If only the market could have foreseen how risky Zillow's (Z -1.45%) (ZG -1.27%) homebuying program was. Turns out that this isn't a sustainable business model, the company ended up paying more to buy and fix up a home than they could sell it for. 

Zillow's announcement that it was winding down the Zillow Offers program sent the real estate information giant's stock into a tailspin, losing 36% of its value. But maybe this is actually good news. Or it will be after Zillow works through the inventory of homes it has in its portfolio.

Stacks of $100 bills.

Image source: Getty Images.

Flipping houses is harder than it looks

There was some sense as to what Zillow was attempting, but only in a rising market, and arguably only in one that was white-hot and bubble-like. Flat or even falling markets as we might be entering into, would be death to such a program. 

Zillow has some of the best information available about any particular market. Its algorithm knows:

  • Available houses that are selling in an area.
  • How fast they turn around from listing to purchase.
  • The prices the homes are going for.
  • Whether buyers are looking to move into an area or get out.

It churns out that data into what it calls its Zestimate. Zillow Offers bought houses at what it estimated they were valued, after which it would make any necessary repairs before putting them back on the market to presumably sell at a profit. At least that's what all the reality TV house-flipping shows make look easy.

It didn't quite work out that way for Zillow, though. In fact, while Zillow Offers is its biggest revenue generator, some $2.7 billion over the first three-quarters of 2021 (it made $1.7 billion for all of 2020), it also generates massive losses, well over a half-billion dollars so far this year. And this was during a housing boom that's rivaled the one that preceded the financial market's collapse.

Two people looking at home plans.

Image source: Getty Images.

Clouds on the horizon

It's easy to see why Zillow has decided to get out of the home-flipping business, especially now that the housing market may be beginning to cool. The number of houses listed on Zillow that featured a price cut before getting a contract to buy almost doubled, from 7.9% in April to 14.7% in September. Monthly home value appreciation has slowed in 44 of the 50 largest U.S. metropolitan areas.

Zillow reported it generated $1.2 billion in Zillow Offers revenue in the third quarter, but that was below the $1.4 billion to $1.5 billion it expected. Having gone on a buying spree, Zillow now has about 7,000 homes in its portfolio that it needs to get rid of and is reportedly looking to receive around $2.8 billion for them or about $400,000 per home. It's possible it can get that price, as Zillow sold over 3,000 homes in the third quarter, for an average price of just under $386,000. Though the housing market is beginning to slow down, prices remain elevated.

People in front of a for sale sign

Image source: Getty Images.

Better now than later

Zillow CEO Rich Barton essentially admitted that despite all the information it has available, the Zillow Offers algorithm isn't nearly as good as the company thought it was: 

"We have been unable to accurately forecast future home prices at different times in both directions by much more than we modeled as possible...Put simply, our observed error rate has been far more volatile than we ever expected possible and makes us look far more like a leveraged housing trader than the market maker we set out to be." 

It will take some time to wind down the business, but the end of the iBuying program is ultimately good for investors because it eliminates a lot of the risk Zillow was taking on. And if the housing market is truly heading for a fall, it was best for it to get out now than when the collapse occurs. Long-term debt had grown to $1.7 billion, while its current liabilities more than tripled in the past year to $3.1 billion as it took on more short-term borrowings to finance its home buying program.

The fact that house flipping makes for better reality TV than an actual business model was an expensive lesson to learn. But exiting the Zillow Offers program will make Zillow a much more financially stable real estate stock in the future.