The US Residential Real Estate Market Lost a Few Whales


If you follow the US real estate market at all, you’ve probably heard about these “iBuyer” (instant buyer) programs started by some of the large real estate data companies like Zillow and Opendoor.

The idea is that these firms hire really smart quantitative researchers who can create real estate pricing models that can accurately value a house, as well as project the value in 3-6 months.

If they can buy a house meaningfully below their theoretical value, then they can make a profit. 

So they offer to buy their customers houses in minutes with an instant offer after some basic information is collected.

What Are iBuyers?

iBuyer stands for “instant buyer.” These are large, well-capitalized real estate buyers like Zillow (Z) and Redfin (RDFN) that stand willing and ready to buy most houses in the United States for the right price.

Their quants figure out a model to quickly model a price to buy your house which will be profitable for them, while being acceptable to you for the convenience of immediate liquidity.

The edge in iBuying comes from superior data. It makes sense that real estate data companies like Zillow and Redfin got into the business because those who have the best data and the best interpretation of the data wins.

Theoretically, this is a very smart business model. There are a lot of homeowners that want to sell quickly and are willing to take a minor haircut in exchange for an instant, stress-free sale.

There’s an entire industry of real estate investors who make money solely off of this phenomenon, scouring their local areas for “motivated sellers,” like the widow who wants to move in with her family or the empty nesters that want to move down near their children. 

It’s the classic situation of non-economic sellers. The type of people who sell to iBuyers aren’t selling to maximize their returns, they simply want to sell their house so they can move elsewhere, size down, need cash quickly, or a number of other non-economic reasons. 

The iBuyers aim to act as market makers, much in the way Citadel does in the equity markets. They sit on both sides of the market, willing to buy and sell on the bid and ask, collecting the spread in-between. The difference is that iBuyers only buy houses, so they don’t have a short inventory to hedge against a downturn in the real estate market. 

Besides pricing models being incorrect, the biggest risk market movers usually have is inventory risk.

This is the risk that in the midst of making a market, the price of the inventory you hold changes significantly against you. In the equity markets, this is easier to mitigate because of the relatively tight spreads and high liquidity.

If you’re an equities market maker and you’ve built up a huge inventory of Ford (F) stock, you can buy some Ford options, or even short some General Motors (GM) stock to hedge your inventory risk. 

However, real estate is a very slow moving market.

A transaction between two very motivated parties can still take months to close due to all of the outside parties that need to get involved like title companies, inspectors, attorneys, and whatnot. So the inventory risk real estate market makers like iBuyers take is paramount.

They could be holding their inventory for months while a traditional equities market maker might hold their inventory for seconds or minutes. 

For this reason, it’s necessary for iBuyers to project houses 3-6 months into the future, because that is their predicted holding period. In 3-6 months, a lot can change, like a super hot real estate market experiencing a slowdown, forcing companies to mark down the value of their inventory significantly. 

Furthermore, there’s no way to short-sell a house, so iBuyers only buy houses. This means that all of their inventory risk is in one direction, making hedging that risk out much more difficult.

There are no derivatives you can buy to hedge against a specific neighborhood’s price decline like you can in the equities markets. 

How Will iBuyer Failures Affect the US Real Estate Market?

While it’s easy to paint iBuyers as some sort of disruptive “Uber of Real Estate,” the reality is that they haven’t penetrated the real estate that much yet.

Most of them only operate in major metro areas and their accompanying suburbs. Morgan Stanley estimates that their total market share of the US residential real estate market will be only 3-5% by 2030. So it’s safe to say that a few big iBuyers exiting the market won’t be a huge deal. 

Furthermore, they’re not really doing anything regular real estate investors have been doing for years. They have a landing page that they drive motivated sellers to, estimate a value for the house, then give the seller a cash offer for the house.

The primary difference is that iBuyers do this at scale across several different regions, while individual investors might just focus on one neighborhood where they’re an expert, and iBuyers have an amazing source of traffic

However, this has huge implications for real estate investors. Much of the chatter from folks in the industry was assuming that the days of extreme information asymmetry in real estate are over.

How could you possibly negotiate a great deal when the seller could always get an all-cash offer from an iBuyer better than yours? This is a big win for the classic, back-of-the-envelope, gut-feeling landlords and house flippers that know a neighborhood intimately.

Fancy quantitative models couldn’t beat them.

Zillow’s Exit from iBuying: The Beginning of the End?

Zillow has exited the iBuying business called Zillow Offers. They wrote down their housing inventory $380 million, with another ~$300 million writedown coming next quarter, and laid off 25% of their workforce. 

Not only are they marking down their inventory, but they’re offloading it too. They just sold 2,000 homes to a large real estate investor called Pretium Partners. 

So what happened? The models got it wrong.

While competitors Opendoor (OPEN) and Redfin (RDFN) began scaling back their buying by making lower offers, Zillow’s models got more aggressive and began paying up for houses. Then the housing market slowed down, leaving with a bunch of inventory that they overpaid for. 

The interesting factor here is human intervention.

Zillow’s pitch with iBuying was that their expert quants would create great models free of human irrationality. You don’t have a hard-nosed contractor “taking a chance” on a house, but instead you have a model that estimates how much you can pay for a house to make it profitable.

But Zillow’s quants tweaked with the algorithm to make it more aggressive, scooping up houses at elevated prices while their competitors were taking a step back. 

Bottom Line

iBuying is not done. Zillow is out of the game, but Opendoor (OPEN) and Redfin (RDFN) are still in the game. But Zillow’s painful exit strikes a blow to investor confidence in the industry and brings important questions to the forefront. 

It was Zillow’s models that got it wrong this time, but it could be Opendoor next time. Furthermore, if a model getting it wrong shuts your business down, are you in the right business, or are you over concentrated?

These are questions the other iBuyers have to answer now that there’s a dent in their armor. 

The post The US Residential Real Estate Market Lost a Few Whales appeared first on Warrior Trading.

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