Why Has Zillow Decided to End the House Flipping Business Program?

This post will at times get a little technical about the "insides" of what's it's like to be working with sellers *before* they list their houses, and it should be noted, that it's an opinion piece.  (Although I did read the full Zillow statement yesterday and there are numerous supporting statements in it.) I think, though, they also left a lot of stuff out (that they'd rather not talk about), and I'm speculating here as to what that is.

On the surface - to wall street types and others - it was a marriage made in heaven.  Zillow, creator of the "Z-estimate", and owner of one of the biggest advertising platforms for houses, would use their estimate power to buy houses direct, fix them (or not) and then flip them for a profit, largely by their own expertise and - importantly - cutting out the real estate agent, to make the process more easy for home owners. Genius, right? I had to answer a lot of questions about "was Zillow going to put me out of business" and the like.  And every time I was asked, I laughed, and usually answered, "Let's see if they make money at it first".  

The issue, you see, cut right to the heart of Zillow's z-estimate.  I know (most professional real estate agents as well!) that Zillow's estimate of a homes value has a LOT of blind spots (especially in places like Massachusetts, but I'm sure it doesn't work as well as they need it to everywhere).  If you're going to be buying (and flipping houses), you need to know what they are worth.  That is a huge starting point. Here's what else you need:

1) You need to know what it's going to be worth when you sell it

2) You need to know how much you're going to spend in fixes and carry costs

3) You have to do all that stuff while doing for less than half the average broker commissions in the area

4) You have to make *enough* money to make it worthwhile.

Guess what? Each of those is HARD.  It is easy to say - from Wall Street, or Seattle - that home buying and selling with the traditional real estate agent model is inefficient.  And expensive.  And unnecessary.  But now with Zillow's announcement - a company that has spent hundreds of millions trying to prove this - we can definitively say it's not nearly as inefficient as Zillow (and others!) think. Let's talk about why. 

Three's a Crowd

When you buy and sell a house, there are two primary cost sharing parties involved.  Buyer and seller.  The real estate agents protect and aid both parties for a fee.  Most agents work alone, under a brokerage, and have (relative to a large corporation) minimal costs.  They use personal cars, personal phones, and tend to stick to their local area, reducing travel time and other overhead.  

How does adding a company (will all the overhead and bureaucracy of a corporation) make this process more efficient? You wouldn't expect it to.  Generally, larger companies need to benefit from economies of scale to offset the additional expenses of "being big", which is why manufacturing is hard for start ups and good for corporations.  But what economies of scale are to be gained in buying houses? Can you save money on recording fees and title companies? Carrying Costs? Reduce fix or update costs? In most cases, the answer is no - these are fixed transactional costs, and there's no large company on the other then to leverage for "bulk pricing" - just independent contractors and governments that are working on fees that most feel are too low already. 

Here's another way to look at it.  When a seller sells a house, they pay their end of the recording fees, the full carrying costs (usually because they are living there), and the listing agent fees.  The buyer takes on the buyer's fees, and the buyer agent fees (yes, I know the fee comes out of the seller's net, but a more accurate accounting is the buyer is paying for the buyer agent fee*). This is all straightforward stuff.  So how does it look when Zillow (or Open Door, or anyone else) does it?  

Well, then you have the seller to Zillow transaction, and then the Zillow to Buyer transaction.  You now have 3 parties, and two transactions, instead of 2 parties and one transaction.  Is this easier for the seller?  I guess so, you don't really have to worry about the buyer not getting financing.  But is this more efficient on paper? It doesn't look so, and it's hard to figure out where any savings are coming from.  Oh, there's no agent! Well, sort of. 

Where did the Real Estate Agent Go?

We'll talk about the "ideal" situation first, and then the "less ideal but closer to actual".

Ideally, for Zillow, the goal was to buy the house direct from the seller based on their pricing model (no agent) and then sell it direct (no agent) on their website.  Selling direct is also called For Sale By Owner, or FSBO, and historically  FSBO's tend to sell about 5% less than they should.  Let's say Zillow was able to cut that in half - 2.5% - they still have to do an extra transaction for 2.5%. And that is to break even.  Ultimately, they probably need to come up with profits (which was the goal) and that's after they pay all the expenses.  (Zillow regrettably axed 2000+ employees who were working on the flipping of homes). 2.5% on a 400,000 house is 10,000. Let's say a goal of profit being 10,000, (frighteningly small) and internal expenses of 10,000, and transaction costs of 10,000.  That's $30,000 of costs that need to be covered, and only $10,000 of room to do it with.  This is starting to not look like a good business, where you lose about $20,000 on each "flip."

The less ideal situation is that Zillow was still paying buyer agents to sell the homes they bought.  So much for the 2.5% saved!  AND, they were also paying agents to come in and tell them what to pay for the house (they didn't trust their computers, and wisely).  These things just make the "theoretical" margins smaller and smaller, and increase the chance you'll never make any money. And the agents?  They haven't gone anywhere.  They are on both sides of the deal, as before. 

What was the plan to make money? 

Most of the talk about getting rid of agents was just that - talk.  It played good on Wall Street, sounded good in the media, and resonated with folks.  But it wasn't the plan.  The plan was to screw sellers.  We've already done the numbers.  Zillow (or any other home buyer), needs at least 20,000 to cover expenses and profits (it's probably more like 30,000), and no buyer is going to pay "extra" for a house.  Buyers pay market.  So where was the money coming from?  

Sellers.  You have to get the purchase price down by your profits and expenses. Just like professional flippers, the money is made at purchase - not at the sale.  That means you have to get the sellers down to a profitable price.  There are many agents (and others!) who have always offered you cash for your home.  But there's a catch - you get convenience, but you don't get market value for your home.  Zillow offered nothing different, except in situations where they overpaid - and took the loss at sale (65% of all their sales were underwater according to various media outlets).  Here's how the conversation goes:

Seller:  What will you pay me for my house?

Flipper/Zillow:  $420,000.

Seller: But my house is worth $450,000! 

Flipper/Zillow: Maybe, but we will take all the risk, let you close when you want, and pay cash. 

Seller: That's great, but 30,000 is a lot of money.  No thanks, I'll take the 30,000. 

I mean DUH!  Almost everyone wants the money!! It's a lot of money!!  In fact, Zillow stated that 90% of all "serious" home sellers weren't interested in Zillow's cash offer.  I bet the numbers were even more brutal when you start counting the "non-serious" sellers. I bet for every 200 inquires, they probably got one house to buy.  Which house?  The house where they mis-calcuated what it was worth, and paid the seller too much.

Home Sellers Aren't Stupid

Do I really need to point this out?  Home sellers have generally good ideas about what their house is worth.  They pay attention.  Most are close.  On average, they tend to overvalue their house a bit, because most of them love their house, but they generally don't grossly undervalue it.  And they get second (and third) opinions often, and they generally demand information to help them piece out the puzzle and make sure they have it right.  Sellers can do math.  And if you have an inefficient model that is going to take money out of a seller's pocket,  they are going to figure that out, and not do business with you. 

Ultimately, that is what today's announcement says.  Despite all the criticism that Real Estate Agents often get, the fact is we are pretty efficient at what we do, and we deliver more value than most other models (currently all other models!). Is there a faster, better, cheaper way to sell a house?  I'm not sure there is, but I spend a lot of time thinking about it.  Zillow did too - and spent hundreds of millions of dollars hiring very smart people and putting a plan into execution.  They failed spectacularly.  My clients are very happy with the value they get on the purchase side and the sale side.  I help them make and save money, with the largest single investment most of them will ever have.  The advice I give is hard to standardize, because people and houses are all custom, and the deals we do are custom.  People value real estate agents because the advice we give isn't generalize, it's specific to their purchase, and their sale. As long as that remains the case, computers are going to have a hard time catching up.


*Really, the buyer pays the fee.  If the buyer doesn't buy the house, no fee is generated.  It's the buyer's money that allows a fee to be collected, as such he is equally responsible for payment.