Brokerage Valuation: Focus on Company Dollar

There must be something in the water. I got three separate emails recently regarding publicly-traded brokerages. Two were on EXPI because they hosted an analyst day, and one was on Compass. Plus, there’s a lot of noise out there debating whether Compass is a tech company or a brokerage or whatever.

Since I’ve been covering EXPI for quite some time now, and have been following Compass and the rest of the residential real estate industry for years, I thought I would make an observation that may or may not be helpful to analysts, investors, and industry leaders.

If you’re doing evaluations of real estate brokerages, no matter what type, focus on Company Dollar (or in some cases, Gross Margins.) I think there are a lot of metrics being put out that really don’t matter all that much, because that’s how the industry has evaluated itself over the years… but that self-evaluation was the result of wanting to hide and obfuscate the true health of the business.

Standard Metrics

The standard metrics the industry uses are things like Sales Volume, Transaction Sides, and Agent Count. Look at both RealTrends 500 and Swanepoel Mega 1000. Both lists are done on Sales Volume and Transactions. And within the industry, most people just talk about agent count as a measure of a brokerage’s success. If you have 1,000 agents then you’re more successful than a brokerage with 100 agents, etc.

Ever since I got started in real estate, I’ve wondered about these metrics. I mean, I guess they’re better than nothing but they’re actually not that useful for evaluating the health or lack of health of a brokerage.

For example, high Sales Volume could be because a particular brokerage happens to specialize in luxury properties. Compass is a good example of this. Is a brokerage that sells 100 homes a year but each home is worth $5 million a “better” brokerage, or financially healthier than a brokerage that sells 1,000 homes a year at $500K each? Are they identical since they both have $500m in Sales Volume?

I’m not entirely sure why the real estate industry focuses on these metrics, instead of, you know… profits. It’s probably because most brokers and MLSs and tech companies in our space are privately held, so nobody has any idea how profitable any of them are. So the industry doesn’t care about profits or profitability… except when it comes to tech startups; then the real estate industry is all about profits and downplaying all these “venture-funded” disruptors.

Key Numbers: Cost of Revenue and Gross Margin (Company Dollar)

In widely reported findings by Steve Murray at REAL Trends (which my own research tends to back up, but my sample size is smaller than his), the average real estate brokerage in North America has 3% net income margins on 15% Company Dollar. But that was from a couple of years ago. If I had to guess, today, the number is likely lower.

I’ve come to decide that the key numbers in evaluating any brokerage company of any business model are the two sides of the same coin: Cost of Revenue and Gross Margins (Company Dollar). What do you have to spend to make $1 of revenue, and what do you have left over after you’ve spent that?

I think this is the key because it skips over difficult questions about management effectiveness, cost saving measures, marketing campaigns, and so on. Just about everything that the business operator does comes after Gross Margins, since expenses get paid out of Gross Profits (Revenue minus Cost of Revenue).

With that in mind, then, take a look at these gross margin numbers posted by publicly traded brokerage companies:

A few things to note here:

1. Compass characterizes its Incentives to recruit agents, including very generous splits, as “Marketing”. I disagree. I think Compass agents would insta-leave if their sweetheart deals and splits were to change to the default commission splits, so I can’t call that a one-time marketing expense; I think it’s more like ongoing cost of revenue. So I estimate the true Company Dollar to be Cost of Revenue + 85% of Marketing expense line, which gives us the gross margin numbers above. Obviously, this could be inaccurate.
2. I compute Realogy’s Company Dollar margins by taking segment revenue, then subtracting agent-related expenses. That might or might not be the same as Company Dollar depending on what else goes into that bucket.
3. Redfin’s Gross Margins (above) likely understates its true Company Dollar since Redfin spends beaucoup bucks on showing expenses, property marketing expenses, etc. that other brokerages do not pick up.

So we’re not talking about real precise numbers here, but with the exception of Compass and its accounting policies, I think the above is a reasonable look at Company Dollar trends.

Each company then pays for all expenses out of what’s left to get to net income profit. You can get the reported Net Income/Loss numbers easily, so go do that.

But to me, the numbers above (and the actual dollars of Gross Profit for each) represents the key metric for a brokerage. Because all of the talk of technology, or unique business models, or whatever don’t really matter unless those things move the Gross Profit number, move the gross margins up.

So for example, EXPI has had a great 2020 with record agent count growth, record revenue, and record profitability. But its gross margins have retreated to 2019 levels in Q3 and Q4. The fantastic gross margins of Q1 and Q2 helped pull the annual numbers up.. but that retreat is not a great sign for EXPI.

Conversely, Redfin has not grown as much as EXPI, but those gross margin numbers for Q2-Q4 of 2020 tell a story of a strong path to profitability. With higher revenues, those margins means more dollars that Redfin controls as a company to invest into technology, iBuying, or whatever else Glenn Kelman wants.

Meanwhile, Realogy has very high Company Dollar margins… but notice that it’s going down steadily every quarter. That’s the infamous commission pressure that Realogy execs have to deal with every single quarterly report, and not with much good news, like ever on that front.

In contrast, Compass has very low margins but they went up in the second half of 2020 and substantially so. That’s a rather hopeful sign, and for Q1/2021 results, that’s the key thing that everyone needs to be focusing on.

Cutting Through the Noise

I think this focus on Gross Margins/Company Dollar really helps cut through the noise of business models, rapid growth, revenue growth, etc. etc. It allows for some comparisons to actual tech companies, or iBuyers, or whatever, because Gross Margins is fundamentally about how much of the revenue remains for the company to spend on its strategies.

So for example, everybody in the industry and most of the Wall Street analysts are skeptical as hell about iBuyers. Well, Zillow Homes in Q4 of 2020 posted gross margins of 8.9%. That’s better than gross margins at EXPI and Fathom. Opendoor posted Q4 gross margins of 15.4%, which is better than everybody other than Realogy and Redfin… except that Opendoor’s gross margins are up 162% YOY, while Realogy’s gross margins are down 12% YOY, and Redfin’s gross margins are up by 27%.

So now how do you want to think about those businesses?

Doesn’t that help cut through a lot of the noise? I think so.

Strategy Evaluation

Now, take two passages from recent earnings calls.

From EXPI’s nontraditional earnings call, we have Glenn Sanford saying this:

Yeah. So, our gross margins are highly influenced by the sales volume and agents capping. And coming out of a really strong Q3 and then having a follow-on really strong Q4, put a lot of agents in a position where they had basically paid the most money they’ll pay to eXp for their given cap year. And so that created some pressure on our gross margins. And then alternatively, I mentioned a little bit about Showcase IDX. Alternatively, we’re really getting into a position where we should be able to actually increase a little bit of the gross margins. I don’t know what percentage that is.

That position where EXPI should be able to increase the gross margins? That is explained later:

Yeah. I think it’s — I think we’ve backed off. And we really — I think even starting in early 2020, we really backed off the top line number of 10% gross margin for core brokerage just because as we learned more about how all this mixes together, it would be tough to get there if we didn’t fundamentally change the model, which we don’t have any interest in doing because our model makes sense, it’s attracting a large number of agents. It’s the — really the best model in the industry. And for us to get to 100,000, 200,000, 300,000, 500,000, whatever the number is eventually, we need to make sure that we’re highly competitive for our agents and brokers.

And that’s the other side, which is the mortgage, the title escrow and other services, which would be, where we would expand gross margins. But we do think that on the net margin basis, we’re really focused on what is that — what are all the things that we can do to get that to closer to 4% on a net basis. And so when we sort of look at that, we think that there’s a path there, that’s a lot more viable because we really were talking about the 10%, 6%, 4% model, we think that there’s something less than 10% on the top side, there’s something less than 6% on the expense side and we think that 4% is still a viable sort of net number as we continue to grow.

So what we have is a company that is embracing brokerage as a bit of a breakeven proposition, to get to a huge number of agents to drive leads to the actual profit centers of mortgage, title, escrow and other services.

The kicker is, of course, that EXPI doesn’t have much in the way of mortgage, title, escrow and other services yet. I’m sure they’re building that out as fast as they can, but it is as yet completely unproven. That makes EXPI pretty much the same prop bet as Compass, which went public talking about the flywheel effect, and the agent as the center of the “referral economy” around housing.

Then we look at this passage from Realogy’s Q4 earnings call, where Ryan Schneider says:

Yes, well, let me start with the strategic answer. I kind of talked about this a little bit in the future Ryan, which is we have a vision, which a lot of people I think have that there could be much more done to create an integrated transaction for the customer. So just make the process easier, and that — and most of that process by the way, is the closing process. And we have the pieces of it with title and mortgage and some of the digital products we’ve invested in plus our leading position in brokerage. And in 2020, we started to put that together and you can just see how much we were capturing more of the economics by creating a better closing experience and beginning to integrate these things. We think strategically there is a lot more room to go on that.

That sounds identical to the strategy that both EXPI and Compass lay out, no? Except that Realogy actually has all of the ancillary services of mortgage, title, escrow, and other services already in place. Realogy Title Group dropped $226 million in Operating EBITDA on $736 million of revenues in 2020 after all. Notice how healthy that margin is.

Yet, as of this writing, Realogy’s market cap is $1.85 billion on $15.83 per share, while Compass is $6.97 billion on $18.00 per share, and EXPI is $5.37 billion on $37.12 per share.

Does that make sense to you? It doesn’t to me, because both EXPI and Compass have lower gross margins from brokerage than does Realogy, and their growth is premised upon one day converting all that agent count and transaction growth into ancillary revenues… which Realogy has already and they do not… yet both of them are valued higher than Realogy.

Either Realogy is significantly undervalued or EXPI and Compass are significantly overvalued. I’m not an investment analyst, so I can’t rightly say which, but you might ask investment analysts what they think about that.

And fundamentally, I see nothing in any of the three companies earnings calls where they talk about any initiative or strategy designed to increase gross margins. If anything, I hear EXPI admitting that they’re just giving up on gross margins from brokerage, and that the dynamics of agent splits and caps mean that gross margins from brokerage will be lower over time. “Commission pressure” as one might say.

I think it’s useful to evaluate whatever strategy a company announces by its impact on gross margins and Company Dollar. Feels to me like doing otherwise is noise. Agent count, sales volume, transaction count, number of offices, technology implementation… whatever a brokerage wants to talk about… I just ask, “How does that impact gross margins?”

It’s been and remains a very useful analytic tool for me. YMMV.

-rsh