[VIP] Redfin Direct vs. Zillow Offers At Full Scale: A Thought Experiment

[I will be on the road all next week so blogging will be a bit light. I hope the flurry of activity in recent days will provide enough reading and thinking materials until I can get back to writing.]

VIP Subscriber, and the proprietor of Stratechery, Ben Thompson posted a question in a recent comment:

Compare Redfin Direct v Zillow Offers, both at full scale. Assume a 2% fee for Redfin direct v 7% fee for Zillow Offers. For sellers & buyers, what is more appealing assuming a price point between 500-750k?

We’re all about service here at Notorious! (No, we’re not, but still… that is a truly interesting question.) So let’s think about this.

Let me state the conclusion up front for the TL;DR crowd: Zillow Offers at full scale would dominate real estate and completely change the landscape. Redfin Direct will not.

Now, I can conclude that because I have a very particular definition of what “full scale” means for Zillow Offers and for Redfin Direct. Let’s get into it.

My Thesis on iBuyers: It’s About Financing

If you go back to one of the first posts I ever wrote on iBuyers, in December of 2016, you will find this:

The piece I was missing was the relative size of the real estate market and the mortgage market. I wish I had better statistics and figures than what follows, but I actually have to do some work ? so if you have more accurate figures, I’d welcome them. (Who knows? Maybe I’m wrong.)

As best as I can figure with rough calculations, with median home price of $232,000 and annualized existing homes sales of about 5.6 million, real estate brokerage should generate about $71.5 billion in commission income in 2016 (based on 5.5% average commission rate). Large number, but of course, broker profits are something far less than that due to agent splits.

Mortgage… well, we know that banks make money primarily from interest payments. This article from American Banker bemoaned the fact that mortgages are the least profitable product for banks:

In my analysis, I have grouped together the 500 U.S. banks with the most residential mortgages relative to their total loans, and compared those institutions to other peer groups and to the industry as a whole. While the nation’s roughly 6,000 banks had a median return on equity of 7.82% through the third quarter of last year, our peer group’s median ROE was only 3.5%. Meanwhile, the peer group of banks with the lowest ratio of residential loans to total loans had a median ROE of 9%.

In addition, the median U.S. bank generated 55 cents of net income for every dollar paid in salary and benefits last year. But the 500 banks with the most mortgage loans had a median ratio of net income to salary and benefits of only 31 cents. Banks with the least commitment to a mortgage business had a ratio more than twice as high, at 70 cents.

Nonetheless, the bemoaning writer above is still talking about 31 cents of net income (not revenue, not company dollar, but profits) to a dollar of salary and benefits.

And according to St. Louis Fed, in 2016, the top 100 banks held $1,744 trillion in “interest-earning, all loans and leases, gross, secured by real estate, single family residential mortgages.”

…

Opendoor, I think, is aiming at a piece of that market rather than the few billion dollars in commission income from real estate brokerage.

Furthermore, because mortgage is so painful today, I hypothesized that the ultimate endgame for Opendoor (and therefore, for later market-maker iBuyers like Zillow) is this:

• Seller-financing, by a well-capitalized “market maker”
• Private-label RMBS, at above market rates, which avoids the whole “conforming loan” business and all of the regulations that surround that
• Private insurance, since Fannie & Freddie are unlikely to insure those

So my take on what a market maker iBuyer is at “full scale” has very little to do with buying or selling houses. It has far more to do with making seller-financing mortgages to buyers, packaging them up into private-label RMBS, cycling the capital, and doing it again and again.

Keep in mind that a seller-financing Zillow Mortgage doesn’t have to be above-market rates. It could be a convenience play, meaning someone who will easily get a mortgage from Bank of America might be enticed into getting one from Zillow because Zillow can close in 3 days without any paperwork instead of performing a financial proctology exam, oh and it’s 0.5% cheaper from Zillow. Now what? Highly qualified, no-risk borrowers flock to Zillow, that’s what.

And marginal borrowers — think self-employed people — can qualify under Zillow’s underwriting where they couldn’t under normal mortgage lender underwriting. Because seller-financing. Maybe they pay 1% more, maybe 2% more — whatever the higher rates are to compensate Zillow and its ultimate investors would likely be worth it to people who can afford to buy, but have trouble proving it to a traditional loan officer.

Part of the reason why Zillow can take such risks that traditional lenders can’t is that Zillow can foreclose all day, every day, and twice on Sunday. Because it can turn around and sell that home very quickly, while a traditional lender would have to go through the arduous REO process.

I mean, we can get even more fanciful, but I think you get the point.

And consumers would love it. Love it. Quicken Loans is making bank on Rocket Mortgage, and all that does is the preapproval. Zillow Mortgage could do the entire loan using the same (or very similar) push-button process. Buyers would flock to it.

Zillow Offers at Full Scale

Now, I know for a fact that a number of Zillow executives read that post, because they told me so. It is likely far too arrogant of me to think that I might have influenced them in any way, but….

In Q1 of 2018, Zillow announced that it was really entering the iBuyer space. I wrote about that in the June Red Dot. In August of 2018, Zillow announced that they were acquiring Mortgage Lenders of America. In that announcement, we find this:

“Getting a mortgage can be the toughest, most painstaking and time-consuming part of the home-buying process,” said Greg Schwartz, president of media and marketplaces at Zillow Group. “Now that we are buying and selling homes through Zillow Offers, we believe that having our own mortgage origination service as an option for consumers will allow us to streamline the process for people who buy a Zillow-owned home. Over time, we expect the work we do in conjunction with this new line of business will help us expand our offerings to our partners – including real estate brokers with existing in-house mortgage operations and third-party lenders who co-market with Premier Agents.” [Emphasis added]

Why, if that isn’t exactly what I predicted in 2016….

So when I talk about Zillow Offers at full scale, I don’t just mean Rich Barton’s stated goal of 5,000 homes a month, $20 billion in revenues, at 200bps of profit. I mean that plus Zillow Mortgage becoming a seller-financing monster, who then packages up those loans and sells them to investors via private-label RMBS securitization, effectively creating an entirely new channel for financing home-buying in the United States.

Say Zillow takes… 2% market share. According to this website operated by LendingTree, $1.75 trillion in mortgages were originated in 2017. Say whatever year that Zillow Offers goes “full scale” comes to $1.8 trillion in mortgage origination. 2% of that is $36 billion with a B. As a point of comparison, Bank of America in Q1 of 2019 made $11.5 billion in first mortgage loans.

Everything will have changed by then. In fact, things will have changed long before Zillow gets to 2% share of the mortgage market. I think it changes the minute Zillow prices a RMBS offering with some investment bank, and those securities sell. I’ll touch on that below.

Redfin Direct at Full Scale

Compared to that, Redfin Direct even at “full scale” doesn’t change the world quite as much. Ben’s thesis is that Redfin can shave quite a lot of cost to the seller and 1% cost savings to the buyer with Redfin Direct, which creates a positive network effect. Sellers would want to list with Redfin, in case a buyer goes Redfin Direct, which reduces the total cost to 3% (1% Listing Fee, 1% Redfin Direct Fee, 1% Discount to Buyer) from 4% (1% Listing Fee, 3% Buy-side Compensation), and buyers would want to go Redfin Direct since they would save 1% from the price of the home, which could be substantial for more expensive areas.

Thing is, that’s nice to save some money, but… the consumer experience is not significantly altered. Ben’s original thesis behind the question is that for real disruption to occur, whatever is offered has to be “better” and be “cheaper” than what it is disrupting. Redfin Direct is cheaper, but is it better? I don’t know if that’s true.

It’s not better for the seller; it’s the same old traditional list-and-stage-and-sell process that happens today. It’s not necessarily better for the buyer, especially since Redfin Direct is basically a FPBB (For Purchase By Buyer) with some online advice and such. Sure, there are likely thousands of buyers who have done it a few times before and don’t feel like they need a REALTOR helping them, but it doesn’t feel like a better buying experience.

And it certainly won’t feel like a better borrowing experience, which is where almost all of the truly painful crap in buying a house is.

Where Redfin Direct at full scale (or long before full scale) will change the world is the real estate brokerage industry. But that reaction from the industry makes it even less likely that Redfin Direct ever gets to “full scale” or that if it does, it would change everything.

Dynamic Market, Dynamic Reactions

The way I see things, it isn’t as if the rest of the world is standing still while Zillow does its thing and Redfin does its thing. They will react, adjust, compete, or form partnerships, or whatever. It’s impossible to predict how everybody else will react to Zillow Offers and Redfin Direct going full scale, but let’s just engage in some fantasy for fun and profit. But let’s take it in reverse order, with Redfin Direct first.

Likely Reactions to Redfin Direct

Sometime before Redfin Direct goes “full scale”, there are two reactions that are quite likely to occur.

First, all other brokerages will also offer XYZ Direct: KW Direct, RE/MAX Direct, Coldwell Banker Direct, etc. If the companies won’t do it, the better agents on the ground will. They’re the ones who are really competing against Redfin and its agents after all. Sure, it’ll eat into their profit margins a bit, but agent teams have ginormous profit margins today anyhow, compared to traditional brokerages. They can adjust.

Second, just about every buyer agent will start executing Exclusive Buyer Agency Agreements which specify that the buyer will pay her fees should the cooperating compensation not be enough. These are relatively commonplace already today, though not often enforced. If Redfin Direct takes off, you can bet that buyer agents will only work with buyers who agree to make up any difference, including all of the fee if the house is a Redfin Direct house.

It hasn’t happened yet, because Redfin Direct is (a) new, (b) unproven, and (c) an experiment in one market that five people have taken advantage of so far. That changes if Redfin Direct is available on all Redfin listings, becomes proven, and thousands of buyers start to take advantage of it. Brokers and agents will react, and react quickly. Because commission rates are something that they control.

So Redfin Direct could drive commission levels down, cause enormous pain for other brokerages and quite a few agents, but beyond that… once the industry adjusts to the new normal, it doesn’t really have much of an impact past that.

Now, look at Zillow Offers at full scale, or approaching scale.

Likely Reactions to Zillow Offers + Seller Financing

There is nothing that the real estate industry can do about Zillow Offers today beyond talking shit and predicting bankruptcy when the market turns, or when investors get tired of losses, or whatever the theory du jour is. The industry can’t blacklist Zillow Offers, because Zillow is a principal in the transaction. Zillow doesn’t rely on the industry to bring it buyers or sellers.

So it seems unlikely that the industry can do anything about Zillow Offers tomorrow.

Sure, brokers and agents can reduce their commissions so that Zillow Offers and its 7% fee is far more expensive by comparison… but then, Zillow pays less to buyer agents when it sells the home, which means it can lower the 7% Convenience Fee… so not sure that’s going to work.

The Seller Financing piece is a major revolution, obviously, and the real estate industry really has very little to do with mortgages. The mortgage industry might react, though… but how? They can’t offer seller financing, since they don’t own the property. For commercial banks like Bank of America, JP Morgan Chase, Wells Fargo and the others, they also have banking regulations they have to deal with since they are lending out somebody else’s money on someone else’s property.

Absent major changes in legislation and regulation, there really isn’t anything that even the mighty banking and mortgage industry can do about Zillow offering seller financing on homes that it owns. They would need to get into the iBuyer game if they want to do that, and if you’re a big commercial bank that makes tens of billions in revenue each year, the fastest way is to acquire an iBuyer, then ramp up the Seller Financing piece.

Where the industry gets hammered is in mortgage brokerage. Affiliated services is a big part of the profitability of many brokerages. If that goes away because buyers would much rather go through the push-button-and-get-approved deal that could be Zillow Mortgage, well, expect a lot of brokerages to shutter their doors. It could also have an effect on certain agents and agent teams, who today get a lot of love from mortgage brokers and lenders, as they are the primary marketing channel for many of them. Again, if consumer behavior changes, then that channel is no longer as important, and agents could see a massive drop in the number of mortgage brokers who used to call them once a week and sponsor their client parties and such.

Important note here: this applies only to Zillow Offers and Opendoor style “market maker” model of iBuyer. The Knock and Flyhomes models, which are really similar to bridge loans, can’t work this way.

To Answer Ben Thompson

So, with all that out of the way, let me answer Ben’s question. Which is more attractive to buyers and sellers assuming a $500K home, Zillow Offers at full scale, or Redfin Direct at full scale?

The answer is Zillow Offers, of course, because it is extremely unlikely that the Convenience Fee remains at 7% if Zillow is making billions from mortgage. I can’t imagine what the math looks like, but we do know that Spencer at one point mentioned $10K in revenue per loan from MLOA.

But more than that, take the buyer’s perspective for a moment here. Redfin Direct means the buyer saves $5K on a $500K home, by going it alone. Maybe pay an attorney $1,500 or so to do the legal paperwork. Maybe pay a title and escrow company a few hundred dollars for some of that grunt work. But the process itself is not “better” than it is today. And getting the mortgage means the same thing it does today.

Zillow Offers could mean finding the house, buying the house, and getting approved for the mortgage in three days by pushing a button, giving permission to Zillow to look at your bank account (like Rocket Mortgage), and saving 50 bps on the APR because of your excellent credit. That’s a better experience, and it could be cheaper — it will be well nigh impossible for Zillow’s mortgage not to be cheaper, since Zillow’s marketing costs for that mortgage are next to nothing, its administrative and underwriting costs are a fraction of whatever other lenders have to shoulder, and its risk in case of foreclosure are nothing compared to a traditional lender’s risk.

For the seller, the 7% fee seems steep… but as you VIP readers have already seen from the analysis of the data to date, we’re talking about $6K for three months of avoiding the uncertainty, the risk, and the inconvenience of the modern home selling process. And that $6K is not counting carrying costs and renovation costs and maintenance costs and so on.

But that’s on a $300K house; on a $500K house, maybe that goes up to $10K. I think quite a few people with $500K houses would be in a financial position to gladly pay $10K not to deal with the process for three months. Then again, if the seller is doing a Move Up… selling the house to Zillow and buying a Zillow home and financing with Zillow Mortgage… I can’t imagine the fee not dropping precipitously. If Allstate can bundle home and auto insurance, Zillow can and will bundle all kinds of services to save that consumer money. Now it’s better and cheaper.

In contrast, for the Redfin Direct seller, we’re talking about going from 4% to 2% transaction costs… but dealing with everything that comes with selling the house the current way. That’s $10K on a $500K house, minus carrying costs, maintenance costs, and renovation costs. I think if you went to people who owned $500K houses and offered them $10K to live in a staged house that they must keep spotlessly clean for three months, most would pass on the offer. It’s cheaper, yes, but it isn’t better.

So between the two programs, at full scale, Zillow Offers is The One.

That’s my take on those two programs. I know it got long and involved, and I likely cheated a little bit since I got to define what “at full scale” means… but I’d appreciate your thoughts in the comments or via direct contact.

-rsh