Episode Summary

  1. Know your market. Do your due diligence. Even with the biggest aggregated data set on the planet Zillow couldn't find a way to execute a profitable flipping business eventually leading to them overpaying and taking 100s of mills in losses
  2. We've said it before, we'll say it again. Comps for residential dwellings are now being driven by how much a property can get with rental income rather than more traditional methods. Which leads to...our favorite...
  3. Affordable housing is a supply and demand issue.

Zillow has stopped flipping single family homes* (4 min read).

But what happened? Who is buying the houses now? (3 min read - paywall)

Transcript

Episode 43 - Patterns of Development

Hey everyone it's Kyle and this is patterns of development where I, we, the collective we, want to spend time thinking about and deconstructing what's going on in real estate, architecture, and urban planning. What are the things that are happening in our built environments, what are the things that are affecting our built environments?

This week, a different twist to the show, I usually talk about 3-4 different articles. This week I shared a couple of links in my newsletter and wanted to break down what's going on with the Zillow Group.

Zillow Group, also known as Zillow, is an American online real estate company founded in 2006. The founding team came from an experienced technology background with experience from Microsoft, Expedia, and Hotwire...oh how times have changed.

Zillow's original business model was to make money through ads. Simple enough. And over time the business has grown into a publicly-traded company that offers a variety of real estate services including home loans, agents, brokerage, and managing rental properties.

In 2018, Zillow launched a digital home buying service, sometimes called "ibuyer", with the creation of Zillow Offers. The plan was to purchase homes and flip them leveraging the enormous real estate data library Zillow had built over the previous 12 years.

Zillow Offers allowed homeowners to sell to Zillow instantly for cash. A process with significantly less friction than the traditional process of agent, bid, close.

Zillow would then update, fix, and flip the home using their platform's other services.

3 years later, Zillow bought 9,680 homes between July-Sept 2021, more than double the previous quarter's purchase total. They sold only 3,032.

Then 2 months later, in November of 2021, Zillow announced they were exiting the flipping business. Writing down $304m with total losses potentially pushing up to $500m. Zillow's market cap in February of '21 was $48b. In the weeks following the announcement, their market cap dropped to about $16b. That is a decrease of over 60%.

From a business strategy perspective, this looked like a killer cocktail use the data you have to buy and sell physical assets (homes). The business model rested on the assumption that Zillow’s algorithm, fed by the company’s trove of data, would be able to predict home prices with pinpoint accuracy. And it couldn't.

Co-founder and Chief Executive Rich Barton said, “We’ve determined the unpredictability in forecasting home prices far exceeds what we anticipated, and continuing to scale Zillow Offers would result in too many earnings and balance-sheet volatility...”

He added that “Predicting the price of homes six months ahead is really hard” in the COVID age.

The limits of technology, specifically algorithms, were exposed here. COVID is a model breaker. No one quite knows what the "new normal" is and the data that Zillow had been gathering for more than a decade could no longer be counted as an asset in this business environment.

Real estate has been semi-tech resistant because of the human elements of the business. The nontangibles. Home is one of the more emotional words in our language. There are personal tastes, years of happiness, sadness, first steps, first kisses, all the emotions and events baked into homes. When we talk about the business of buying a home you can't quantify that. Oh and the year-plus of labor shortages and supply chain issues only magnified the issue of profitability.

In a letter and in a call with shareholders, Mr. Barton admitted that the company’s algorithm had failed to accurately predict swings in home prices, upward and downward.

Zillow isn't the only publicly traded group that was operating in the flipping of houses; Open-door and Offer pad offer similar iBuyer experiences and reported record profits during q3 of 2021.

So what did Zillow do wrong?

  • They were overpaying for houses
  • They didn't understand the nuances of each marketplace (community) they were operating in
  • The data they thought was an asset was a liability
  • They got too far away from their core business. Flipping houses was a volatile bridge too far

Zillow’s quick exit “calls into question whether Zillow is just really bad at this, or whether they see stuff in the data — keep in mind Zillow’s got access to a lot of unique data,” D.A. Davidson analyst Tom White told MarketWatch.

“Maybe Zillow is seeing something in the data that suggests this is going to be a tough business year over the near term or the longer term,” White said. “It’ll be interesting to see how Opendoor OPEN, +0.06% reacts, especially because it’s just been on an absolute tear.”

The last piece to this puzzle, as Zillow looks to get the houses off their books, they are selling to groups like Pretium Partners. Who is buying over 2,000 houses in 20 markets with plans to rent them to families?

According to the Wall Street Journal, "Three Democratic Senators, including Banking Committee Chairman Sherrod Brown of Ohio, have raised concerns about real-estate investors limiting the number of homes available to ordinary homebuyers. In a letter on Monday to Zillow Chief Executive Rich Barton, the senators asked about the company’s plans to sell homes to investors, including to Pretium, which the Senators said had “a troubling track record,” citing reports of poor home conditions and tenant complaints about billing practices."

This leads to our patterns of development:

  1. Know your market. Do your due diligence. Even with the biggest aggregated data set on the planet Zillow couldn't find a way to execute a profitable flipping business eventually leading to them overpaying and taking 100s of mills in losses
  2. We've said it before, we'll say it again. Comps for residential dwellings are now being driven by how much a property can get with rental income rather than more traditional methods. Which leads to...our favorite...
  3. Affordable housing is a supply and demand issue.

That's all for this week, and I'll talk to you soon.