Zillow (NASDAQ:ZG) (NASDAQ:Z) is in the midst of one of the biggest tech disruptions since Amazon started selling books online: Zillow is taking on the neighborhood real estate broker. Zillow Offers is part of its new strategy of flipping real estate. This new venture carries opportunities and risks. However, Zillow is one of the first companies to enter the sector and has an immense amount of data at its disposal.

A "replatforming" of the real estate industry

Zillow's strategic plan (Zillow 2.0) involves disrupting one of the most traditional activities in the US: the homebuying experience. For decades, home sales were brokered with realtors, who would represent the seller throughout the process, handle the listing, negotiate with the buyer, and so on. The seller would pay all of the realtor commissions. Almost every offer would contain contingencies, such as the sale of another property or receiving approval for financing. 

Home with Sold Sign Placed Over Sale Sign

Image Source: Getty Images

No longer. With Zillow Offers, a seller can click on an ad and get an offer on their property within 48 hours. Instead of going through the typical months-long process to sell a home, the seller can simply transact with Zillow and be done with it. 

Using its deep data mining expertise, Zillow intends to buy and sell homes for their own balance sheet and charge the seller a service fee. The fee will vary depending on the property, and Zillow will offer a side-by-side comparison of their charges versus the expected expense of selling a home traditionally. Zillow's value proposition is mainly convenience: the seller is able to exit the property quickly without contingencies, or the expense of staging, cleaning and running open houses.

The Zillow Offers business model

After a Zillow Offer is accepted, Zillow finances 85% of the property value with a line of credit, and targets a 90 day holding period. So far, the business has lost money. Zillow makes money on the gain, but the start-up expenses are eating that up. Once the activity is up to scale the company expects to make 4% to 5% per property before interest expense. So far, Zillow has purchased 2,300 homes and sold 1,200. Zillow Offers is only available in 21 markets, but they have been adding about 8 markets a quarter. 

To get an idea of how big of an opportunity this is, consider the latest numbers from the National Association of Realtor's (NAR) Existing Home Sales report. NAR estimates that 5.4 million homes will be sold this year, with a median sale price of just about $270,000. If Zillow manages to capture just 1% of those sales (54,000 homes), the revenue will be $14.5 billion. Last year, Zillow did $1.3 billion in total revenue. Assuming they can hit their target 4.5% margins before interest expense, the segment will be throwing off over $650 million in EBITDA. Subtract out interest expense of about $200 million, and you are looking at almost half a billion in profit. It will take the company years to get there, but the opportunity before it is immense.

How risky is this business?

When investors hear that a company is getting into the home-flipping business, they might imagine the guy on a late night infomercial, who buys "undervalued" homes and sells them for their "true" value. In other words, profits result from successful speculation. That isn't what Zillow is doing. Zillow will generate fees all throughout the transaction. The biggest risk for Zillow is liquidity risk. For example, a financial crisis that causes banks to pull its lines of credit. While there is an additional risk that Zillow Offers could create a conflict with realtors, many people will still prefer the human touch, and Zillow Offers won't be available in every market. 

Could Zillow overpay for homes based on imperfect Zestimates -- Zillow's proprietary home value estimation model? It isn't an idle question. Zillow is looking to make 400 to 500 basis points per transaction eventually, and their Zestimate model has a median error of 1.9%. This means that on half of all transactions in the market, the Zestimate is within 1.9% of the eventual purchase price. On the other half, they are off by at least 1.9%. Zillow has had years to calibrate its Zestimate model, and certainly has an idea of which markets it can estimate best. This amount of data is certainly more than any private equity firm that might be interested in the activity and should be at least as good as Redfin.

Enormous opportunity

As of now, this is a "tomorrow story." While Zillow is earning a modest gross profit on the houses they sell, the technology and marketing costs are sizable. However, keep in mind that about $1.5 trillion worth of homes are sold per year, which echoes the huge growth opportunity that internet retailers saw in the late 90s. For investors, this is a bet that an early mover can disrupt the way homes have been bought and sold for decades.