Method to the Madness: Thoughts on the Redfin 2017 Earnings Call

One of my recurring dreams is that some kind of IPO fever sweeps real estate, and dozens of brokerages go public. I want to see KW’s numbers, hear Hoddy Hanna on an earnings call, gain transparency into what Kuba over at RealtyOne is thinking, etc. I can’t wait for Compass to go public, so we can learn what Ori Allon and Robert Reffkin are doing over there.

Alas, as far as brokerages go, there are only three I can look at. One is Realogy, which is more than just a brokerage, but there’s enough there to make it worth while to see what they’re doing. I just wrote about them.

The other is Redfin, which is actually an agent team that calls itself a brokerage and ever since their IPO last year, they have quickly become The Most Important Brokerage in North America for a number of reasons.

(The third is eXp Realty, the small-but-fast-growing “virtual brokerage” who hasn’t reported Q4/2017 as of this writing, and they don’t do earnings calls as far as I know because no Wall Street analyst covers them… yet.)

The reason why Redfin is so important is that Redfin is painting a picture of what real estate brokerage services might look like in the future. What they’re doing now is probably just a shadow of what they’ll actually be doing in 5, 10, 20 years’ time. (Assuming they’re still around, of course.) But what they’re doing today points the way to what they will be doing tomorrow.

And there are good reasons to think that what they will be doing tomorrow is what everybody else will have to do as well….

Let’s get into it.

First, the Numbers

Redfin’s Q4 and full-year 2017 results are… well, deflating if you think of Redfin as a tech company and jaw-dropping awesome if you think of them as a real estate brokerage.

For example, Redfin posted the following results for full year 2017:

• Revenue of $370.0 million
• Gross Profit of $111.8 million, which means Gross Margins of 30.2%
• Net Loss of $15.0 million

Redfin investors, of which I am not one, can take comfort in the improvements over previous years. For example, it’s not great to lose $15 million, but that’s a 33.4% improvement over 2016 Net Loss of $22.5 million.

But here’s what I mean by the “tech company” vs “real estate brokerage” making all the difference.

For 2017, Zillow Group posted revenues of $1.08 billion with $85 million in cost of revenue for a 92.1% gross profit margin. Alphabet (Google’s parent company) has historical gross margins in the 60% range. Facebook’s gross margin in 2017 was 87.6%. They then go and spend a bundle on technology, marketing, and so on, but their gross profits are ginormous.

Compared to that, Redfin looks like ass with 30.2% in gross margins. A bunch of bear analysts knock the hell out of Redfin for this reason alone, and I imagine they have a solid point. It’s hard to give a Redfin tech company valuations if it doesn’t have tech company gross margins.

But compared to real estate brokerages? 30% Gross profits is double the 15% average Company Dollar is among North American brokerages. That’s significantly sexier, no?

For what it’s worth, for the first nine months of 2017, eXp Realty posted $110 million in revenues, with $97.6 million in cost of revenues, for a Gross Profit/Company Dollar margin of 11%. (Yeah, that’s a 90/10 split in effect.) That’s closer to the “average” brokerage in North America.

Method to the Madness (AKA, Deciphering Glenn)

While numbers are interesting, it’s what Glenn Kelman lays out during the earnings call that’s worth looking at in detail.

The first observation is that there is a method to the madness of Redfin. It all makes logical sense, but you have to work at making sense of what Glenn Kelman says. (It helps if you’ve met the guy, and can start to tease out how his rather superpowered brain works.)

The narrative that Glenn offers, especially in his prepared remarks, jumps around all over the place. He starts by saying, “The most important measure of our performance is our customer satisfaction” then cites a November 2017 survey (done by or sponsored by Redfin, one imagines) showing Redfin’s Net Promoter Score being 52% higher than traditional agents.

Then he immediately starts talking about market share. Then advertising. Then instant home tours, proprietary offer writing software, then investing in personal service, then upgrades to software, then the 1% listing fee, then an experimental program called Redfin Concierge, then Redfin Now, and ends with Redfin Mortgage.

Like I said, it jumps all over. It almost sounds a little bit like “Hey, we’re tech guys who do discounts and pay attention to NPS!” It’s easy to fall into the assumption trap of the industry and write Redfin off as yet-another-VC-backed discount broker with a fancy website, especially when he says things like this: “Most of our potential customers still don’t know about us.” Or this: “Most of the customers our agents spend time with don’t end up buying a home with us.”

If you want to dismiss Redfin as a serious competitor, it’s easy to do that too. “So, you have a fancy website, and some good engineers, but uh… people don’t know who you are, most of your so-called customers don’t buy with you, and you’re a discount broker with 0.71% market share? Cool! I’ll tell all my clients to use your website and app!” It makes sense why Ryan Schneider of Realogy, who has 16% market share or so, in his earnings call mentioned “competitors” who cut fees, but haven’t made real market share gains.

I think that would be a mistake. I could be wrong, but I say there’s a method to the madness, and it all makes perfect sense.

Close Rate, Customer Service, Efficiency

Further down on the transcript, you find this exchange that serves as a bit of a Rosetta Stone type of key in understanding Redfin’s strategy:

Jason Stuart Helfstein – Oppenheimer & Co. Inc., Research Division – MD and Senior Internet Analyst

And then do you have — maybe share your — are you willing to share any technology road map of additional products coming out that can help agent productivity, in addition to what you said in the prepared remarks?

Glenn Kelman – Redfin Corporation – President, CEO & Director

Well, we try to understand that in 2 different ways. There are ways to save agents’ time and then there are ways to increase close rate. And most of our labor-saving software is really focused on the support staff because those folks are performing a high number of repetitive tasks where we can either automate it or simplify it so that we can take $10, $20, $50, $100 out of the deal by just having fewer support staff per agent.

But with the agent, the name of the game is really to increase close rate. And the way that we do that is giving agents better tools to serve our customers. So if you notice that a customer is online on our website, but just hasn’t been active with the brokerage, that’s a signal that you probably need to reach out and see what’s going on. If you notice that the customer is searching often but hasn’t set up online alerts, that’s a sign that you need to do that for the customer.

So I think most of the software that we’re developing over the course of this year is to personalize the service so that we know more about what that customer needs at any given moment and can be there to deliver that service at the right time. And we think that it can significantly increase close rate because we still spend most of our time with people who don’t end up buying a house. [Emphasis mine; formatting edited for clarity]

It starts to make sense now. All of it starts to fall into place.

Redfin realizes that they make money if and only if a transaction closes. So the most important KPI is “close rate” — what percentage of customers they spend time on actually go on to close a transaction?

Right now, it’s fairly low, by Glenn’s own admission. He didn’t say how low, and didn’t disclose what Redfin’s close rate is, but it seems obvious, no?

So what is Redfin going to do to up the close rate? The answer: customer success. Glenn spent quite a bit of time on the weak macroeconomics of the housing market — primarily lack of inventory. That means buyers are going to have a harder time finding something to buy, and if they do, they’ll be in competitive bidding situations far more often, with all of the attendant ills: offering more money, waiving contingencies, writing personal letters, whatever it takes. If Redfin’s buyer doesn’t “win” the house, Redfin doesn’t get paid. So their buyers have to “win” more often.

How do you do that, exactly? Having a nice website with tons of traffic doesn’t help with this problem. Traffic generates leads, and sure, converting leads to a customer is a challenge all its own, but in a low inventory environment, converting visitors to buyers doesn’t pay the bills. Having buyers actually buy a house does.

Redfin’s Answer: Jerry Maguire

Glenn and Redfin’s answer to that problem surprised me. It’s the same answer that got Jerry Maguire fired from his job: FEWER CLIENTS, LESS MONEY.

What Glenn lays out is a strategy of reducing the number of customers with whom a Redfin agent works. That’s right; reducing. Fewer clients. He says:

Coming into 2018, Redfin plans to lower the number of homebuying customers each Redfin agent supports by 10%, hiring more Redfin agents than we would have in 2017. The ratio of customers to agents will still be slightly lower than it was in 2016, a year when our buyers’ agents were nonetheless more productive than in 2017. If this new level of personal service doesn’t make our customers more successful in 2018, agent productivity and profit per transaction will decline.

Dude. Brass cojones. But it’s not crazy:

But the dwindling number of homes for sale notwithstanding, we have reason to believe our 2018 homebuyers will in fact be more successful. In 2012, when the market first swung sharply in sellers’ favor, reducing the number of buyers supported by each Redfin agent increased our customer success rates. We saw the same correlation in 2017. The agents who served fewer customers had higher customer success rates. We’ve also been encouraged by more recent developments, including a successful trial last fall of coffee shop strategy sessions with our customers for comparing the terms of winning and losing offers. [Emphasis mine]

Glenn is betting that fewer clients won’t mean less money in this crazy low-inventory seller’s market that we have in many major metropolitan areas — exactly where Redfin is concentrated. He’s betting that fewer clients, more personal service, more interaction, more communication, more time per client will raise the all-important close rate.

To support that “Fewer Clients, More Money” strategy, Redfin is investing in technology products that directly support this counter-intuitive play:

To help our agents give customers more personal service, we also upgraded our software with a new online calendar that shows an agent what’s going on with each of our customers this week, whether that’s a home tour or negotiating deadline or a closing. Other software released in the fourth quarter made it easier for Redfin agents to focus on customers who most need attention based on the customer’s online search activity and brokerage interactions. This lets our agents immediately see the customers who signed up for one tour with Redfin, but not a second, or which customers have engaged a Redfin agent without subscribing to alerts for new listings in their price range.

Whether these products raise the close rate or not, that’s pretty cool, isn’t it? Redfin agents can see (and presumably get an alert) when someone signed up for one tour, but not a second. Time to call that customer! There are other products Glenn mentioned in that vein, but the whole point is to help drive the close rate up.

Oh, by the way, Glenn… the reason you don’t know of any other brokerage that’s taking such an aggressive approach to software, as you mentioned in the call, is because no other brokerage is doing any such thing. It isn’t clear to me that any other brokerage even knows how many customers one of their agents has at any given moment.

More on this below….

That Obsession With Close Rate

The rest of their software innovations, at least the ones Glenn talked about, make perfect sense once you understand the obsession with close rate. For example, he talks about automating the home tour: “We updated our scheduling software so that we could automatically find the time for an agent to meet a customer on 83% of our December home tours, up from 68% in September.” Then he goes on to talk about how Redfin confirmed 9% of home tours “without requiring a Redfin buyer’s agent to do anything except show up.”

I admit the first time I read that, I did a giant shoulder shrug. “So what? Who gives a damn?”

The same went for this new “offer writing software” — it was a case of “seen that, been there, big yawn.” Online forms is not exactly a new thing, nor is it rocket science.

Except… Glenn says:

This commitment to speed is why we’ve also invested in our own offer writing software, which lets our agents put together a bid on a listing in a few minutes. In the fourth quarter, we expanded the markets the software supports from Chicago, D.C. and Virginia to Maryland. The localization involved for each market is extensive. Different states, counties and cities require different offer forms, and local customs around earnest money amounts and other deal terms require different default values for the forms field.

In Maryland alone, we have to support 30 addenda. For these reasons, it will take us years to adapt our offer writing software to every major U.S. market. But as we do, we believe we’ll be able to move faster than any other broker at lower cost and with comprehensive data about what it takes to win in each neighborhood. [Emphasis added]

Huh. So… let me get this straight. Automated scheduling, automated home tour confirmation… those mean that Redfin buyers can get in to see the house they find interesting as quickly as humanly (or inhumanly, in Redfin’s automation-driven case) possible… and then once your buyers have seen the place, and decided to put in an offer, your agent can use Redfin’s proprietary heavily-localized forms-and-customs-driven software to write an offer as fast as (in)humanly possible… informed by your Big Data analytics on what it takes to win more often… so while other agents are driving back to the office to fill out a form, your guys are already calling to negotiate waiving contingencies….

Yep, win more often, higher close rate, more money.

There’s a method to the madness. It makes sense. Risky, sure, but it makes sense!

The 1% Listing Fee: Also About That Close Rate

That understanding puts the “1% listing fee” in a slightly different light, doesn’t it? I mean, yes, sure, of course, it is a market share grab. Glenn said as much in a previous earnings call. But the obsession with close rate does mean that offering sellers a hugely discounted commission is just fine in this low-inventory seller’s market we have now.

There are some markets (Seattle? Denver? San Francisco?) where really, sticking a yard sign in front of the house means multiple offers within 48 hours. Close rate is going to be really high on those, dontcha think? Glenn more or less admits as much when he says:

I would say that it’s early in those markets to declare victory, but it was a well-established finding before we launched in those markets that the overall impact on share among buyers and sellers accelerates modestly when we shift pricing toward the seller to benefit the seller. And that’s, as we said, because the seller is so much more price-sensitive. She signs a contract before listing her house. She agrees to a price before listing her house when she chooses an agent. And so in Denver and San Diego and Seattle and places like that, we had run 1% pricing for years. And we carefully studied whether that hurt our share among buyers, whether it helped our share among sellers. And what we determined was that, overall, it had a positive effect. And it’s possible, of course, that as the market shifts, which inevitably it will, toward buyers, that we want to recalibrate that pricing to benefit the buyer more. But right now, everybody in real estate wants to represent sellers, and our pricing really favors that. [Emphasis mine]

Home sellers are not idiots. They know they’re in a seller’s market. They know that they’re likely to sell their home, possibly above asking price, as long as they’re not going cuckoo for cocoa puffs. So the idea of paying 2.5% or 3% to some big-name agent is far less attractive if Redfin can sell it in six days for 1%. And buyers are desperate in some markets to win the bidding war; they’re less sensitive about the commissions. They just want to buy the house, and not lose out to a cash buyer for the seventeenth time.

Plus, if Redfin is double-ending the deal, with a Redfin buyer on a Redfin listing, all of that speed-enhancing software and technology makes it that much easier to close the deal for everybody involved. Which is why Glenn said during the Q3 earnings call:

We’ve had far more buyers than sellers because we’ve built a real estate search site for buyers, but the strategic advantages of listing homes are numerous. It gives us more leverage over other websites and it really lets us serve our buyers better when we also have our own homes for sale. So we will continue to drive listing share as a financial lever, but also as a market lever. [Emphasis mine]

It’s all making sense now, isn’t it?

They’re not discounting for the hell of it, or because they have no other value to offer. (Although, to be fair, discounting is part of Redfin’s mission to change real estate….) Redfin is discounting to raise the close rate as much as possible, because Redfin only gets paid when a transaction closes, and Redfin has labor costs that others do not.

About that Labor Cost and that Labor Force

See, what is becoming clearer as I’m reading Glenn’s words is the deep relationship between all of the parts of Redfin.

They’re obsessed with close rate, because they have to be. Because they’re making payroll every month, and have expenses every month, whether they sell a house or not. But they only get paid when they sell a house. It’s why traditional brokerages moved away from having employees, and only have 1099 independent contractors.

But having a W-2 workforce of agents means that Redfin can do all of the things laid out above… including the Jerry Maguire strategy of fewer clients for less money (which Glenn bets will lead to more money — which is sort of what happens in Jerry Maguire as well).

Just imagine a traditional brokerage announcing a new policy to reduce the number of buyers its agents can work with. Said announcement would be met with gales of laughter at first, as agents would think it was a very funny joke. “You’re telling me how many clients I can have at a given time? Oh, that’s hilarious!” Then, when they realize that the broker is serious, the place would turn into a ghost town pretty quickly as they leave for other brokerages (at better splits, at that).

Well, here’s an exchange of how it went down at Redfin:

John Peter Egbert – Stifel, Nicolaus & Company, Incorporated, Research Division – Associate

I was wondering how longtime Redfin agents are responding to plans to lower the number of customers they’ll be working with. Are they worried this could hurt their individual earnings potential? Or do they buy in to the rationale that this could benefit closing rates across the company?

Glenn Kelman – Redfin Corporation – President, CEO & Director

So the strategy to reduce the number of customers each agent supports was met with widespread enthusiasm at our annual kickoff, which we held on January 12, even among the most well-tenured agents. And I think it would be different if we were taking them to a level of customers that was radically lower than what they’d experienced in the past. This is higher than what they had in 2016, just lower than 2017. And I think everyone just felt that this is exactly the service we want to provide and that we’ll actually do better by our customers given the difficulty of the housing environment. So I would say that I’ve rolled out, Chris has rolled out, Scott, our president of real estate operations, has rolled out all sorts of initiatives that have been met with mixed responses at kickoffs. This was one that was universally or near universally embraced. People love it.

Of course they do. Fewer clients, more personal attention, potentially more wins, which equals more bonuses. And they’re all getting paid a salary to do the job. None of them are worried about making car payments next month.

Which means they too can obsess about close rate, which in turn means obsessing about numbers that matter from an agent’s on-the-ground job, such as conversion rate (“How many leads turned into customers?”) and NPS (“How well did I do in providing customer service?”), as opposed to numbers that don’t matter, such as agent split (because 90% of zero is still zero) and how many followers one has on Instagram.

The company’s interests and strategy are aligned with their own. Of course they want more money for less work — every single employee in the world wants that. So does every single business, every single independent contractor. But one assumes that grown-ass men and women recognize that the company that pays them has to have revenue in order to pay them, and that they have to work to generate that revenue… which means higher close rate, which in turn means higher “success rate” for their customers. And in this crazy market, that means fewer clients, more personal attention. Yep, they’ll get on board that train.

It all fits together. There’s a method to the madness.

A Related Observation about Customer Service

There’s one more way it all fits together, which is what Glenn opened the earnings call with: Net Promoter Score, a measure of customer service.

I don’t have research at hand to prove this, but I strongly believe it.

In service businesses where there is a clear win and a clear lose, it’s really hard to have customers think you provided excellent service when you lose. They can and do often think you provided poor service when they win, but the reverse is not true. Unfair, I know, but that’s life.

For example, if you’re a lawyer, and your client loses the case, it’s going to be real hard for that client to think you’ve provided excellent customer service. “Yeah, I know I’m going to jail for 20 years, but man, my lawyer really went to bat for me. She was truly excellent, and I recommend her to all my friends!” That doesn’t happen. Because as far as the client is concerned, he’s going to jail, which means you suck and it must be your fault for not convincing the jury that he didn’t do it, or that there was a reason he did it, or the cops screwed him, or whatever. But rarely, very rarely, does the loser in a lawsuit think his lawyer provided him with excellent representation.

Doesn’t matter how many times you’ve called him to update him on the case, how empathetic and kind you were during the trial, how much work you did behind the scenes, etc. If you lose, your client is not going to be a fan.

The same applies to real estate, no? So the first condition of earning a high customer service rating is to win, whether that’s buying the house they want, or selling the house at a price/timeframe they want. Agents know just how unfair clients can be about this, but that’s life. Redfin and Glenn Kelman apparently understand that, and hence, the obsession with close rate.

Tomorrow, In Real Estate Brokerage

What Redfin is doing is more or less the future of real estate brokerage, in one form or another. Traditional brokerages also kinda sorta understand this dynamic, but because of the business model choices they have made, the whole “close rate” thing is a step or two removed from their day to day reality.

For example, if you’re Re/Max and your revenues are about continuing franchise fees and annual dues, you care about client success and close rate indirectly since your customers (the franchisees and their agents) need to have money in order to pay your fees and dues, but it’s a big step or two removed.

I think what Redfin is doing today, what they’re obsessed about today, will lead to the real estate brokerage of tomorrow. The close rate (which means consumer win) will be all-important, because it means you got paid, and it means your customer service rating will be higher, which leads to more referrals (i.e., low-cost high quality lead generation), which leads to more conversion opportunities, which leads to better brand awareness, which leads to more business, etc. etc.

I think the technology stack will support that obsession and every aspect of technology will be geared towards improving the close rate. Just like Redfin, that starts with lead generation, but tech will move down the funnel to conversion, data analytics to support quick decision-making, and automation to speed up execution.

I believe that’s the brokerage of tomorrow, primarily because the agent team has to move in that direction. You can’t just keep stuffing the top of the funnel (that is, leads, leads, MOAR LEADS!) while having crappy conversion and client care and fewer client wins down below.

If that’s the case, then Redfin will have a pretty serious head start on the rest of the industry in terms of experience and learning. They’re doing this today, in 2017 and 2018, with the capital and technology to support their focus on close rate. Their competitors are mostly still working on MOAR LEADS and recruiting and retention. By the time the rest of the industry pivots (say in 3, 5, 7, or 10 years), Redfin managers and agents will have spent that many more years learning what does and does not work in raising the close rate given a particular market environment.

Ignore Redfin If You Want, But….

So I think Redfin is the brokerage to watch if you want to know where the industry is headed, instead of where the industry has been or where it is today. It’s why I called them the most important brokerage in North America. I stand by that.

But their market share is tiny — 0.71% in the 2017 earnings report — and they make no headlines. They’re not Compass flaunting big recruiting wins. They’re not eXp who are making waves by recruiting top producers from all over the place. They’re discounting like crazy. So yeah, feel free to ignore them if you’re in the recruit & retain business of modern brokerage.

Just… try not to be surprised a few years from now when you have to walk down the trail that Glenn Kelman and Redfin are blazing today.

-rsh

https://www.youtube.com/watch?v=L6oP0nrR_Ng