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Why Zillow And Redfin Are Willing to Lose Millions

By Jon Quast - Nov 19, 2019 at 8:21AM

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It's a complicated plan to make money from Zillow Offers -- but there is indeed a plan. Meanwhile, Redfin seems to have an edge.

Imagine you need to sell your home fast. So you just click a button and get a cash offer with the chance to close in under 90 days, without cleaning, fixing, or remodeling. Some call this a dream come true. The rest of us call it the iBuying real estate trend.

Both Zillow ( Z 2.36% )( ZG 2.65% ) and Redfin ( RDFN 3.33% ) are riding the iBuying trend by giving out cash offers, fixing up purchased homes, and then selling them. Each company is aggressively growing this segment of its business. The only problem: So far, it is extremely unprofitable, with both companies losing millions. 

A man frowns as money flies out of his wallet.

Image source: Getty Images.

There is a reason these companies are willing to lose money while growing their iBuying businesses. But investors need to know if this can ever be profitable, and which company stands the better chance of making it work.

Zillow Offers

Zillow Offers is only six quarters old, but this segment has grown quickly. In the third quarter of 2019, the company bought 2,291 homes and sold a record 1,211.

Quarter Houses Sold Total Loss Average Loss per Unit
Q1 2019 414 $1,353,000 $3,268
Q2 2019 786 $2,292,000 $2,916
Q3 2019 1,211 $5,844,000 $4,826
YTD Total 2,411 $9,489,000 $3,936

Data source: Zillow.

The bad news is that last quarter, Zillow's average loss accelerated to nearly $5,000 per home. Long term, management envisions buying and selling 5,000 homes per month. Assuming that number is split evenly between buying and selling, the company is looking at a $10 million monthly loss based on the year-to-date average loss per unit, or $30 million quarterly, which obviously isn't sustainable.

You could look at Zillow Offers with the glass half full. In the third quarter, Zillow sold homes for about 10% more than the price it paid, before considering expenses. The company affirmed that losses are temporary, stating in its shareholder letter, "Once we achieve scale, however, we expect to deliver an average return on homes sold before interest expense of 400 to 500 basis points per home."

Yet this argument doesn't hold up. It's true Zillow can scale in areas like technology and advertising, but certain costs don't improve with scale. Meanwhile, small-scale flippers incur the same costs as iBuyers, yet still manage to turn a profit. Renovation and holding costs are calculated along with the flipper's desired return before buying.

In regards to interest expenses, Zillow has accrued an average of $4,500 per home sold in 2019. That is a very real cost. Even if the company delivers the returns it's promising, that's before interest. Unless this also drops, there won't be much profit left over.

But perhaps profit isn't the primary concern with iBuying. Losing millions to achieve a bigger goal is common for growth stocks. And in Zillow's case, it wants to offer an entire ecosystem of real estate solutions. That includes iBuying and also new products like its mortgage segment. To be sure, the company hopes Zillow Offers will be more profitable someday, but that's secondary to the primary goal of offering an "end to end" real estate product.

With that in mind, you can think of Zillow Offers as a gateway product into the Zillow ecosystem, but to me, that's pinning a lot of hope on an unproven strategy.

RedfinNow

RedfinNow is also unprofitable. The company doesn't give an exact number of homes sold per quarter, but so far in 2019, it has reported revenue of $141 million for its iBuying business, resulting in a $3.4 million loss. That puts Redfin's margin at negative 2.4%, which is worse than Zillow (negative 1.2% in this segment).

Redfin, like Zillow, considers the home-buying business as a way to drive customers to more profitable products. But an important distinction needs to be made between these two companies. Redfin is a real estate broker -- Zillow is not. As a broker, Redfin actually employs real estate agents and brokers the deal.

Across all real estate transactions, a broker is almost always used. In the case of RedfinNow transactions, the broker is always Redfin. In the third quarter earnings call, Redfin CEO Glenn Kelman explained that although iBuying is still unprofitable, its brokerage business gains a transaction it likely wouldn't have had otherwise. The same can be said about Redfin's "other" segment, which includes mortgage and title services. The business segments enjoy a direct boost from iBuying, and these segments are profitable. In the third quarter, the brokerage segment had a 35% gross margin and the other segment had a 1% gross margin.

Given this difference in the two companies, I really think Redfin has a greater chance at making iBuying a sustainable part of its business before Zillow does. While I wouldn't rule out Zillow completely, it does seem Redfin has a clearer path forward.

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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Stocks Mentioned

Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
ZG
$53.77 (2.65%) $1.39
Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
Z
$54.25 (2.36%) $1.25
Redfin Corporation Stock Quote
Redfin Corporation
RDFN
$39.43 (3.33%) $1.27

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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