission on the homes they do sell. If the mainstream market gravitates toward the faster and more fair options, as we seem to do, by 2030 traditional real estate brokerages could be circling the drain.
Market snapshot of iBuyers and alt-brokers
The value proposition of next generation brokerages and their business models are one in the same. Their value is in their dramatically reduced fees, and their reduced fee is enabled by a much more efficient and economic business model…
Brick and mortar overhead will be the death of traditional 5/6% brokerages.
Unlike traditional brokerages, an alt-brokers ability to reach additional customers doesn’t entail additional expenses. They don’t need more locations and more Realtors to acquire more customers, i.e., outbound, sales force-driven model.
Homie.com, a full-service real estate brokerage in Utah, can help everyone in the state of Utah sell their home with just one location managed by a handful of employees. They charge $199 up front and $1299 at closing. That isn’t to say they aren’t full-service, they have agents in close proximity to all the markets they operate. Similarly, Uber doesn’t need a physical location in Pittsburgh to be able to service that location. There is nothing involved in a real estate transaction that necessitates a brick and mortar location. The days of walking into a brokerage to flip through a binder of listings are over. The operating costs of a physical location are in gross excess of the utility or value of the location. The reason they’re around, the dirty little secret, is this: Traditional 5–6% brokerages don’t give a shit about homes or homeowners. They are in business to do one thing and one thing only: Recruit as many real estate sales persons as possible. These locations exist solely as a means to house the agents they recruit that generate their revenues. The brokerage with a giant office is able to persuade more agents to come work for their firm than the brokerage with dinky, little offices. But these offices do absolutely nothing to get a home sold any faster or for more money. They certainly don’t help homeowners retain any more of their hard-won equity. They are an enormous expense that gets passed onto the consumer.
Meanwhile, REX, Door, Reali, and Trelora can setup one location and service the entire state. They salary their agents, so their expenses never exceed their need for the expense — it’s all predictable. Expenses are in proportion to profits gained. Traditional brokerages have unpredictable months, some great and some terrible. Alt-brokers made a couple of tweaks to the business model, they operate virtually and salary agents, and are able to give homeowners the same full-service for a fraction of the cost. Traditional 5–6% brokerages are going to get crushed for the same reason Blockbuster couldn’t compete with Netflix. Blockbuster and Suncoast Video allocated hundreds of millions of dollars for the expenses surrounding thousands of brick and mortar locations and the millions of square feet required to shelve millions of DVDs, while only a small percentage of DVDs generate the majority of revenues. Traditional real estate brokerages have to shelve as many agents as possible to drive sales volume, and they too spend hundreds of millions of dollars across thousands of brick and mortar offices to accommodate everybody when only a small percentage of the agents in the office are generating any meaningful revenues. It’s amazingly inefficient and it’s why homeowners continue paying excruciatingly exorbitant fees to sell their home. Alt-brokerages are an antidote to this inefficiency and financial waste.
Analysts and investors are missing the point.
Zillow’s decision to move (no pun intended) into mortgage lending and buying and selling homes wasn’t just about bolting on another revenue generating vertical, they also have to prepare for the strong possibility that the real estate agent population will be thinned out as the market adopts better, alternative ways to buy and sell homes.
My prediction:
2019
2025
Commission compression devastates Premier Agent revenues.
National Average Realtor Commissions:
1992 = 6.04%
2005 = 5.02%
2011 = 5.3%
2013 = 5.38%
2014 = 5.18%
2015 = 5.26%
2017 = 5.12%
In 2017, Real Trends Consulting, a research and advisory company that monitors hundreds of realty brokerage firms and compiles data on sales and commission rates of 450,000 sales agents across the country, concluded that the average commission rate would continue to decline and dip below 5% within the next few years.
Economists from Cornell and MIT looked at 10 years worth of transaction data in, “The Costs of Free Entry: An Empirical Study of Real Estate Agents in Greater Boston”. They calculated that cutting the commission by one-half would eliminate a third of new agents from entering the business, and in their time period, yield $2 billion in savings for Boston homeowners and $900 million in cost savings from having fewer real estate agents bumping around. A similar national decrease in commission temperatures would wreak havoc on the Realtor ecosystem. To take the stance that Zillow shouldn’t migrate into Instant Offers is to speculate that the majority of homeowners will not opt to use alternatives like Rex or Offerpad when they become available in their market, or that a decrease in commissions is not a condition for a decrease Zillow revenues. Criticisms of Zillow Offers should be addressing all of this.
Premier Agent redefined.
At the moment, iBuyers like Zillow, Perch, Offerpad and Opendoor resell the homes on the open market and pay buyer’s agents a 3% commission for bringing a buyer. When Zillow purchases and resells the property, they enlist a Premier Agent. The guaranteed nature of these leads enables Zillow to achieve the same revenues with far fewer agents. They can charge ten times more for “guaranteed leads” and “high probability leads” that convert 80-100% of the time, conveying far less risk to agents compared to the the 3–7% conversion rate that comes with their flagship product. In 2016 they delivered 17 million leads to Premier Agents, when just 5.51 million homes sold that year. The vast majority of these leads lead to nowhere. There is less friction in committing to a 6 month contract when Realtors can be confident in the likelihood a lead will close. It’s common for agents to pay anywhere between 25% and 50% of their entire commission for a referral. Should the market shift, and we see sellers opting to sell to an iBuyer or use an alt-broker, Zillow will be doing agents a favor by keeping them relevant and in the mix.
The instant offer business is not without it’s future challenges. It’s viable right now because sellers are already used to paying egregious 5-6% fees to sell their home and are willing to take less for their home in exchange for convenience. However, when alt-brokerages drive down conventional selling fees, the gap between the cost and convenience will increase, and we’ll likely see more sellers opting to get fair market value on the open market through a 2% all-in firm like REX, or a flat fee broker like Reali, Trelora, Door and Houwzer.
Zillow’s three revenue streams.
1. Wholesaling
Flipping is associated with properties with condition issues. Wholesaling is the term for acquiring a property in any condition below fair market value and reselling it at fair market value to profit the difference. Zillow reported that at scale, their net profits could be $3,500 per transaction. Their net profit is calculated as the difference between what they pay to buy the house and what they sell the house for less their update costs, commissions, holding and other selling costs. The bulk of these expenses are all built-in to their offers. For example, if they’ve concluded for a particular property that there will be total of 9% in fees, including title, commissions, holding costs, transfer tax, insurance, etc., they could offer 9% below fair market value with another +1% room for error in calculating the absorption rate or market’s temperature, 10% total. The $3,500 net profit they are referring to is anything that comes after that 10%. Say, an additional 1%, so the fees now total 11%. Take a house valued at $350,000. 10% would be $35,000, so they would offer $315,000, resell the home and it would be a wash. There are two revenue streams here though. The first is the $3,500 net profit from flipping. So they wont charge 10%, they will charge 11%, or more, and that additional 1% yields them the $3,500, on average. The final Zillow Offer becomes $311,500. They plan to resell the house, on average, for $315,000 after all the costs and pocket the $3,500.
2. Guaranteed leads and high probability Premier Agent leads
The second revenue stream is Premier Agent revenues. If the seller agrees to the Zillow Offer, the buy-side commission is 3%, or $10,500 of a $350,000 house. Using their auction system, guaranteed leads like these will easily command between $2,300-$4,700 (25%-50%, similar to a referral fee that agents are happy to pay all the time).
3. Mortgage origination fees of 1–2%
The “trade-in” concept is severely overlooked as a revenue generator. If the seller purchases their next property through Zillow, there are two more revenue streams.
iBuyer competition
Having an in-house lender gives Zillow advantages over the competition that I think could only be rivaled by Amazon, should they move forward with the acquisition of Quicken Loans. Keller Williams and Redfin announced they are entering this space as well. It’s just a matter of time until instant offers become available in every market, and when it does, the leader in this space will be the one who can offer closest to fair market value. The first fees to go will be the Realtor fees built-in to the offers. The money Realtors are willing to pay for seller and buyer leads is what is powering Zillow’s business. Their relationship with Premier Agents would have to be costing them more than what they are earning from them before Zillow will phase Realtors out entirely. As national average commissions reach sub-4 and sub-3% ranges, all iBuyers will have to reduce their fees to stay competitive.
Dealing with common objections
Critique number 1: Zillow’s new plan to purchase homes provides little impact to the company’s bottom line.
It seems to me this concern stems from the $3,500 net profit figure Rascoff quoted on an earnings call. It’s true that flipping is a lot of work for just $3,500. No investor would even dream of flipping a home for just $3,500 in profits, but wholesaling is not flipping, and that’s 1 of 3 revenue streams. The vast majority of homes will not need any significant repairs or work done to them. This kind of wholesaling can be streamlined and scaled. I do suspect it will take longer than Zillow quoted us to hits their target of purchasing 5% of all resales, or 275,000 homes a year. But any movement in that direction will add substantial revenue to the bottom line and mitigate losses from the inevitable decline of commissions and agents.
1. Zillow Offers: 275,000 x $3,500 = $1Billion
2. Premier Agent “guaranteed Zillow buy lead”: 275,000 @ $2,300 = $632MM
3. Premier Agent “guaranteed seller buy lead”: 275,000 @ $2,000 = $550MM
4. Premier Agent “high probability to sell lead”: 275,000 @ $1,000 = $275MM
5. Mortgage origination fee of 1% (We’ll assume 10% of sellers buy their next home through Zillow / Mortgage Lenders of America): 27,500 x Avg Sales Price $275k = $75MM
Critique number 2: Zillow’s estimates for scale and profitability are not realistic.
Zillow’s goal of acquiring 5% of the inventory is indeed a lofty one, but any progress in that direction will yield more revenues than if they just stuck to basic Premier Agent program that has been experience declining growth and is at odds with the earth shattering change headed for Realtors. Zillow can’t afford to do nothing. This point of view also underestimates the percentage of the market who will opt to go the instant offer route when it becomes available in their market. Offerpad, Perch and Opendoor are also relentlessly evangelizing instant offers. This raises the tides for all the iBuyer boats.
Critique #3: This requires too much capital.
Zillow acquired Mortgage Lenders of America, a non-bank lender that borrows against a line of credit. 275,000 mortgage originations in a year poses no problem whatsoever and that would be a good thing. These loans are 75% LTV and they get the debt off the books as they sell the homes. Quicken Loans originates nearly half a million loans each year, around $20 billion in volume each quarter. MLoA will have no problem obtaining the capital for this venture as they grow and scale in proportion to profits gained and reinvested.
Critique #4 The project is a distraction from Zillow’s core business.
The Premier Agent revenues account for 70% of Zillow’s stock or two of the three pillars supporting the entire company. One would never accuse a pharmaceutical company of being distracted from a flagship product if that product is approaching the patent cliff. Zillow needs new products to replace the income that will be lost due to 5 and 6% commissions constraints. We can be empirically certain of this. Premier Agent growth is declining, iBuyers and alt-brokers are gaining in popularity. Entering the iBuyer space is at most is an great opportunity to dramatically grow the company, at a minimum it will keep Zillow relevant and mitigate loses.
Critique #5 Zillow is competing with its core customers by purchasing the homes directly from the seller.
In the most cynical sense, Zillow is kidnapping inventory and holding it hostage in exchange for a fee to be the buying or selling agent. Statistically though, if Zillow achieves their goal of purchasing 5% of all homes sold each year, then it stands to reason there’s just a 5% chance they will purchase something out from underneath an agent. However, quite a few sellers will be looking for an instant offer prior to Zillow convincing them to do it. The chances are greater that Premier Agents had listings in their futures, but home owners abandoned them for Opendoor, Offerpad, Perch or Knock. It would seem to me then that Zillow is actually doing Realtors a favor by getting involved in this so agents still have a shot at some profits that they would have otherwise lost.
The same forward thinking people who predicted consumers would prefer to search homes online are predicting that homeowners will be leaving traditional Realtors in droves. Analysts aren’t thinking this through or looking out far enough. Bringing Barton on board was clearly just an act to show investors they are changing things up, but nothing has changed. Zillow will steer the course, as they should.
