Zillow (Z -1.23%) (ZM -1.13%) has a very nice, profitable business in the internet, media, and technology (IMT) sector with its Zillow app. The company generates well over $1 billion each year by selling advertising space and other services to real estate agents, who use Zillow to connect to customers. 

But the future of Zillow as a growth stock isn't just as an advertising platform, it's as a real estate transaction company. Zillow can leverage its user base and data to actually buy and sell homes, reducing the friction in real estate transactions. But the strategy doesn't come without risk, so understanding how the business works and how Zillow will measure success is important for investors. 

Homebuyers in front of their new home.

Image source: Getty Images.

Zillow Homes and the future of real estate

The Zillow Homes segment is driven by Zillow Offers, which buys and sells homes. A customer can use Zillow Offers to request an offer for their home with a closing date set and no public showings before they move out. Zillow takes on any renovation costs, the costs of holding the home, and any selling costs like realtor fees. 

I like to think of this as digitizing the painful real estate transaction process. In time, Zillow can layer on mortgages, title work, insurance, and other services into a digital real estate transaction. If you've ever bought a home, you know what a dream that would be. 

When analyzing the Offers business, I think investors can look at it like a retail business -- but instead of selling a $3 bag of chips, it's selling a $400,000 house. In retail, the amount of inventory you have determines the capital needs of the business. Turnover shows how quickly a product goes from being purchased by you to sold to a customer, and margin shows how much profit is made on each sale. 

These are the three main levers of the business. Less inventory is good (all else equal), higher turnover is good, and higher margins are good. Here's where Zillow stands on these metrics.

  • Inventory: 3,142 homes on the balance sheet, or around $1.2 billion in value. 
  • Turnover: 2,086 homes sold in Q2 2021, which implies a turnover rate of current inventory of 2.7 times per year. 
  • Margin: $19,636 per home.

These numbers will fluctuate as Zillow grows the Offers business, but over time it will help us judge how the business is performing, just like we would judge a retailer. 

This also shows the potential for Zillow. According to Statista, 6.7 million homes were sold in 2020, while Zillow sold 5,337 homes. It could grow home volume 100x and still have just a 10% market share.

How Zillow Offers becomes a disruptor

To show how disruptive this could be in the market, let's break down the business and show how it can be competitive long-term

Let's assume that the eventual sale price for an end buyer isn't impacted by Zillow, but rather is a function of the real estate market overall. That would mean the levers Zillow can use to grow and expand margins include: 

  • Raising or lowering the acquisition price of a home will impact both margins and competitiveness in the market. Right now, Zillow pays 87.1% of the final sale price for a home, meaning the margin sellers give up is 12.9%, which I'll call the "acquisition discount margin". This compares to an agent's fees of ~6% on average. 
  • The selling cost for Zillow is 3.8% of revenue, which mainly goes to a buying agent. Any reduction in this fee would either increase margins or allow Zillow to reduce the acquisition discount margin. 
  • Renovation costs are 2.7% of the final sale price, which could be raised or lowered to impact Zillow's margin. 

Long-term, if Zillow is going to be competitive in the market, I think the 12.9% acquisition discount margin will need to come down. But it's possible that it will as Zillow Offers grows and turnover increases. Think about this from a seller's perspective. If the acquisition discount margin of going through a broker is 6%, but that involves weeks of home tours and potentially paying for a home you don't live in any longer, what would you take as a discount for closing and the sale price to be set without any showings? An extra 2%? Maybe even 4%? It's definitely worth something. 

Zillow will want to increase turnover to take market share, and may be able to do so by reducing margins. If Zillow can sell 10,000 homes per quarter with a $10,000 margin, it's far better than selling 1,000 homes for a $20,000 margin. Ultimately, growth and scale could make Zillow very competitive with traditional realtors. 

We don't know exactly how much Zillow will want to trade margins for growth, but it has the chance to do so as it builds the Offers business. Understanding how the business works and the levers management has to pull will be important for investors. 

Zillow the disruptor

The real estate business hasn't changed much in a century and is due for disruption. Realtors charge high fees and information about the market is asymmetric, with most sales data sitting on MLS databases that members restrict access to. Zillow was one of the first places to make information freely available, including live "Zestimate" home values. 

Zillow could disrupt the market by not only buying and selling homes, but also connecting buyers with mortgages, insurance, maintenance, and other needed services. These could all be profitable businesses that develop long-term relationships with real estate customers. 

I think this is one of the strongest potential businesses on the market today, with trillions of dollars in potential revenue. If Zillow can increase turnover and reduce the acquisition discount margin to be more competitive in the market, it could be the most disruptive company in real estate.