Is Red really the new Black?
It’s a catchy phrase and it reflects the apparent sentiment of some of the bigger players and their backers. Along with the other term used in the same discussion, “sustained unprofitability”, it posits that
- Success in the real estate business for now relies on continued short-term losses to build an advantage over one’s competitors.
- Investors and financial backers will overlook this in anticipation of a big score further down the road.
Then again, it’s worth noting that the stock performance in the past 12 months for all four has been dismal. Maybe investors realize that profits do matter regardless of all the chatter about technology?
Profits and Losses
Everyone in the industry knows that the best time to make a profit is in the second quarter. Three of these companies – Zillow, eXp and Redfin – posted a loss for Q2 but all four situations require a little more amplification:
- Year-over-year comparisons can be misleading. All four have had noticeably “down” quarters in the past 12 months that would make the same quarterly report a year later look good by comparison. In eXp’s case, it has posted a string of quarterly losses back to Q1 of 2018 so anything positive going forward will look good by comparison.
- In all four cases, each company’s financial situation was lifted to some extent in Q2 by the rising tide of the spring selling season. The real test starts late in the third quarter and these companies will have their weaknesses exposed when that same tide falls in the winter.
- For all of eXp’s revenue growth, it appears to have more than a short term issue in posting net earnings consistently. Its biggest cost driver, “commissions and other agent-related costs” (page 26 of the SEC document), continues to rise more than its revenue on a percentage basis. One would think that with such a big revenue increase, it would get some economies of scale on the cost side – apparently not. Continuing quarterly losses into next year will only drive the point home that eXp’s “cloud-based” brokerage approach is not a difference-maker for it or for the industry. So much for this technology as a game changer.
- One of Redfin’s problems continues to be its employee-based agent model especially when it comes to 4th and 1st quarter financial results. Its partner revenue growth has tailed off and its iBuyer segment is still an iffy proposition. Management talked about the problem of increased home tour numbers not manifesting itself on the profit line, demonstrating again that technology helps but is not a valid substitute for boots on the ground and knowledgeable people in the field.
- Realogy was the lone profitable company in the second quarter but its agent split continues to deteriorate. Realogy management also talked up its 2% net gain in its agent base during its earnings call but again, anyone knowledgeable about the industry knows that a 2% increase in agent population will take at least 6-9 months to translate into something noticeable on the profit line, especially when Realogy’s primary recruiting targets have been agents with 3-5 years of experience. Technology may provide a little boost on the recruiting front in general but that one is just going to take time.
Zillow Stands Alone
As far as Brad Inman is concerned, Zillow is the real estate industry – period. That sounds like a bit of overstatement, but no more so than the recent article in Housing Wire. According to Steve Eisman in that article, “Zillow has one of the most flawed business models I’ve seen in a very, very long time” and Zillow investors “don’t have a clue.”
Unless, of course, Zillow has been planning for this day for a couple years. Rich Barton was upfront on the Q2 earnings call in telling the analysts that the investment in its iBuyer business and a transition to deferred revenue recognition for its Flex pricing model were going to cause hits to its earnings in the short term.
Looking at its 10-Q, Zillow has also clearly recovered from its mistake of a year ago on its Premier Agent advertising business and finally recognized that there’s more profit to be made with many of those same Premier Agents with its new Flex model. It’ll take time to show a meaningful result from revenue on a 35% agent referral for a closed transaction. It will also take time for Zillow to scale up from its initial efforts in the iBuyer segment but if 2019 is any example of its potential, Zillow will become the clear leader in that marketplace by late 2020. It has the funds, it has the footprint, it has the consumer eyeballs, and it has the attention of a lot of top-producing agents.
Wild Cards and End Game
A recession could spell trouble for everyone especially if it results in a downturn in the housing market. Of these four companies, Zillow should come through it with the least amount of damage. The pending lawsuits against the industry also should have the least impact on Zillow should anything come from them.
And at some point, Compass and Opendoor will have to go public, providing two more valuable data points for investors to compare against these four and shining a bright light on their own individual finances. Will these tech-enabled unicorns start public life with profits or losses? ”Sustained unprofitability” indeed.
This is not to say that Zillow is going to be the winner here. But it has made a major pivot to a new revenue model where the others cannot or will not, and it will likely result in meaningful profits by the end of 2020.
In the meantime, Winter is still coming to the real estate industry and people should remember the lessons from the dot-com bubble 20 years ago. A lot of investors back then also believed that Red was the new Black and technology would lead the way. They learned the hard way. Twenty years later, Red is STILL NOT the new Black and, again, technology will not change that.