Real estate business

Is an algorithmic real estate business inherently risky?

It’s not every day that a business owner gets up and says, you know this huge business opportunity that we put money into and thought we were the bee’s knee? Well, we have to stop doing this PDQ thing, otherwise it could bankrupt the company.

This is essentially the message Rich Barton, co-founder and CEO of Zillow Group Inc., was forced to deliver on November 2.

His $ 22 billion company closes its Zillow Offers iBuying business – the digital home flip, for you and me – after its pricing algorithms failed to predict house prices accurately, causing heavy losses.

During a conference call explaining the decision to shut down the unit, which unfortunately results in major layoffs, Barton said pricing errors had made Zillow a “leveraged real estate trader” and that his models and assumptions had “a high probability, at some point, of putting the whole company at risk.

If this is indeed a serious risk, then the only possible conclusion from Zillow’s humiliating about-face is this: it is absolutely the right thing to do. Zillow still has a very popular real estate listing website. It may not have the rapid growth and total addressable market (TAM) of iBuying, but its margins are significantly better (the adjusted ebitda margin of the Internet, media and technology segment was 43% in the third quarter. ). There is no shame in focusing on this, as well as adjacent businesses that don’t involve betting on the business.

I’m sure this episode and Barton’s answer will one day become a business school case study. (By his own admission, Zillow got into iBuying in part for defensive reasons. Looking back, that wasn’t a good reason. But should companies stick with what they are doing? better? Of course: provided they’re willing to risk being disturbed.)

At this point, an important question remains unanswered: Is iBuying terribly risky, or was Zillow really bad at it? It sounds like an evasion, but I guess it’s a bit of both.

IBuying’s still relatively new activity first caught my attention a year ago when Zillow’s big rival, Opendoor Technologies Inc., announced that it would go public via a Chamath Palihapitiya SPAC, and that Stunned retail investors called it “the Amazon of housing.” (Palihapitiya called it his next 10x idea.)

IBuyers buy houses, renovate them and sell them a few months later. There is no doubt that Opendoor, Zillow Offers and their ilk provide a convenient service – they offer cash offers and much of the process takes place digitally – but the rich reviews seemed to ignore how low that margin is. and a lot of capital.

These companies need a large scale for the investments to be profitable. But with the scale comes even more risk, a point Barton made this week. There are so many houses in inventory. What happens when the housing market suddenly cools down and an iBuyer is left with a rapidly depreciating asset along with significant inventory holding costs such as financing? The $ 300 million inventory write-downs that Zillow has taken suggest things can go wrong pretty quickly.

I’m sure Opendoor will also be asked a version of the same question next week when it prepares to release third quarter results. He’s sure to put up a fiery defense. (A spokesperson told Bloomberg News he was “well positioned to meet consumer demand” and “open for business.”)

IBuyers stress that they are not trying to take a massive punt in the housing market. They aim to make money from the fixed fees they charge to sellers and buyers, not from rising house prices.

Right now, of course, the appreciation in house prices creates an additional benefit – because by the time the iBuyer comes to sell them, they are worth more. This is one of the reasons Opendoor made a small adjusted profit in its last quarter. Offerpad Solutions Inc. is also making decent money, given that it is still quite small. Just because – to use Barton’s words – Zillow took a “big hit” and missed it, these others won’t too.

Although the US real estate market has cooled somewhat recently, conditions remain relatively favorable. This suggests that Zillow missed its golden opportunity, due to a combination of unnecessary algorithms and an inability to meet demand. In contrast, when the pandemic caused the housing market to temporarily shut down last year, Opendoor lost its stock at an impressive rate (although this hampered sales when the market quickly rebounded). With Zillow now leaving the scene, he has one less competitor to fear.

Even so, after Zillow’s humility, there will certainly be a reassessment of iBuying’s risks. This is not a bad thing. It is better that all the vulnerabilities of this business model become apparent now. These companies still only sell a few thousand homes a year. It’s scary to imagine what it would have been like if the weaknesses manifested themselves after taking control of the entire housing market.

Chris Bryant is a Bloomberg Opinion columnist covering industrial companies.

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