This is an update to the original February 24th 2019 post.

Zillow and Rich Barton’s Big Hairy Audacious Goal to bring his “power to the people” economics to home buying

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“I have a particular penchant for and attraction to big swings. And we are really in the process of remaking Zillow Group right now and formulating a new mission, one where we're looking at the sky, looking at the moon and saying, ‘We want to land there. We want to walk on that thing.’ It takes a really big, hairy, audacious goal, BHAG, to get an organization to transform itself.” - Rich Barton on Zillow’s Q4 2018 earnings call this last week.

Zillow is undertaking what will likely be one of the largest business model pivots I will see a public company make in my career - there is a reasonable probability that it results in only one of two possible binary outcomes: bankruptcy or a 10x increase in value! I am certainly rooting for the 10x increase, but there is a scenario where this shift to a capital-heavy, cyclical business model from a marketplace or media model crashes into an economic slowdown or housing crisis and bankrupts Zillow and other competitors. The question at stake is this: can a high-friction, real world transaction take place in a digital marketplace model? Or, as Rich put it, can Zillow “Uberize” the home selling experience? The answer from my perspective is: I don’t know yet, but it’s worth figuring out which questions to ask in order to understand why this would succeed or fail. There has been a lot of activity attempting to innovate in the real estate business over the last couple of years as startups like Opendoor and established players like Zillow and Redfin attempt to create liquid transactions for selling your house - immediate offers for a predetermined value - known as the iBuyer business. Zillow is currently an advertising and media company effectively selling leads for real estate agents to find buyers and sellers while providing information like the Zestimate home value estimate for consumers. With the co-founder of Zillow, Rich Barton, returning to the CEO role following the tremendously successful stewardship of Spencer Rascoff, the company is boldly moving toward the transaction itself, while still trying to keep agents in the revenue model by using them for selling houses they acquire.

How much would you pay to sell your house? The answer might not be what you think:

When I’ve looked at this concept in the past, I was struck by the counter-intuitive conclusion that the 5-6% commission to sell a house might be high in some cases, but might also be low in other cases, i.e., people might be willing to pay more than 5-6% to get liquidity in their house for a variety of reasons. So, it’s possible that the blended commission is still 5-6% supporting an approximate $90B annual revenue opportunity in the US. Increased liquidity could also drive increased turnover as people are able to get closer to their workplace, trade up with less risk, etc. Consumers should be willing to pay for the benefit of liquidity - the overall addressable market then could be well into the hundreds of billions of dollars annually. Initial consumer demand looks very strong: Zillow reported on their May 2019 earnings call: “In Q1, we received more than 35,000 seller requests, and that demand is rapidly accelerating. We now receive one request every 2 minutes, which is nearly $200 million in potential transaction value per day.”

What are the current strategic problems I see with Zillow’s business model, and why are they buying and selling houses direct instead of building an iBuyer marketplace?

I’ve criticized Zillow in the past for creating a power law in the real estate agent business - they effectively created super agents or power agents that were Zillow-savvy who created teams of subordinate agents - recreating the brokerage model for mid and high priced homes. Rich is famous for his “power to the people” democratization business models like Expedia, but this power-law Zillow created for agents didn’t seem to quite fit in with the leveling of the playing field Rich often promoted - instead it just flipped the power dynamics for agents. A 2nd criticism I’ve had of Zillow’s core agent ads business is the cost of marketing spend required to maintain the consumer side of their marketplace. One of the problems with low frequency transactions like cars or homes, which take place on average every 5-10 years, is that you need to constantly keep your brand relevant to consumers, which means a heavy advertising and marketing spend just to remind people you exist. This low frequency and high advertising combination makes a media business like Zillow lower margin and less attractive long term. Lastly, a criticism I raised with the company last year as they began this pivot into iBuying was “why aren’t you creating a marketplace for regional and national investors that want to buy/sell homes instead of doing this as a vertically integrated buyer yourself?” Home buying and selling can be a very location-specific business with a high degree of local knowledge needed. I didn’t feel comfortable with the idea of taking balance sheet and housing cycle risk instead of leveraging Zillow’s strong consumer brand into a transaction marketplace. On the conference call last week, Zillow indicated they still believe iBuying should be done by them directly instead of as a multi-sided marketplace model - I remain unconvinced on this point, but remain open minded about it.

Who will own the network effect for the home buying and selling transaction and why?

Another question I have is: what would cause home buying to be winner-takes-all (or winner-takes-most), like many other traditional industries that have been digitized and impacted by increased transparency in the Information Age? Is there too much friction and market-by-market heterogeneity in the housing sector to create a power law network effect that hits escape velocity for buying homes? For example, why are there seemingly dozens of marketplaces for buying and selling cars instead of one winner? Cars are a high friction transaction, but lower friction than moving from house to house - why hasn’t a marketplace model hit escape velocity for the automobile asset class - is it a bad comparison, or are there lessons to be learned from that market? Rich has referenced Netflix’s (Rich is a board member at Netflix as well) shift to streaming as an analogy for Zillow’s shift to iBuying. One of the reasons Netflix has over 100 million subscribers today (and I think they will have 500M-1B or globally) is the data network effect they garnered when they hit around 20M streaming subscribers, which created a virtuous circle flywheel of viewing habits that allowed them to invest intelligently in content to grow more subs, to get more data, to invest in more content, to grow more subs, etc. Zillow has great data on home transactions already - all of which is public information, but it’s possible owning the transaction gives them more granular data, and sooner, than they could otherwise obtain it.

ROOTMO - leveraging a Resilient business to build new Optionality

A pattern we look for in investments is companies that can take a Resilient core business and layer on significant out-of-the-money Optionality to it (we call this ROOTMO: Resilience with Out-of-the-Money Optionality). Zillow has Resilience today with their core agent ads business, but will they risk any of that Resilience in this model shift? In other words, is this Optionality to transform the entire home selling experience going to risk the FCF that is funding it? Zillow has attempted to build Optionality in the past, with rentals, mortgages, and home decorating, with limited success. However, mortgages are of course another way to interject themselves into the transaction and that’s an important part of this strategy shift for the company. What Rich Barton is attempting with Zillow is what we want to see when disruptors face their own disruption - this is exactly the kind of thinking and risk taking I like to see technology companies undertake even when they are public and under investor scrutiny! If the shift to iBuying represents a long term threat to Zillow’s core, Resilient advertising, and media business, then, not only is the decision to pivot fully into the transactional business model the right move, it’s a gamble that needs to be undertaken quickly and at all costs.

The questions I am asking:

I think the world of Rich and everyone at Zillow and I want them to be successful with this transition - I am rooting enthusiastically for Rich and Zillow to be correct with this huge business pivot. Although I have not discussed Redfin much in this post (see an update at the end for more on Redfin), I also like the more conservative democratization approach that Glenn is taking at the technology-driven brokerage Redfin. I am rooting hard for Glenn and Redfin as well. You could see a situation where there are multiple marketplaces for home transactions - one winner for homes that are around the median price or cheaper and another for higher-end homes (where Zillow’s advertising business has traditionally been of higher value while Redfin has traditionally been strong around the median home price market). If we zoom out and try to generalize the problem and the solution, we have a $90B annual tariff on transacting a house today in the US. Is that tariff too high? Whenever we see the pattern of information transparency causing a tariff to be reduced we pay close attention - often that creates a tidal wave shift of positive feedback loops. Should that tariff become a gradient of 1% to 10% instead of an average 5-6%? Will a reduction in friction and increase in liquidity drive velocity and better outcomes for all? Should the risk of home buying and selling shift from the home owner to a financial intermediary model such as Zillow, Opendoor, or other iBuyer? Would a major acquisition like Zillow buying Opendoor accelerate and bolster a network effect assuring success? If all of this is the right strategy shift for the industry, will there be a winner-takes-all (or most) network effect created? If so, what are the underpinnings of that network effect - data, liquidity, brand, trust, access to capital, etc.? Why would Zillow be the winner of the “winner-takes-most” iBuying transformation of buying and selling houses? I see two possible answers, both speculative: first, brand and aggregation of users (Zillow is the top real estate portal by far), and, second, culture and execution (Zillow has a great culture of innovation, execution, and listening to customers). These are its advantages over challengers, like Opendoor, in my opinion. It’s possible, however, that some other advantage, like access to capital or ability to sustain long-term loses, will be the winning determination – it’s up in the air. I am very excited to watch this play out over the next decade and I have nothing but wishes of luck and success to the democratizers of the home transaction!

I started with a quote from Rich here and I’ll finish with his closing remarks from their conference call which sums it all up nicely:

“As we've discussed, we are in the middle of a critical transformation that is reshaping our company and redefining the rules of real estate as we know them. By moving into transactions, Zillow Group will cover the entire consumer home shopping funnel top to bottom, giving today's on-demand consumers a full spectrum of options to shop, engage, transact on their terms. By transitioning our relationship with agents from advertisers to real partners, we better align our mutual goals and incentives and cooperate to delight our shared customers. This all makes us well positioned to unstick those shoppers ready to follow their dreams and getting to a place they love and can afford.

Finally, just to restate, I know Zillow Group's aggressive expansion has not just evolved our business model, it's affected your Excel models. We've added a high-revenue, low-margin business that requires large investment and distributed operations to our proven, high-margin media business that you know and love. And that can be unsettling, especially when our execution on the core business has been bumpy. It was unsettling for us, too, initially, but we came to believe the prize was quite large, and further, it was a strategic necessity. This is where consumers are heading, and they'll ultimately get what they want with or without us. We decided to lead them there. Can you imagine if Netflix had just ignored streaming?”

You can probably tell I'm excited. I hope you are, too. Thank you in advance for keeping an open mind and for giving us a chance to show you what we see. We value your counsel, and I look forward to our upcoming conversations.”

Update with some scenario analysis - reference point is 2/27/19 with Z Stock at $41 with a market cap of around $8.3B

In case it’s useful here is how I would provide a framework for the stock going forward - please note this is absolutely NOT investment advice and this is very much “back of the envelope” analysis with so many assumptions it proves its own uselessness - it’s just one way of looking at the various angles on the stock. While I applaud Zillow’s aggressive effort to disrupt its own business, it comes with a widening range of outcomes and significantly increased risk. If the effort fails I think Zillow’s core advertising and media business could be worth about 60% of the current market cap, or 40% downside. That assumes most of the revenue holds, but they likely lose some of the base, and incrementally it’s not as high of a growth business in the future as some transactions shift to the iBuyer model (at competitors of Zillow like Opendoor) or brokerages that don’t advertise on Zillow (such as Redfin). That would leave you with a business similar to 2018 which posted $1.3B in revenues and likely around $200-250M in FCF. I assume they need to continue the high level of advertising and marketing expense but could moderate other ancillary investments if growth slows down to a moderate pace. This assumes that Zillow can exit the iBuyer market if they don’t reach their goals without significant balance sheet harm - that’s a BIG “IF” still. This would leave a moderately growing, strong vertical search media business in the US real estate market which I would put a moderately high FCF multiple of 20x on. That gives around $4.5-5B in market cap compared to the $8.3B today (as I write this on 2-27-19 ZG is trading around $41). Zillow has net cash of $700M, but I believe there is balance sheet risk to the iBuyer model, and I am going to put that aside for this analysis. So, that gives around 40% downside with some fat tail risk of an existential balance sheet crisis if they cannot effectively offload capital risk and they concurrently see a negative impact to their pre-existing core business. I think this is a fairly conservative analysis of the downside scenario and it’s quite possible things end up much better than this even if they fail at the iBuyer market.

With that sort of downside profile, as a long term investor I would want to see the potential to compound at 15-20% or more over the next 5-10 years. Or effectively I would ask the question, what would need to happen to give Zillow a 2-3x market cap from here? A shorthand way to think about this would be to go out 5 years and use a multiple of 18x on FCF for a $18B market cap (roughly 2.5x over 5 years which is 15-20% compound annual returns) which implies they need $1B in FCF (4-5x the current level) or roughly $800M new FCF from the iBuyer business transition with minimal cannibalism to their core ads business today. At $5,000 in profit per home $800M in FCF would imply around 160,000 home transactions for Zillow or a 2-3 percent market share of the total. However if we look slice and dice the market into the addressable price ranges for the iBuyer model that would represent a somewhat higher percentage share. For some grounding of the numbers, discount technology brokerage Redfin was founded 15 years ago and in their 2018 10K indicated the have .8% share of the value of US home sales transactions. So, Zillow would need to achieve around 3-4x that success rate in 1/3 of the time. You can play with these assumptions plenty, so they are just illustrative - for example they might make more per home when you layer ancillary services like mortgages requiring lower market share, etc. There may also be a transformative merger that accelerates the transformation and assures a higher degree of success. Zillow has indicated publicly that they think this is a $20B revenue opportunity at 1% share and could be around $600M in EBITDA (let’s assume that’s FCF, which it’s clearly not, just for the sake of simplicity) in 3-5 years. My assumptions are different, but in the ballpark of what the company is framing for investors.

There are TONS of assumptions here, and I want to come back to one of my opening statements that I think this outcome here is likely to be more binary. It’s more likely that either 1) Zillow far exceeds the assumptions in the paragraph above and Zillow or someone else like Opendoor creates escape velocity in the iBuyer market, OR there is a shock to their business and they end up with a small but decent media company in the best case outcome...or are forced to sell a distressed business in a worse case outcome. If Zillow can actually drive $1B in FCF off the iBuyer model with all of the TAM expanding opportunities, then that implies they can probably drive $10B in FCF off it.

This is a classic example where Bayesian logic will inform an investment decision. Put a flag in the ground today on your scenarios and objectively analyze each new incremental data point to move your credence up or down with as little cognitive bias as you can humanly muster - that means you need to find a partner in your analysis who will hold you accountable for remaining objective to the facts. This is also a classic example of a complex adaptive system where the outcome is unknowable with any certainty. Therefore, as you gain more confidence that you are making fewer predictions for your world view to come true, own more, and if instead you are making more specific predictions with a wide range of outcomes, own less or sit on the sidelines. We discuss this type of analysis and portfolio construction process in our investing white paper and there is an excellent and brief overview of Bayesian logic you can find here. Lastly I want to say this one more time: Zillow’s bold move to disrupt their own business and industry is what many companies are facing across many industries around the world today. While it’s the right strategy to undertake, most of the time it will fail. It takes a strong leadership team and culture of innovation and adaptability to have a shot, and that means Zillow has a shot, but only time will tell.

Update on 7/17/19: Thoughts on Redfin and the broader trend of institutional capital in consumer assets

To the extent the shift to iBuying is not a “winner-takes-all” transition, I think Redfin is taking an approach with a narrower range of outcomes and increased chance of success in the segments of the market they shine in compared to Zillow: by providing an iBuyer offer to interested customers (but then having the option to instead sell that customer’s house with varying degrees of assistance for a range of fees) an integrated-technology brokerage model like Redfin seems to me to have the best consumer value proposition today. Redfin’s CFO described this in part at an investor conference in early May:

“So where I think it fits in really is this set of 3 choices for the consumer. For some people, 1% pricing or 1% listing fee will make the most sense. Their home looks great. They can put it on the market today. They can pay the lowest possible fee. For other people, there's some work that needs to be done on the home, but the customer is willing to take some of the pricing risk associated with that, and that's how I think about Concierge Service. And then RedfinNow is the service that provides the most convenience for the customer, but we're taking the economic risk as the company, and so as a result, the customer likely receives fewer dollars than he or she would on that transaction. And so I really do think of these 3 services as being across the spectrum of the risk the customer is taking and the risk that the company is taking.”

Subsequently in early July 2019 Redfin and iBuyer leader Opendoor announced a broad partnership whereby Redfin customers can get an offer from Opendoor to instantly sell their house in select markets where Redfin has not launched their own Redfin Now iBuyer business. The company explains that this partnership conversation began a year before Zillow’s pivot to iBuying. I think Redfin is leading the market here by offering a broad range of choices to consumers with various liquidity and timing needs. By integrating Opendoor, this is more of a marketplace type approach that I previously thought Zillow should pursue for iBuyer offers to homeowners. 

This enlightening note from Redfin CEO Glenn Kelman on the topic of consumer choice is worth reading for all real estate industry watchers. Here are a few quotes:

“But the truth is, we’ve decided that the only way for all of us to prosper is by being an agent of change, not a victim, by being an advocate for consumers, not just for ourselves. We aren’t going to wait for another company to give consumers a better deal and then scurry to figure out how we can talk people out of it. We’re going to imagine a better future for our customers, and build a company where everyone benefits from our success. This is what every broker that cares about its agents should do.”

“The winner [in our industry] will have a culture of service and financial discipline. That culture depends on a thousand friendships between agents, engineers and lenders, on love disguised as hard work, and hard work disguised as love.

What’s so strange about our society today is that we believe there’s more magic in a company’s technology than in the people using that technology, or in the way those people treat one another. Redfin believes in technology but technology on its own is just a glorified toaster oven. Our culture is our deepest source of competitive advantage. It’s why we are more sure than we’ve ever been that we can win.”

The broader economic impact of institutional home ownership

Over the last couple of decades, the number of homes that have sold to institutional buyers has nearly doubled to 11%, and in some cities the number is around 20% or even higher. The NYT and the WSJ ran dueling articles in June on the rise of institutional ownership and iBuying of homes in the US. I think the mainstream media continues to completely miss the foundation of these trends in the single-family home market. Instead of vilifying institutions for turning homes into mass scale investments, you have to look at the real causes: low interest rates have not been enough to maintain affordability for home buyers, (especially first-time buyers and homes under $500-600k), and, at the same time, low rates give big institutions access to cheap capital. As a result of technology-driven deflationary trends, rates are structurally low, and the world is awash in capital at the top of the economy. When Redfin reported their Q12019 earnings in early May, one thing that stood out to me was the repeated notion that consumers are really “stretching” to own homes right now even with lower rates (“Home prices have increased so much faster than wages that you just have a bunch of aspirational people who really want to get into a home. It's our duty to serve them as well as we can but they are stretching.”) 

The only way to get homes back into the hands of families instead of institutions would be to drive wages significantly higher. That sounds like an echo of the article from Nick Hanauer on the paradox of the US education system, which also called for higher wages. Yet, as this article argues, there is ample labor pool available, and therefore no reason to expect widespread wage inflation any time soon which also feeds lower rates. So, absent rising wages, the shift to renting instead of owning isn’t all bad (e.g., more flexibility and less maintenance for the renter, nationwide investment in home improvement by institutional owners). I suspect the trend will continue, and it will be important to see increased renter rights and benefits that match the advantages homeowners already have (as a result of social engineering policies after WWII, home owners receive significant tax advantages, although Trump has walked some of those back). One last point on affordability: Deloitte reported that millennials have a net worth that is $8,000 lower largely due to student debt. This increased leverage makes mortgages much more difficult for millennials to qualify for. Resolving student debt would have an intriguing potential multiplier effect on the economy and the housing market.

The transparency of the Internet and new data-driven software platforms can make it easier to find quality rentals and maintain good renters – Invitation homes, which owns more than 100,000 single-family home rentals in the US, is a good example. iBuyers like Zillow, Redfin, Opendoor etc. are enabling the acceleration of institutional buying by packaging up and handing off fixed-up homes to be transformed into rentals. According to the WSJ, about 10% of iBuyer homes in Phoenix are flipped to institutional owners, and the iBuyer platforms in Phoenix are now buying about 5% of homes sold. The biggest issue I see with declining home ownership is the loss of a key mechanism for saving and building equity for households, which has the potential to exacerbate inequality long-term. I see the liquidity and flexibility of the iBuyer programs as one mechanism to help the overall housing market, but obviously more could be done with respect to wages and consumer leverage.