During the pandemic's height, demand for homes hit levels not seen in years. In 2020, home sales were the highest on record since 2006. This surge in demand and home prices was welcomed by those in the industry, including Redfin (RDFN +0.00%), the online real estate brokerage.
Demand was robust in 2021 as well. However, the boom would not last. In early 2022, the Federal Reserve began aggressively raising interest rates to bring down inflation, which reached its highest level in four decades. The rate hikes had ripple effects across interest rate businesses, including residential home sales.
Investors who bought Redfin amid the home-buying frenzy have seen incredibly disappointing returns. A $10,000 investment in the real estate company in 2021 would be worth a fraction of its value today and carries an important lesson about investing in cyclical stocks.
Image source: Getty Images.
Redfin's business is connecting buyers and sellers in residential real estate
Redfin provides online real estate brokerage services, connecting residential home buyers and sellers. It operates a website and app where users can search for homes. It also employs real estate agents who can help buyers and sellers. The company earns listing fees and commissions when real estate agents close transactions based on a percentage of the home's sale price.
Redfin attracts customers with low commissions. It charges most home sellers commissions of 1% to 1.5%, compared to traditional brokerages that charge between 2.5% and 3%. This seemingly small difference can add up to big bucks when selling a home valued at hundreds of thousands of dollars, and is one reason why Redfin grew so rapidly during the pandemic's height.
Here's how much a $10,000 investment is worth today
If you had invested $10,000 in Redfin at the start of 2021, your return would greatly disappoint. Initially, things got off to a good start, and your investment would've peaked at around $14,000 in early 2021.
However, higher home prices and interest rates have put a lid on record home buying, putting Redfin stock under pressure. Since the start of 2021, your investment would have declined 91%. In other words, your $10,000 investment in Redfin would be worth just $940 today.
RDFN Total Return Level data by YCharts
The risk of investing in cyclical stocks
Redfin is an excellent example of the risk of investing in cyclical stocks. Cyclical companies can perform well (or poorly) depending on the economic conditions. These companies have high highs and low lows, which can make investing in them a rollercoaster of emotions.
During the pandemic's height, there was a boom in buyer demand. Driving the boom were ultra-low mortgage rates, people seeking larger houses as they worked from home, and those buying second homes. Home sales reached multi-decade-high levels in 2020 and 2021, and Redfin stock traded at a premium valuation of nearly 11 times sales, well above its historical average.
RDFN PS Ratio data by YCharts
To justify this valuation, rapid growth needed to continue. That was not the case. Home sales have declined in the last couple of years, as has the median price of houses sold. In 2022, existing home sales fell 18%. Through August, year-over-year home sales continued to decline by 15%.
Not only that, but Redfin's foray into iBuying (instant buying) was a drag on the business. In 2017, Redfin started its iBuying program, RedfinNow. This business model was simple: Redfin would offer cash to home sellers and then try to flip the house for a profit. Home sellers would benefit because they could quickly close on their homes, albeit at a discount.
When the housing market was hot, home sellers didn't mind the discount they would take in return for a quick cash payment. However, the business never bacame profitable and required Redfin to hold lots of homes on its balance sheet (and use debt to finance it). Last year, the property segment that included RedfinNow had a gross profit loss of $23 million. The real estate broker announced it was winding down its RedfinNow business in November.
What's next for the stock
Redfin has struggled in today's economy. Investors who bought Redfin in 2021 saw their investment plunge and learned a lesson in cyclical stocks. These stocks can perform well in a strong economy where conditions are right and outperform the broader market. However, the fall can be just as drastic when the winds shift and conditions no longer align. Adding to the challenges was Redfin's iBuying business, which exacerbated losses in a difficult environment for residential real estate.
Today, Redfin is valued at merely 0.4 times its sales and is the cheapest the stock has been since going public in 2017. While it has been a poor performer for a couple of years amid challenging economic conditions, its low valuation makes it an intriguing stock that investors can take a chance on -- especially if the Federal Reserve is done raising interest rates, which could result in a housing recovery right around the corner.
