Zillow Group (Z 0.98%) (ZG 0.97%) is no longer content with just hosting the online platform where housing buyers and sellers interact; it has entered into the transaction process itself recently with a venture it calls "Zillow Offers." The company is providing sellers the chance for an immediate cash offer on their homes in the hope of making money when it flips the properties to buyers.

The move comes with new risks to Zillow; will it pay off?

A person holds a key to a home in their hand.

Image source: Getty Images.

How Zillow Offers works

The Zillow Offers product was rolled out in select markets in May 2018 with the goal of providing homeowners a quick, no-hassle way to sell their homes. To get an offer, a homeowner simply needs to fill out a form on Zillow's website and set up a time for an inspector to visit. The homeowner can get a cash offer on their home within days and close the transaction at a time of their choosing within 90 days.

In exchange for providing an immediate cash offer to buy a home, Zillow charges a transaction fee in the range of 6% to 9% of the home's value depending on several factors, including how much it would cost to fix-up the home and how quickly Zillow estimates the property can be sold. Zillow's transaction fee is higher than a typical real estate agent fee, but it allows a homeowner to avoid a potentially lengthy negotiation process with buyers and to close the sale quickly.

Zillow finances the purchase of homes with borrowed money via a corporate bank loan facility. Once the deal is done, the company will quickly make any renovations it thinks can add value to the acquired properties and then relist them for sale on its website. If all goes according to plan, Zillow will sell its housing inventory within a couple of months for more than it paid.

Early results and long-term potential

Zillow started directly buying homes in May 2018 and started selling the homes it bought in July 2018. In the first quarter of 2019, the company bought 898 homes and sold 414 homes. This brought in revenue of $128.5 million, which led to Zillow reporting a 51% year-over-year increase in total revenue compared to Q1 2018. However, the segment currently operates at a loss, contributing an operating loss of $45.2 million in the first quarter.

As it currently stands, Zillow Offers only operates in eight housing markets, but it is quickly expanding nationwide with plans to operate in 20 markets by the end of Q1 2020.

A map of the U.S. showing where Zillow Offers operates

Image source: Zillow.

For the fiscal year 2019, the company believes Zillow Offers will generate revenue exceeding $230 million. In the (very) long run, Zillow believes this business can produce $20 billion in revenue by selling approximately 5,000 homes per month. This is definitely an aspirational goal, but it is within the bounds of reason if one considers that each year, the U.S. housing market generates $1.8 trillion in transaction value.

Although Zillow Offers doesn't make a profit today, the company is targeting long-term EBITDA margins on the business between 2% to 3%. That translates to $400 million to $600 million in EBITDA if the company hits its long term goal of $20 billion in Zillow Offers sales.

However, the Zillow Offers unit doesn't need to make a large profit margin for the venture to pay off. Each home transaction creates the opportunity for Zillow to generate revenue in its traditional business of selling advertising on its website and selling leads to real estate agents. For example, if a homeowner sells her home on Zillow, it's likely she will still need to buy a home, and she may also use Zillow to do her research or hire an agent.

The company is also adding what it calls "adjacent" businesses to drum up additional fee revenue from home transactions. This includes title and escrow, moving services, home warranty, insurance, and mortgage underwriting. Zillow hasn't rolled out much of these adjacent services yet. For example, it isn't yet offering insurance or title. However, the company is heading in this direction, and it's certainly a way to sell more services around the process of flipping a home. Zillow did acquire a mortgage company toward the end of 2018 and is getting ready to integrate it into the Zillow Offers product.

Will Zillow Offers pay off?

Zillow's move into directly buying and selling homes has its fair share of critics. Some observers are concerned that the company is taking on the risk that housing prices fall during the few months Zillow owns a home. Furthermore, Zillow is buying homes with borrowed money, which will only maximize the pain if housing prices move sharply against the company.

While these concerns are well-founded, the company can mitigate the risks by slowing its rate of home purchases if the housing market becomes tepid or raising the transaction fees it charges sellers. Home prices are not as volatile as other asset classes. In the last cycle, for instance, U.S. housing prices started to decline in 2007 before the housing crisis really picked up steam in 2008 and 2009. A company (like Zillow) following these trends close enough would have some lead time to moderate its business.

Also, Zillow's strategy is less focused on profiting from actually flipping the home and more about making money selling ancillary services generated by the transactions. Each transaction generates a transaction fee, and the company aims to also provide additional services such as mortgages, insurance, title, and escrow. These fees are all on top of any potential "spread" Zillow makes from buying low and selling high.

When it comes down to it, Zillow is flipping houses because it sees an opportunity for growth that is synergistic with its existing web platform. Zillow is already the most visited website for researching housing prices. Homebuyers like the price transparency and the ability to conduct a great deal of research before ever leaving their living room. Home sellers like the speed at which Zillow is able to close a transaction. Connecting buyers and sellers through a transparent marketplace improves the shopping experience and democratizes the process.

It is too early to tell if Zillow Offers will ultimately pay off, but if any company can pull this off, it's Zillow.