The real estate market faces significant challenges at the moment. With inflation at a 40-year high, the U.S. Federal Reserve has no choice but to aggressively raise interest rates, which puts pressure on house prices because consumers can't afford to borrow as much money.
It might sound like a bad time to buy stocks operating in the real estate sector, but there's a unique opportunity unfolding at Zillow Group (Z -1.10%) (ZG -1.10%).
The company shuttered its iBuying (direct buying) business last year after sustaining major losses and sold nearly all of its remaining homes in inventory during the second quarter of 2022. It has paved the way for a new, capital-light Zillow Group that could make for a great long-term investment.
Image source: Getty Images.
Life after iBuying
When house prices are consistently rising, it makes sense that companies would seek new and innovative ways to benefit from those gains. The iBuying practice is one of the riskiest but potentially the most rewarding ways to profit in a strong real estate market. It involves companies like Zillow purchasing homes directly from willing sellers and attempting to flip them for a profit.
It's a very capital-intensive business because it requires holding thousands of houses in inventory until they can be sold, which also means any dip in the real estate market can have catastrophic financial consequences. Cracks began to appear in some areas of the U.S. housing market in 2021, catching Zillow off guard and forcing the company to absorb a segment loss of $881 million for the year. It subsequently ceased its iBuying operations.
In the second quarter of 2022, Zillow sold 1,211 of its last homes in inventory, leaving just 71 remaining. It effectively marked the end of this experiment, and it allows the company to recalibrate its focus on the more promising areas of its business.
Zillow's new goal is to be a one-stop shop for real estate services. It continues to develop its "housing super app" that will leverage the company's enormous digital footprint with consumers, which spanned 2.9 billion hits online from 234 million monthly unique users during the second quarter.
The new Zillow Group
Zillow's new app will offer a mixture of in-house services and referrals to third-party providers. The company estimates that every house sold in the U.S. comes with a fee-based revenue opportunity that totals an average of $17,000 from referrals, seller services, closing services, and mortgages. Right now, Zillow is only capturing $4,100 of that.
The company is already very well established in core service segments, with its Premier Agent brand providing customer introductions to a network of realtors. Plus, Zillow Home Loans receives millions of inquiries annually and originations grew an impressive 58% in the second quarter of 2022 despite a difficult market.
Last year, the company acquired ShowingTime, a tour-booking service that aligns buyers, agents, and sellers to arrange showings at their convenience rather than during specifically allocated days. Zillow just rolled out a real-time availability feature for this service. It's an innovative solution that ensures eager buyers have the best shot at quickly putting an offer forward, which is also great for the agent and the seller.
And although Zillow has exited iBuying, it doesn't mean it's no longer involved in the business. The company recently struck a major referral deal with iBuying specialist Opendoor Technologies (OPEN -3.72%), which will allow a Zillow customer to receive a direct-buying offer for their home. In exchange -- if the customer proceeds -- Zillow earns a referral fee from Opendoor. It's a great low-risk arrangement that involves zero capital investment from Zillow's side.
Zillow has to shrink to grow
Zillow's iBuying segment was by far its largest, making up 73% of the company's $8.1 billion of total revenue in 2021. That's a big hole to fill, and the company anticipates it will take several years for revenue to climb back to those levels.
It's targeting $5 billion of annual revenue in 2025, which would still be well shy of its 2021 result. However, it could be a far more profitable company because services typically carry a much higher profit margin. By 2025, Zillow expects to have a 45% adjusted EBITDA margin, which means its $5 billion in revenue could generate $2.25 billion of earnings before interest and taxes. That's more than 10 times higher than the company's 2021 result.
Therefore, despite Zillow becoming a much smaller company, it appears destined to be a much healthier one with far fewer risks. For investors seeking long-term exposure to the real estate market, this is one technology company worth buying now.
