Should You Stay Away From This Real Estate Stock?

December 3, 2021
By The Investing Insider Staff

Instead of creating a housing bust, the pandemic spurred one of the most competitive and tight housing markets in U.S. history.

But are the good times about to end for this real estate stock?

A couple factors aiding the recent housing boom were record-low interest rates and Quantitative Easing by the U.S. Federal Reserve.

Between August 2020 and August 2021, home prices increased by a record 19.9%, surpassing the previous highest 12-month price increase of 14.1%, which occurred in the run-up to the 2008 financial crisis.

However, in the past few months as more inventory entered the market and fewer purchasers engaged in bidding wars, the housing market has started to stagnate.

Zillow Group Inc. (ZG:NASD) is currently feeling the effects of this situation.

The company is discontinuing its algorithm-powered home-flipping operations, after an ambitious effort to transform. The company collapsed when its pricing algorithms failed in its function. According to the company's Q3 earnings, its home-flipping segment, Zillow Offers, lost more than US$380 million.

Business Model of Zillow

Back in 2018, the real estate listings company Zillow announced that they were getting into the business of buying and selling homes rather than just listing them online. They claimed there was an opportunity in acting as a “market maker”, flipping houses within months to earn small but consistent profits.

Zillow was already dominant in the online listings space where they charged real estate agents for online leads. Afterward, they wanted to capture more of the economics of each transaction.

As a result, they launched “Zillow Offers,” a new service.

Here, homeowners may request an offer on their home, and Zillow would determine a price using its algorithms. If the seller agrees, Zillow will purchase the property, make some minor repairs, and relist it for sale. They would operate as industrial-scale flippers, earning money on price appreciation and the spread that they charge.

The Trouble with The Algorithm

When the algorithm was first released in 2018, Zillow stated that it had taken a lot of prudent measures to mitigate and minimize risk while designing the algorithm. They tested this predictive model using historical data and several simulations.

The unit economics goals required them to keep within 200 basis points of breakeven, eventually transacting enough to profit. The purchasing prices were adjusted based on consumer demand trends and data that they had on the housing market. They eventually altered their selling prices to match market conditions.

In recent months, Zillow changed its algorithms to make more aggressive offers, causing them to overpay for homes precisely as the US housing market began cooling. Despite having a reasonable balance sheet, Zillow went into trouble by holding illiquid houses for a thin profit margin.

Lessons For Zillow

It is a big challenge to account for unknown variables when utilizing historical models and algorithms to make buy and sell choices in something as large and complex as the housing market. It was commonly acknowledged that millennials were approaching the prime age for starting a family and that housing demand would surge.

However, no one could have predicted how quickly a global pandemic would alter the housing market's fundamentals. On the company’s earnings call, CEO Rich Barton cited price forecasting volatility as one of the main reasons Zillow has been overpaying for houses.

Another cause for Zillow's collapse was its over-reliance on the algorithm.

For example, Zillow might list two houses as “comparables” even if they have vast differences between them. Many property purchasers consider qualitative factors that aren't taken into account by Zillow's algorithm.

As a result, this caused them to misprice houses which were ultimately exploited by many buyers and sellers. Most successful flipping is done by local flippers using intimate knowledge of existing home conditions, renovation costs, and market idiosyncrasies, which is very difficult to obtain purely through an automated home value estimate.

Finally, Market Making is an uncertain strategy in the real estate market. In the stock market, the standard high-frequency trading market-maker buys and sells stocks at a very quick pace since it has high liquidity and the prices don’t have sufficient time to move. However, the real estate market is rather illiquid, and selling a home might take anywhere from 3 to 6 months. Therefore, the organization is extremely vulnerable to liquidity risk during those months.

Should you “Buy the Dip?”

A dessert that is not sweet couldn’t be called a dessert.

In this case, Zillow was the dessert, and “Zillow Offers” was the sweetness because of which it was valued so high.

Now, when “Zillow Offers” is discontinued, does it make sense to buy a dessert that is not sweet? It may take a long time to first recover the losses and then again build a platform enough sustainable, that would be capable to recover the wealth lost.

In many cases, companies may never recover.

Not every dip is worth buying – and this could be one of those times…

-Investing Insider Staff
This article is informational purposes only and is not investment advice.  See full disclaimer here
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