Redfin, Durable and the Future of Brokerage

Given my somewhat unique position, I am often amused by the gap between the world of real estate and the world of finance as it comes to news that affects both. A prime example comes to us from the announcement that Redfin raised $110 million in equity funding from Durable Capital Partners.

On social media, we get real estate people — brokers and agents alike — tut-tutting the deal:

Of course, Mr. Mahallati is just spouting what he heard somewhere since he doesn’t quite realize that every one of Redfin’s agents is a card-carrying, dues-paying REALTOR. Calling Redfin a “silicon valley company” is kind of like calling the Ben Kinney Team a “tech company in Seattle.” I mean… I guess?

Then there is Giuseppe “JP” Piccinini, the CEO of one of the fastest growing brokerage/franchises in the country, JP & Associates REALTORS:

I do have a different opinion, because mine happens to be correct and based on facts and figures instead of biases and inferences.

That’s in real estate. On telephone calls and emails, I get the finance people (whom I can’t name, for obvious reasons) saying this is a bet by a very smart investor on the future of real estate.

If you have spent any time reading my work over the years, I think you know which side I come down on. I thought about not commenting, but since many of the VIP audience are still industry people, I thought it worth pointing some things out.

Redfin Strengthens Itself

As I have mentioned in a previous post, at the end of 2019, Redfin had $304 million in cash in the bank versus monthly expenses of ~$15 million. With zero cuts and zero income, Redfin could have survived for 20 months.

Add the additional $110 million from Durable, and Redfin can now survive for an additional 7 months. That’s more than two full years of operating at zero income. And now layer on all of the cost-saving measures Redfin has already put into place, and we are looking at a company that is so far from “about to go bankrupt” that it is difficult to come up with another name in real estate with its equal strength. Zillow and HomeServices of America are the only two I can think of right now.

Note further that Redfin’s cost-cutting measures are designed to keep agent pay high:

“The compensation of our agents is heavily variable and driven by home sales,” Mylod wrote. “However, with an expected material drop-off in transactions in the coming weeks and months, our agents’ wages are likely to be hurt disproportionately.”

The fixed portion of agents’ income will be temporarily increased while the company waits to better understand the possible length of the downturn associated with the pandemic. The company hasn’t ruled out eventually furloughing some workers and laying off others, including both agents and workers at the company’s headquarters.

In an effort to pay for the cuts, Kelman will not take a salary for the remainder of the year and the company’s management team has elected to not take cash bonuses for 2020. All of the employees at Redfin’s headquarters won’t take cash bonuses in the first half of 2020. The Redfin board of directors also unanimously agreed to forgo cash fee payments for serving on the board for the year, according to the letter.

If you are an agent, ask yourself this question: Is it better to file for “unemployment” under the CARES Act, or get a forgivable SBA loan, or to keep getting a paycheck along with health coverage, retirement benefits, and expense reimbursement from an employer? What about when the employer raises your base pay, because the “variable bonus” component is going to drop, and the CEO refuses to take a salary for the rest of the year, and the management team won’t take a bonus, in order to give you that raise?

If you were a Redfin agent, think you might feel a bit of gratitude? Think your loyalty might be strengthened a little bit by these actions?

Now, if you are a broker, ask yourself this question: you have told all of your agents to go file unemployment or get a SBA loan for independent contractors. That’s great for the top producers, who all have teams, and for the bottom tier part-timers who don’t need the commission check to pay their rent. What about those in the middle?

Just how desirable is a job at Redfin now for your mid-tier professional agents who rely on real estate to make a living?

Henry Ellenbogen Bets Against Traditional Brokerage

I had a conversation with someone in the finance world who is very high up and knows Henry Ellenbogen, the founder of Durable Capital Partners.

His opinion was rather simple. He said, “This investment is Ellenbogen betting against Realogy and RE/MAX.”

I think there’s something to that. And this is not stupid money coming in here. Here’s a brief mention of who Henry Ellenbogen is:

Former T. Rowe Price star manager Henry Ellenbogen has raised $6bn for his new fund, which will invest in both public and private companies, according to reports.

The Financial Times reported that Ellenbogen’s new firm, Durable Capital, which he set up in 2019 after leaving T. Rowe in March that year, has raised the money for a fund that requires investors to lock up their cash for three years.

Ellenbogen had been with Baltimore-based T. Rowe for 18 years and enjoyed a hugely successful spell running the T. Rowe Price New Horizons fund. At the time of his departure the fund had $25.2bn in assets under management and was ranked first out of 111 Small-Cap Growth Funds tracked by Citywire for 10-year total returns to the end of 2018.

As well as investing in public small-caps, under Ellenbogen, the New Horizons fund invested in a number of pre-IPO names, including Twitter, GrubHub, Workday and Atlassian.

He has quite a track record, no?

With $6 billion under management, and all of it locked up for three years, Ellenbogen could have made any bet on real estate in the midst of this pandemic situation. He could have easily bet on Realogy, which desperately needs cash; we know this because Realogy tapped its credit line, something that is counter to all of the debt paydown they’ve been doing for a few quarters now. He could have easily bought major stakes in RE/MAX, or even put some money into private companies like Keller Williams and Compass.

He bet on Redfin.

Why?

Familiarity is a part of it, as the news release notes:

“Durable’s Henry Ellenbogen has been leading investments in Redfin since 2013, when we were a private company and the market was recovering from the great financial crisis,” Kelman said in a statement. “In chaotic times, he understands our long-term commitments to our culture and our technology and why those commitments position us to take share in a housing market that is being transformed by this pandemic to be more virtual, convenient and efficient. We’re proud to be his partner.”

So why does the real estate industry keep knocking Redfin?

“Unprofitable During Good Times”

I think most of it has to do with a very dangerous misunderstanding by the real estate industry. It’s a difficult one to correct, because people have a vested interest in holding that interpretation.

That misunderstanding is that Redfin is not profitable and never has been.

That is, of course, factually true. Redfin has never posted a net profit in any year. But it’s not entirely true either, since Redfin did post five quarters with net profit in the last 12.

More importantly, Redfin consistently posts very good gross profit numbers… then spends like crazy on technology and marketing to post net losses. For example, take 2017, since Redfin wasn’t doing iBuyer stuff that year so we can look at just the brokerage component:

• Revenues: $370 million
• Cost of Revenue: $258 million
• Gross Profit: $112 million, at 30.2% gross margins

The average brokerage in North America is sitting at 15% Company Dollar. Gross Profit might be slightly higher due to fees and such (depends on how they do their books) but Redfin is far more profitable at its core than a traditional brokerage is.

But then, Redfin went and spent:

• $43 million on Technology & Development
• $32 million on Marketing
• $53 million on General & Administrative

Total was $128 million, leading to a net post-tax loss of $15 million or so.

“Ha! See? They couldn’t make a profit during a hot market like 2017, even with huge gross profits!” cry the naysayers.

They misunderstand two things.

Redfin is a Team

First, they misunderstand that Redfin is not a real estate brokerage. It is a giant agent team, but with a huge website instead of a top producing agent as its lead source.

This is relevant because it helps us understand Redfin’s spending on technology and marketing.

A traditional brokerage really doesn’t have to spend that much on either of those. There are no public brokerages that break out those numbers, but I can say from looking at financial statements of privately held brokerages that neither of those make the top 5 expense line items. Because they’re in the business of recruiting agents, not in the business of real estate.

Agent teams, on the other hand, do often spend quite a big chunk on marketing and technology. Because they’re in the business of helping people buy and sell homes.

The thing to keep in mind here is that Redfin spends so much on technology to avoid spending a ton of money on Zillow, Realtor.com, and other online lead generation sources. A big chunk of that Technology spend is on Redfin.com, after all. Other agent teams don’t spend quite as much on Technology, but they spend more on Marketing, which includes lead generation costs.

Seen this way, the only difference really between Redfin and a successful agent team is that the latter gets away with violating all manner of labor laws in all 50 states. This is something we have discussed here on Notorious ROB in the past, for example, in this post about California AB5. I figure, it’s just a matter of time before some lawyer somewhere gets on that.

If agent teams also have to follow labor laws — including minimum wage, benefits, unemployment, etc. etc. — then I suspect that we’ll see their gross margins closer to Redfin’s historical pre-iBuyer gross margins of 30-40%.

If You Have Capital…

Second, I think people misunderstand what capital does for an agent team.

All companies grow at the speed of revenue. Because they have to. Most businesses do not have a giant bank account to grow market share aggressively without turning a profit. So an agent team will grow as fast as its revenues allow it to grow.

That changes if you have venture capital, or have gone public, or have raised cash in some other way. Then you can invest in growth first, and wait for revenue to catch up.

So say you’re a top producing agent with a small team. You’re doing 50 listings a year, and 50 buyers. Your team handles your buyers. You invest in Zillow leads, and start to see some deals close, but you also know a bunch are slipping through the cracks. You invest in an ISA and some admin help. You invest in some technology. But your margins are so fat — because you’re violating labor laws — that you can afford to do so.

Now, say your rich uncle Warren decides that you’ve got a great thing going and gives you $10 million for a stake in the team. What does that do for you?

You can expand aggressively, market aggressively, hire more admins, more ISAs, do more, more, more without worrying about turning a profit.

This is effectively what Redfin has done for years. Left out of all the Redfin-knocking is the fact that Redfin has grown its real estate business 186% from 2015 to 2019. Last three years, Redfin averaged 27% YOY growth in transaction sides, all of it organic — no acquisitions at all. And they did that while charging half or less what the typical agent team charges: 1% or 1.5% listing fee, and buyer refunds, which limits the kind of houses they can help people buy and sell.

Yes, Redfin posted net losses… so? They’re still sitting there with over $410 million (less whatever they spent this first quarter, plus whatever they made) in cash.

The Future of Real Estate

At this point, while we’re all still under house arrest locked down, nobody knows what real estate is going to look like if and when we ever do get back to work. There are all kinds of doomsday scenarios out there, including my own. We’ve read them, and seen the videos and webinars.

Thing is, I’m rather hopeful and optimistic on the whole because I spent a week interviewing some of the top brokers and agents in the business for a special report I put together for the investor community. Short-term, there will absolutely be pain and disruption, which will lead to some longer term changes. I noted most of them in the previous post linked above, and haven’t heard much that changed my mind on those.

Let me summarize briefly. The short-term disruption will result in a lot of brokerages shuttering their doors, and a significant drop in the number of agents. Big agent teams will pick up most of the gains in market share, and be positioned to come out the other end of this with a roar. Some permanent changes may be in consumer behavior: things like open houses may be an artifact of the past, and it seems to me that not a lot of sellers are going to be all that cool with dozens upon dozens of strangers walking through their houses in showing after showing.

I think initial screening, the initial tour, may be done online or virtually and only the serious buyers will be walking through someone else’s home. That cultural change could be permanent.

Furthermore, after the government response to COVID-19, I am reasonably confident that agent teams will be brought under the umbrella of labor laws of the various states. Why? We’re gonna have to find a way to pay for $2 trillion in emergency spending, and given the time crunch, the government decided to send the money out then figure it out afterwards. Well, when the afterwards comes, a lot of folks are going to be looking through all of the 1099 unemployment requests and look for tax revenues wherever it can be found.

Real estate brokerages are likely immune; agent teams are likely not.

So over a 1-3 year time horizon, we’re talking about a concentration of market share into the hands of large agent teams, who will be forced to operate under the labor laws of the 50 states. Redfin is the largest of them all, with $400 million and a top-ranked website. Redfin is also the best prepared and best equipped for a near-virtual real estate experience, and whatever Redfin is lacking today, some of the $40-50 million in technology and development spending can be put towards that.

Piccinini of JPAR still thinks of Redfin as a rival; that’s a mistake. Redfin is not a brokerage; it is a giant agent team. JP has one of the future brokerage models with his 100% fee-only model. It is the only one that makes long-term financial sense for the kind of recruit-and-retain, co-working space + business services for real estate agents model that is today’s traditional brokerage.

Agent teams, which includes Redfin, represent the other future of real estate. Ellenbogen and the other smart money on Wall Street see that. And when Redfin decides to stop trying to grow 30% a year, and decides to start harvesting profits (as Zillow did with its IMT business in Q3 of 2019)… it will easily turn a profit.

We may not know the immediate future, but the long-term future is becoming clearer… and its arrival is getting accelerated due to this current crisis.

-rsh