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Could a Housing Crash Crush Zillow?

By Jon Quast - Oct 25, 2019 at 10:59PM

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Zillow's new house buying venture exposes it to risk if housing prices take a nosedive.

You're probably already familiar with Zillow Group ( ZG 10.53% )( Z 11.32% ). The company has over 180 million unique monthly users across its collection of websites and apps. Through these, users access information on millions of homes and take advantage of a tool called Zestimate to better understand home values. This made Zillow a digital media company, largely protected from risk if the physical housing market crashed. 

Until 2018, this was all Zillow was. But the company recently took bold business steps to become both a mortgage lender and house flipper. Last April, Zillow launched a program called Zillow Offers -- a venture to buy and sell houses. Four months later it announced the acquisition of Mortgage Lenders of America (later rebranded as Zillow Home Loans), a mortgage company originating over 4,000 loans annually. These two new business segments are poised to comprise the backbone of Zillow's overall business in the next few years, as we'll explore. But this move exposes the company to tangible risk if the housing market crashes.

Two men shake hands over a miniature house.

Image source: Getty Images.

What's the plan?

Last year, Zillow management laid out an aggressive three- to five-year business plan. The three-part plan calls for its media segment to bring in $2 billion in annual revenue, its mortgage segment to originate 3,000 loans per month (more on loan originations here), and its home buying segment to buy and sell 5,000 homes per month for $20 billion more in annual revenue. For perspective, trailing twelve month revenue for everything right now is less than $2 billion. Put another way, a mere three years from now Zillow revenue could be 1,000% greater than what it is today. 

Zillow Offers and Zillow Home Loans are expected to work together. The idea is that homeowners will initiate contact with Zillow asking for an offer. From there, the company will buy the house and do whatever repairs necessary. After that it'll look to sell. Irregardless of who buys it, Zillow stated in its annual report that it hopes they will use a Zillow originated loan 33% of the time. This would account for the majority of the loans Zillows intends to originate, although more are needed to reach 3,000 monthly loans. 

What's the risk?

Zillow plans to buy and sell over 5,000 houses a month -- an enormous undertaking, especially considering Zillow does less than half that per quarter right now. 

Quarter  Houses bought Houses sold Quarterly net holdings
Q2 2018 19 0 19
Q3 2018 168 36 132
Q4 2018 499 141 358
Q1 2019 898 414 484
Q2 2019 1,535 786 749

Herein lies the big risk with Zillow Offers. Currently the company holds 1,743 houses worth $552.8 million. Of course it plans to sell them all. But what if the housing market crashes before then? Zillow would be holding a large bag of assets that would have to be sold at a loss. Sure, the company could wait for housing prices to recover. But in real estate, a very real cost is called your "holding cost" -- the cost that accrues every month you hold a property. Zillow finances home purchases with its revolving credit line, so every month it hangs on to a house results in an extra month of interest payments. 

Holding costs are quickly accumulating for Zillow. Q2 alone accrued almost $2.6 million on the 1,743 it currently holds. What happens if it's holding 5,000+ homes with negative equity? Zillow would have a tough choice to make: lose money by selling the homes for a loss? Or keep eating the holding costs until prices recover?

What now?

It's so easy to fall into the "what-ifs" trap. It's better to look at what is. Recent data indicates that there's no impending real estate bubble-pop. Sure, no one's clairvoyant. But real estate economics work a lot like economics in general -- simple supply and demand. The September Zillow Real Estate Market Report showed a 6.4% drop year-over-year in homes listed for sale (low supply). Home prices over the same period are up 4.8% (high demand). 

Low supply and high demand lead to higher home prices -- a good situation for Zillow right now. But it's also fair to note that this isn't the only way. It's still entirely possible to profitably buy and sell houses in a down real estate market. That involves not overpaying, accurately estimating repairs, and predicting holding times.

Conversely, it's possible to lose money even when the market is up, and that's what Zillow is currently doing. In the second quarter the company lost $2,916 per house sold. There are multiple ways to fix this, from buying lower, to selling higher and quicker. But it's something I want to watch Zillow improve on during this bull market before believing it could survive a bear.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
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Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
Z
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