The internet is the most disruptive business platform ever — yet real estate seems impervious.
We live in the golden age of information. With access to the internet, everyone can become an "expert" in real time. Whatever you want to know, there's usually a way to obtain this information immediately and, if you're not too naïve, fairly accurately.
The ability to obtain information about goods and services has been a boon to consumers. For example, if you're in the market for a new dishwasher, it is easy enough to research consumer reports on models, obtain the average price paid in your neck of the woods, and check local inventories. This is all done online and takes minimal time and knowledge; basically, if you're a buyer, the internet has become your most powerful research and pricing tool.
Not surprisingly, pricing in most industries has become much more competitive as a direct result of the internet. Look, for instance, at the automotive industry. Or, better yet, let's look at what Digital Trends says about the automotive industry:
By the end of the 1990s, the Internet had changed the car-buying game - at least for those who knew how to access the information and use it. You could specify a car online, and someone from the "Internet Sales" department would call you with a price. Because you could get bids from several dealers, they couldn't tie you up in the endless "sales manager" game of wearing you down to utter defeat, so they just gave you a pretty good price.
More recently, outfits like CarMax and TrueCar further refined that process by putting a nationwide stock of used cars together and telling you how much you can really expect to pay for a new car. On top of that, Tesla's direct-sales model truly put fear into the heart of every car dealer in America. All of that was just phase one. And what's next is really going to shake things up.
As Digital Trends says, the internet has taken car buying down to levels where the sellers are getting slim to zero margins. They are willing to do this to obtain other business (loans, service, repair work, etc.). Moreover, the other important point that they mention is the fear of the direct sales model. This is where the consumer can go direct to the seller and cut out the middle man completely.
The internet has created a similar scenario of disruption in many other industries. Buying life insurance…who needs a broker? Buying stocks…trade them online if you want. Getting a mortgage? Just apply directly online.
The list is long and pretty much inclusive. It seems that consumers have the world at their fingertips and the ability to drive a hard bargain, buy at close to cost and really cut out the middlemen who add little value, yet take a piece of the pie. There is, however, one business that seems to be impervious to the margin squeezing effect of the internet; residential home sales.
Gen-Xers are the next generation of home buyers
Looking at what happened with car buying, one would imagine that the role of the real estate agent would be affected in a similar way. For example, in the past, a car buyer would go to multiple dealers, kick the tires, drive a few around, then make their decision. Similarly, a home buyer would have their agent take them to a few neighborhoods, discuss the pluses and minuses of each, and show them the available listings in their price range.
Today, however, I would gather that most car buyers do their homework a long time before they hit the dealer. They research the model, know the options they want, and show up with an Edmunds price sheet in hand. They have taken the majority of the sales role out of the equation. And, it's a similar situation with home buying. Home buyers have a world of information at their fingertips, including school data, crime data, etc. Most importantly, they can see the available inventory on line in advance and also see the "market value" of each house as determined by Zillow or some other online service.
Now I'm not saying you don't need a Realtor, but I am saying that a lot of the job of the Realtor can be done by the buyers or sellers themselves. And, if you look outside the US, there is evidence that this is happening. For example, in British Colombia there is a sliding scale; Realtors make 3% on the first couple hundred thousand of a sale price and as little as 1% on the balance. However, this is better than Quebec where as much as 50% of all sales don't even involve a Realtor.
Or look at the UK. An article from The Economist, titled "The Great Realtor Rip-off", says the following:
In Britain, if you want to sell your home, an estate agent will list the property, find a buyer, help you negotiate a deal and guide you through the transaction, all for a commission of 2-3% of the sale price. In America, Realtors provide the same services for roughly double the fee.
Now, I love The Economist. It is my favorite magazine. Yet, they are not perfect and, in this case, they are at a loss to explain US Realtor fees.
Economists are baffled. The internet has squelched inefficient middlemen in other industries, from insurance brokers to travel agents. Why not American Realtors? Although scores of discount brokers and for-sale-by-owner websites have sprouted up, traditional full-service Realtors have somehow maintained their market share of 80% without reducing fees.
Not to say that I'm smarter than the Economist; I'm definitely not. However, I do have a theory as to why real estate transaction costs haven't come down yet, why I think they are on the verge of a decline, and, even more importantly, why home buying and selling is going to change in the US.
It all stems from demographics; I believe the baby boomer generation is scared to NOT use a Realtor. The real estate industry pitches homes as "your single largest investment" and tells you that there is a quagmire of paperwork involved, plus potential liabilities, if you try to go it on your own. This is all complete hogwash. However, the baby boomer generation is still scared to put their credit cards online and doesn't have the confidence to tell their neighborhood Realtor, "hey, I don't need you. I can do this on my own." Instead, using a Realtor is like a cozy blanket; it makes you feel safe and warm.
The next generation, however, doesn't trust people. They have more confidence in what they can research and do online than they have from the Realtor looking to make a very large commission off of their hard work. And, it's a lot of hard work. When you look at certain areas of the country, Realtor fees can be well over $100,000. That's often a year's pre-tax income for an American, much less giving that up after tax!
So, my read on demographics is that the next couple of decades of real estate transactions in the US will be led by Gen X. And, they are not scared to venture into the world of the internet or do it yourself. Plus, they will look at Realtor fees increasing faster than their incomes and saying, enough!
Check out these headlines:
"Gen X Home Ownership on the Rise" - Daily Real Estate News (May 2, 2016)
"Gen-X Homeownership Continues Rising in the First Quarter of 2016" - National Association of Home Builders' Eye on Housing (April 28, 2016)
"Gen X Back in the Housing Game Despite Overall Dip in U.S. Home Ownership" - Construction Dive (April 29, 2016)
It's happening, folks. We are seeing the end of the baby boomer era in the US. The boomers are aging. They are done with buying homes and they are settling into their golden years. The "Greatest Generation" is nearing its conclusion.
There was, as would be expected, a decline in home sales as we move from the generation of the baby boomers into Gen X. Making this markedly more dramatic is that Gen X is not working off the same time table as the boomers. They are marrying later, starting families later and buying homes later. (By the way, this is even more pronounced in the Millennials…see the NY Times Blog "Millennials, Living in Their Parents Basement")
Thus, the last decade or so has seen a cosmic shift in most industries as the internet has altered, or decimated, previous operating models. But, it hasn't affected residential real estate transactions because the people doing the transactions are old school. That's right, in my opinion, the vast majority of sales in real estate (not purchases, but the sell side) are taking place with boomers listing homes. And, they don't know the internet, don't trust the internet, and want a Realtor to hold their hand through the process.
We are approaching the end of this cycle. As more Gen Xers start buying larger homes or selling their aging parents properties, I believe we will enter a cycle of internet savvy sellers really questioning the value of a Realtor. And, this appears to be happening now. According to Total Mortgage, while FSBO (For Sale By Owner) hasn't picked up dramatically, there is a "renewal of interest among home sellers in trying to find a way to forgo the traditional six percent commission that real estate brokerages charge. Typically, that means marketing their homes on their own…the Internet may be empowering consumers to reduce the fees they pay real estate brokerages."
Zillow is the Amazon of Real Estate on the Internet
I have a few beliefs regarding real estate. First, I believe that home building and home ownership will accelerate. We have under built for years and Gen X hasn't really wanted to participate in home ownership. However, we all start to age and, as people get older, they want to build a nest egg. Owning one's house has always been a cornerstone of this and it will continue to be so.
As you can see, housing starts in the US have been well below trend for years. They are starting to pick up and my internal "reversion to the mean" logic says that they will continue to do so until the pendulum swings to above average housing starts sometime in the next few years.
Now, I've already mentioned that Gen X is appearing to finally be accelerating their participation in the housing market; this is confirmed by the housing starts. How they get into the market is going to be different than in the past, however. They don't have experience with Realtors. Heck, a lot of Gen Xers and Millennials don't have experience dealing with anyone live, they are used to voice recognition software, the internet, etc. Thus, as the real estate market picks up, internet usage for real estate transactions will increase. And, this is where Zillow comes into play.
Zillow is the dominant force for real estate on the internet. According to the above graph, if you add in Trulia, which was purchased by them, Zillow accounts for 59% of all unique viewers for real estate websites in the US. This is compelling data, but what makes it even more so is the fact that this data is a year old. According to Zillow's recent earnings call, traffic in January was at 150 million unique viewers and is growing 15 to 25% year over year. For people looking to buy a house, Zillow is the most used option.
For those selling their house, Zillow is again the dominant player. They have an option for listing FSBO, but more importantly they have a Premier Agent program where they steer buyers to agents. Zillow claims that the real estate commission market is a $75B market and that they have had their hand in $3.5B of transactions in 2015 through this program. That $3.5B number is a 27% year over year growth rate, by the way, and makes them the industry leader. Furthermore, Zillow is guiding towards large increases in revenue and EBITDA this year, meaning they believe they are maintaining, if not increasing, their dominant market position.
I believe that market leadership is the most important thing towards which a company can aspire. When Amazon first came public, there were a lot of skeptics that said it was overvalued. There were also a lot of visionaries that saw Amazon's potential. Amazon took an old business model, brick and mortar retailing, and blew it up. I believe Zillow is doing the same thing with the real estate industry:
In what could be seen as a symbolic branding triumph for Zillow, consumers recently became more likely to search "zillow" on Google than "real estate." [Inman, April 26, 2016]
Valuing Zillow, knowing it's a market leader that is investing in their future, becomes a very tricky thing. Do you value it based on its projected earnings? I think to do so would be incredibly short sighted. As a holder of Z, I want them to lose money, investing in the future. I want them to take out all the competitors making themselves synonymous with real estate. I want them to dominate real estate the way Amazon dominates retail.
At the end of the day, I think you value Z based on the potential market size. There is over $1T in real estate changing hands in the US every year. If commissions get cut to 3%, that's $30B. I think it would be easy to see Z taking 20% of this market over time. And, this is just the transaction market. Throw in their mortgage business, leasing, rentals, advertising, etc. and you have a company that has a potential run rate of well over $10B, in high margin business. Heck, they have barely started to scratch the surface of their potential and yet they project over $800 million in revenue in 2016.
Now, I know this is strictly back of the envelope accounting and has large room for errors. That's not the point. Rather, the point is that Z is going to dominate a large market and the potential upside is tremendous. All for a company with current market cap of $6B.
I don't know what the future holds, but I do know fellow leader Amazon has a $300B market cap. More interestingly, over the last 10 years, AMZN market cap has tracked its revenue to a high degree. Amazon, like Zillow, has sacrificed near term profits for long term dominance. I suspect the market cap of Zillow should track their revenue growth as well. Therefore, as long as its future looks like one of growth and dominance, I will continue to be a strong supporter of Z.
At the end of the day, Zillow will leave the competition weeping
Just as the internet is a great disrupter, shredding older business models, it is also a great consolidator. As we've seen with Walmart destroying the Mom and Pop stores, Amazon is currently taking over retail online, Google is synonymous with search these days, and Facebook is the only social media platform most people use. All these companies have taken advantage of the scale of the internet, invested heavily (suffering years of losses) and now have a dominant position. I suspect Zillow is going to accomplish the same thing.
This is not a company you should try to put a multiple on. Instead, look at the size of the marketplace, the trends in the business and ask yourself: Does Zillow have what it takes to be the 800-pound gorilla in this space? I believe the answer is yes.
Disclosure: I am/we are long Z.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.