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Zillow Offers Expansion Makes the Real Estate Company Extra Risky

The massive housing boom that led up to the financial markets collapse was a game of musical chairs where buyers and sellers sought to not be the last person holding onto a property when the music finally stopped.

While the current real estate market doesn't seem to be in the same kind of bubble it was before the Great Recession, Zillow (NASDAQ: Z) is significantly magnifying its risk by expanding its Zillow Offers program. If another decline does hit housing, the real estate information technology company will be the one left standing without a chair to sit on.

Image source: Getty Images.

Eliminating home sales hassles

Zillow Offers has the potential to dramatically alter the way homes are bought and sold. Other so-called i-buyers exist on the market, and some, like Opendoor, are much larger than Zillow. However, because Zillow's database of information and access to Multiple Listing Service home sales data give it a competitive edge, it's likely Zillow Offers will eventually become the biggest name in the business.

Here's how Zillow Offers works. Homeowners can request Zillow to make an instant cash offer on their property, and through a combination of algorithms, owner-supplied information, local real estate agent contacts, and an inspection to determine repairs and costs, Zillow will make an offer to buy the home.

For the homeowner, the benefit is obvious. There's no need to wait around for a buyer to materialize, relieving one of the primary pressure points in a real estate transaction: selling your current home before being able to close on the next one. For Zillow, it wants to buy and sell as many as 5,000 homes a month to "deliver 400 to 500 basis points of return before interest expense" on each one.

Now Zillow is expanding the program and has signed on nine homebuilders to participate. The main difference is that when a house is purchased from one of the partners, the buyer can extend the closing date out for as long as eight months to allow the house to be finished.

Revenues rise, but so do costs

So far business is good for Zillow, but it is increasing its risk by further expanding the Offers program.

Revenues more than doubled in the third quarter, primarily due to the Zillow Offers program. It began selling homes in July of 2018, and sales grew to $384 million in the latest period, from $11 million the year before. The Homes segment is now Zillow's largest revenue contributor, accounting for 52% of the total.

It sold 1,211 homes at an average selling price of $317,600, up from the 36 homes in the year-ago period at an average price of $306,100. However, the program has also increased its costs.

Cost of revenue soared year over year to $371 million from $10 million due to the Offers program as acquisition and renovation costs pushed expenses higher. Zillow expects these costs to continue rising in absolute dollars as it buys more homes.

Buying homes is also increasing Zillow's indebtedness. It primarily uses debt financing to pay for a portion of the purchase price of homes and the renovation costs. As of the end of the last quarter, Zillow had $698 million in total borrowings with a maximum borrowing capacity of $1 billion. Long-term debt has more than doubled to almost $1.5 billion.

The greatest risk, however, comes if there is another recession.

A dangerous game to play

Although demand seems to be in Zillow's favor at the moment, it is scaling up this program quickly. Having as many as 60,000 homes in its inventory when another collapse hits -- it doesn't even have to be nearly as severe as last time -- could cause the real estate company significant financial harm.

While it will be able to control the number of offers it makes -- Zillow notes it received 80,000 requests for it to make an offer last quarter -- if the decline is swift, it could still cause pain. It has obligations for $221 million worth of homes already under contract, which at an average price of $320,000 each amounts to fewer than 700 homes. Vastly scaling up that inventory will also cause its obligations to balloon, which would be problematic in a bear market.

More real estate agents may balk at participating. It's already seeing some pushback with its Premier Agent program, and it may find more agents chafing at helping their competition undermine their sales potential.

When the tide is rising, the housing market can be extremely lucrative. Offers gives Zillow the chance to beat out Opendoor, Offerpad, and Keller Offers for the top home buyer. But it also risks being the biggest when the market falls and the music stops, leaving it unable to unload its inventory with obligations to pay that it can't offset with sales.

Zillow looks like a growth stock now, but it's playing a game investors should be leery about joining.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Zillow Group (C shares). The Motley Fool has a disclosure policy.


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