Instant Over-Reaction: Zillow Exits the I-Buyer Space

The news that Zillow was exiting the i-buyer space caught the real estate industry by surprise last week. Zillow Offers had been one of the dominant players in that space, and its abrupt departure was met with a wide range of reactions – and over-reactions – leading to a number of important questions.

Did Zillow know something about the housing market that others didn’t? Did Zillow’s massive financial losses show an underlying problem with its popular Zestimate? Would Zillow Offers exit have a major impact on home prices in its markets? Was i-buying as a business doomed to failure?

Let’s attempt to answer a few of these questions.

Did Zillow cancel its Zillow Offers program because it saw something troubling in the overall direction of the housing market and home prices?

No. This has nothing to do with the overall direction of the housing market, where the fundamentals remain extremely strong. It has everything to do with a fundamental flaw in the Zillow Offers business model. Investors who flip properties typically make the mistake of either over-valuing a property (paying too much) or underestimating the time and cost needed to bring the property back to market. Zillow Offers appears to have made both mistakes and done so at a large enough scale to result in hundreds of millions of dollars of losses. Published reports noted that Zillow Offers lost over $300 million in the past quarter and has another 18,000 homes on its books or under contract that it expects to take losses on. Zillow exiting the i-buyer market is not a sign of an impending housing market crash; it was a business decision.

Will Zillow’s exit from i-buying have a negative impact on home sales and prices in the markets where it was operating?

It seems unlikely that Zillow controlled enough inventory in any of its Zillow Offers markets to have a material impact on home sales or prices, although we might see a short-term decrease in home price appreciation. While it’s likely that Zillow will be selling off their homes at a loss, it wouldn’t be a surprise to see the homes listed and sold at or near full market value. Zillow will lose money on the sales simply due to the fact that they overpaid for the properties. It’s highly unlikely that we’ll see Zillow sell off all of these properties at once, at fire-sale prices. It’s also unlikely that ZIllow was buying a high enough volume of homes that their departure will significantly reduce demand in those markets. There are other i-buyers, individual and institutional investors and consumer homebuyers who will fill whatever void Zillow’s departure might temporarily have created.

Does the failure of Zillow Offers have any implications for the future of the i-buying model?

Zillow’s exit confirms a basic truth: i-buying is hard to do well. In traditional fix-and-flip investing major property improvements often generate much of the profit. On the other hand, i-buying is pretty much arbitrage – buy an asset for a lower value than you plan to sell it for. Margins are generally fairly slim, and it’s critical to get the math right when determining the purchase price and estimating repair and resale costs. The other major i-buyers appear to have been more successful in adjusting their “buy boxes” to reduce losses and improve profit margins on their sales. Purely speculating here, but that might be because the other i-buyers put more emphasis on local market intelligence and less on a price-estimating algorithm.

We may also see a new generation of i-buyers become more prominent in the industry – i-buyers who focus exclusively on local markets and don’t aspire to scale their businesses nationally. This is what happened in the single-family rental market; after institutional investors entered that business, smaller investors sprouted up in various cities and regions, and we’re already seeing some small-to-mid-sized investors promoting their local i-buying offers in a number of markets.

Speaking of algorithms, doesn’t this prove once and for all that the Zestimate isn’t an accurate estimating tool?

Not at all. No one from Zillow has ever claimed that the Zestimate was 100% accurate, or that it should be used to determine the absolute price of a home. But the Zestimate has come a long way in terms of its accuracy since being launched in 2006. In fact, Zillow notes that nationally, the Zestimate is typically within 1.9% of the sale price on listed homes, and within 6.9% on off-market properties.  But the company also very clearly states that the Zestimate “is not an appraisal, and cannot be used in place of an appraisal,” and encourages “buyers, sellers and homeowners to supplement the Zestimate with other research, such as visiting the home, getting a professional appraisal of the home, or requesting a comparative market analysis (CMA) from a real estate agent.”

One of the factors that enabled i-buying in the first place was the availability of automated valuation models (AVMs) that can give buyers a close approximation of a home’s market value. But any AVM – whether a Zestimate, or a more expensive, proprietary algorithm – is always best used as a starting point, with price adjustments factored in to account for property condition, repair costs, approximate time on market, local sales trends, and costs incurred in sales and marketing activities. Those (and other) criteria all need to be considered prior to making an offer that allows the buyer to subsequently sell a property at a reasonable profit. Even if Zillow used its Zestimate as the only tool to approximate a home’s value, the mistakes were more likely in the adjustments made to the Zestimate rather than in the Zestimate itself. As noted above, i-buying margins are notoriously slim; a 5% miscalculation in the offer price on a $500,000 home could result in a potential $25,000 loss on a single transaction. Perhaps there was too much reliance on the Zestimate as part of the Zillow Offers process, but the problems appear to have been much deeper and more fundamental than the accuracy of the algorithm.