My Bet on Zillow
Zillow accounts for just under 10% of my investment portfolio and represents my second largest individual stake after Disney. Since I started building my position back in late-April, Zillow’s stock has declined almost 35%, a drop that can largely be attributed to the company’s pivot in business strategy. More on that in a bit.
On Twitter Zillow is the stock that I get by far the most hate for having in my portfolio and it is easily my most contrarian investment. I mean, shit, I’m even betting against Steven Eisman, the guy who made a shit ton of money in the 2008 subprime mortgage crisis and served as the inspiration for Steve Carell’s character in The Big Short, who is short the company.
A Brief History of Zillow
When the company had its IPO in 2011, Zillow was celebrated as the Internet upstart poised to finally disrupt the notoriously inefficient and fragmented real estate market. Fast-forward to 2018 and despite growing its market cap from $539 million to over $7 billion (at the height of its valuation), Zillow has fallen short of its lofty ambitions to transform the housing industry. Instead Zillow is a tax on the industry, an annoying but necessary toll that realtors must pay as a cost of doing business. It operates as a glorified lead generation tool for real estate agents, who earn over $6.5 billion in commission on the Zillow platform. Since most of its revenue is driven by getting agents to advertise their listings on its platform, Zillow is excluded from the most valuable aspect of the real estate market, the damn home sale!
Zillow’s high margin digital advertising revenue makes it a potentially lucrative business, on paper at least, but its lack of integration in the real estate transaction caps the company’s true upside. In light of that glass ceiling, Zillow recently announced it will attempt to become a market maker, buying and selling homes. The capital-intensive program was tested in Phoenix and Las Vegas before getting recently expanded as Zillow as noted on the Q3, 2018 earnings call.
The popular opinion among investors is that Zillow is entering the home flipping business competing with SoftBank-backed startup, Opendoor. Instead, I think the right way to think about Zillow is as a market maker, or a provider of liquidity in the extremely fragmented real estate market. That being said, I get it, there’s legitimate risk associated with buying and selling homes. The process also means Zillow will be left with a rather messy balance sheet. And if that weren’t enough, it puts Zillow in direct competition with its customers, the realtors on its platform.
While its current lead generation business makes it easier for people to browse for new houses, Zillow Offers (this is what the company is calling its home buying unit) has the potential to change the game entirely. Zillow is creating a liquid housing market which anyone can access from a smartphone.
Zillow Offers - A Massive Opportunity
I’ll reiterate what I’ve previously written about the dumpster fire that is the real estate market…
Home transactions are frequent in the aggregate, there's always at least one house for sale in your neighborhood at a given time, but for individual buyers and sellers, they are a rare life event. Most people only go through the experience a handful of times. A house is usually the single largest transaction most buyers and sellers undertake, which makes people understandably risk averse. There are also many regulations and a shit ton of paperwork associated with the home-buying/selling process so assistance is quite valuable. However that assistance is not free and people pay it in the form of fees. The United States alone has $25 trillion worth of housing, of which $900 billion changes hands every year. That means well over $90 billion in real estate fees, which is mostly captured by agents skimming 6% off of every transaction. There is a massive reward for disrupting the status quo and becoming a market maker for the broken real estate market. That is Zillow's opportunity.
The company can't come right out and say it is looking to replace real estate agents because, as we have already established, Zillow generates basically all of its revenue selling advertising space to those same real estate agents. Instead Zillow will use realtors on Zillow Offers transactions, kicking agents their 6% commission to keep them happy in the short term.
Ultimately the real estate agents associated with these Zillow Offers transactions are non-vital as the process is almost entirely powered by Zillow's database and realtor commissions will inevitably disappear.
The real risk that the company faces in its pivot from marketing tool to market maker is that real estate agents will revolt and no longer advertise properties on Zillow. However we have years’ worth of evidence that agents will do what it takes to ensure their listings appear on Zillow, because that's where the buyers and sellers are. This is classic Aggregation Theory.
Tying It All Together, Zillow & Aggregation Theory
Realtors have no choice but to continue giving Zillow the money the company needs to complete its pivot and disrupt the real estate industry. The only question that remains is how much power comes from being an Aggregator and how much value can Zillow capture when that power is wielded?
As investors we are always on the lookout for companies with an edge that allows them to dominate in a systematic and predictable way. There are many methods one can use to identify such companies but my favorite is Aggregation Theory.
Zillow, Redfin and Opendoor are the three heavy hitters competing to become real estate market maker. Out of the three, though, Zillow is the only Aggregator.
Nobody can mistake Zillow’s popularity among consumers, as its own zillow.com and trulia.com rank #1 and #4 in terms of web traffic according to SimilarWeb. Redfin’s site comes in at #8 while Opendoor is unranked.
I don't know what Zillow or its margin profile looks like when the company is firing on all cylinders as a market maker but it is a futile discussion right now. The stated goal is to cover every part of the housing transaction and the total addressable market is so huge that you get silly numbers at almost any margin. Given Zillow’s current valuation, a modest ~$6 billion, and the size of the bounty at stake, I’m betting Zillow will be the winning platform because Aggregators thrive in large and fragmented markets like residential real estate.