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Zillow Group (NASDAQ:ZG) is an online real estate website that connects home buyers to local home listings and trusted real estate agents. Real estate agents can market their listings on Zillow.com for a monthly fee, giving them access to a large audience of home buyers. Currently, Zillow.com gets between 40 million and 50 million monthly website visits.

Thus far, Zillow has been a great option for growth investors. A new feature offered by Zillow is its new home-flipping business, Zillow Offers, which allows homeowners to sell their home to Zillow for a cash offer within just a few days' time. Zillow then turns around and attempts to sell the home at a premium,and keep the profits.

A model of a house with keys next to it

Image source: Unsplash.

Despite recent overall company growth, however, investors seem uncertain of the new feature. Here are the potential risks and rewards associated with Zillow's home-flipping business.

How Zillow Offers works

How does the new home flipping business work? It's like the typical home flipping business, where investors buy properties, renovate the home, and then sell it for a profit. It's actually a much more condensed version of this. The way it works is as follows, according to Zillow:

  1. Fill out some basic info on your home, answer a few questions, and submit it to Zillow.com. Zillow will review your home listing for eligibility.
  2. Within a few days, Zillow will notify you if your home is eligible for a full cash offer. You can choose to accept or decline the offer with no obligation.
  3. If you accept the offer, all you have to do is pick a closing date and Zillow will arrange the rest.

If you're a homeowner or have ever sold your home, you may know from firsthand experience the stress associated with selling your home. Perhaps you'd jump at the idea that you could potentially sell your home to Zillow.com for a full cash offer, on your timeline. From an investor's standpoint, it's certainly something worth investigating further. 

Why Zillow invests millions into flipping homes

Zillow has created a powerful real estate platform that already attracts millions of monthly users. Chances are that most of those are by people in the market of buying or selling a home. What if Zillow could capture a small share of the profits of these homes being sold? 

Since it's one of the largest real estate platforms for both buyers and sellers, you can expect Zillow has an enormous amount of data giving it a slight edge on the market. Here are a few of the many reasons Zillow sees potential in its home-flipping business:

  • According to Zillow Research, there's a wave of 3.11 million more first-time home buyers approaching the median age of first-time buyers, which is 34.
  • Zillow's home mortgage segment increased revenue by 40% year over year, making the home buying and selling an overall seamless process for those wishing to use Zillow Offers.
  • Of the $599.6 million of revenue from Q2 2019, $248.9 million came from the home segment even though Zillow Offers was launched just over a year ago.

And that's just the start. Long story short, the data indicates that the demand is there, so Zillow is responding accordingly.

A risky move?

Consider the following risks that may be a challenge for Zillow Offers:

Recessions and housing market declines

Sure, home buying in recent years has been wild. When purchasing our home a few years ago, we'd offer above asking price confident that we'd come out on top and come to find that our offer got beat by an even larger full-cash offer!

But what about a recession like the 2008 housing market? It's safe to say that one might wonder whether Zillow Offers would be profitable during a 2008-like housing market. Perhaps it purchases a home for $227,000 (which is the average U.S. home value, according to Zillow Research) but the home value decreases 15% to $192,950. That wipes out the entire forecast return on investment (ROI) of 4% to 5% and then some, making this a risk to consider.

Valuation errors and miscalculations

This risk may sound a bit questionable at first, but consider how Zillow is able to determine the value of your home and make you an offer within a few days. The starting point is the all-famous Zestimate, a tool that is used to give an approximate value in its home valuations with a slight margin of error. 

With the company's technology and available public info on homes, Zestimate calculates the approximate value of your home. Next, Zillow uses local real estate agents as a point of contact to help pinpoint the home value to come up with a final valuation and amount to offer. It factors in costs associated with renovations and repairs and determine the approximate price it could sell the home to determine if it's worth the purchase.

Sound like a bit of speculation? It certainly could be for the homes that slip through the cracks. It's not unheard of for homes to be undervalued, even by professional appraisers. 

High ROI expectations?

In a recent shareholder letter, Zillow's CFO Allen Parker states that the company expects to "deliver 400 to 500 basis points of return before interest expense." Average real estate agents make a commission of 4% to 6% of the selling price of the home. Expecting to make nearly the same commission that a local real estate agent would make could be a bit of a stretch, seeing that part of the reason customers wish to use Zillow Offers may be to not to have to pay high commissions. Otherwise, why not just use your local agent?

Consider the rewards

According to the National Association of Realtors, approximately 5.34 million homes were sold in 2018 alone. To take that even further, as of June 2019, Zillow reports a current inventory of 1.56 million homes for sale, with an average home value of about $227,000.

According to Zillow's most recent earnings report, it purchased 1,535 houses and sold 786 in Q2. Furthermore, more than 69,000 homeowners requested an offer from Zillow to purchase their home in the second quarter.

Why is this data important? As compared to the entire real estate market inventory from 2018, here's how much of the market share Zillow Offers has touched:

  • Homes purchased by Zillow in Q2 of 2019 represent only 0.03% of the entire real estate inventory sold in 2018.
  • Homes sold from the purchases by Zillow Offers in Q2 of 2019 represent 0.015% of the entire real estate inventory sold in 2018.
  • 69,000 homeowners requested an offer from Zillow to purchase their home in Q2 2019, which represents only 1.29% of the entire inventory sold in 2018.
  • Assuming an average home value of $227,000 from the data above, and projecting an average of 400 to 500 basis points (4% to 5%) return on investment per sale, Zillow would profit between $9,080 and $11,350 per home bought and sold through Zillow Offers (keep in mind those numbers are before interest expense).

In other words, Zillow is just barely scraping the surface of the available market share potential.  Not to mention between $9,000 and $11,000 ROI per sell, a number that would make an investor smile.

Consider the stock market before the internet

Before online brokerages and discount brokers were made available through the internet, one used the local newspaper to follow the stock market prices. When the internet came along, many were skeptical about the speed it offered investors.

While this is a speculative opinion of mine, I think some of you would agree that Zillow Offers closely parallels what the internet did to the stock market. Buying and selling homes is such a lengthy task involving paperwork and hiring professionals, why can't it be as easy as a few clicks of the mouse to buy or sell your home? Hey, it works with stock shares...

Zillow Offers is a true "blue ocean strategy"

The growth of tech companies such as Zillow opened up new markets never before touched. This is called a "blue ocean strategy" -- an area abundant with game where there are no sharks fighting to devour the next meal (the water would be red with blood where the sharks hunt for prey -- or profits).

In other words, Zillow Offers is swimming in an untapped market. The water is cold and blue, ready for the taking, and Zillow Offers may be the first of its kind.

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This article was written by MyWallSt contributor Cameron Williams.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in Zillow. Read our full disclosure policy here.