Real estate is an incredibly secure investment class. It's hard to go wrong with bricks and mortar, because even in difficult economic times, housing has plenty of utility as an income stream -- people always need somewhere to live.
But there are no guarantees in investing. With home prices soaring over the last few years, some companies have participated in a practice called iBuying, where they purchase thousands of homes at scale with the intention of flipping them for a profit. While it has worked well for some, it has been catastrophic for segment leader Zillow Group (NASDAQ: Z) (ZG 2.21%).
Zillow stock plunged 80% as a result of its significant iBuying losses, combined with the broader bear market in the technology sector. But Zillow is now taking its business in a new direction, and that effort is already proving fruitful. Here's why it might be time to add the stock to your portfolio.
Image source: Getty Images.
Zillow's iBuying catastrophe
Zillow was a leader in the iBuying industry based on volume. It was using highly advanced technology like artificial intelligence and machine learning to predict home prices, relying on these models to drive its Zillow Offers brand.
In 2020, it purchased 4,162 homes, but even that pales in comparison to its activity in 2021. Due to the strong housing market, the company elected to take an aggressive approach to the segment by buying a whopping 23,935 properties for the year.
That's where the cracks began to appear as Zillow's predictive models proved not be as accurate as it initially thought. Even though home prices were broadly rising across America, not all geographic markets are created equal -- as the famous saying goes, it's all about location, location, location.
Zillow was operating in at least 35 different markets in the U.S. and it managed to offload 15,436 houses simultaneous to its buying spree. But as 2021 progressed, Homes segment losses only got steeper.
In the third quarter, Zillow lost an average of $80,771 on every home it sold. At one point, up to 64% of the homes Zillow was trying to sell were being marketed for a price below what it paid for them, and in some jurisdictions like Phoenix, that figure was more like 93%.
But thankfully for Zillow, the iBuying catastrophe is close to being a mere memory, and the company lives to fight another day. In the first quarter, it revealed it had just 100 homes remaining in its inventory that weren't yet contracted to be sold.
The way forward
Technology will remain at the core of Zillow's operations, but rather than using it to facilitate direct buying, it will apply it to a wide-ranging suite of real estate services. They include digital touring (virtual open houses), closing services, mortgages, and broker services, to name just a few. Zillow estimates that every home sale generates approximately $17,000 in transaction fees, of which the company only captures about $4,100 at the moment, leaving a significant opportunity for growth. In total, Zillow anticipates this is a $300 billion annual addressable market.
The company plans to facilitate this new direction through a housing super-app for mobile devices. It already has a strong head start, because its existing app has a 63% market share with respect to daily active users, making it three times the size of its closest competitor.
In 2021, Zillow generated $2.1 billion in revenue from aforementioned fees (excluding iBuying), and it has charted a path back to $5 billion in annual revenue by 2025. That's a significant dip from the $8.1 billion in revenue the company delivered in 2021, which highlights just how big the iBuying business was. However, it's no good to the company if it hemorrhages money.
On that note, in the first quarter of 2021, the company reported $75 million in pre-tax income if you exclude the residual $68 million loss from its Homes segment, which should be completely shuttered by the end of the third quarter. It's a looking glass into the future potential of Zillow's bottom line once the iBuying risk is eliminated.
NASDAQ: ZG
Key Data Points
Zillow stock is trading about 20% higher than its 52-week low right now, which could be the first step in a long road to recovery. But for patient investors, there's potential for a highly profitable, low-risk, service-based business on the horizon, which could deliver significant returns in the long run.
