Show Me The Money: Real Estate Revenue In The Modern Age Of Home Flippers
We’ve all heard of home flippers. They’ve been around for almost as long as real estate itself, even before Real Estate Web 1.0 . Watching the dramatized version of them on HGTV is a guilty pleasure for many of us. They purchase distressed homes, sometimes in “up-and-coming” neighborhoods, and make extensive and expensive renovations before flipping them on the open market for as much double what they paid.
One of the ways real estate is being disrupted today is by companies that make instant offers on consumers’ homes. Known as iBuyers, these modern day home flippers are essentially Silicon Valley and Wall Street applying money and (often, very little) tech to the age-old business of flipping. IBuyers buy homes in good-to-great condition in established neighborhoods and make only a few thousand dollars in repairs needed to resell the home on the market for a profit.
As a result of adding so little value, iBuyers’ revenue is much smaller than traditional home flippers. When buying houses, iBuyers reportedly charge up to 10% to 15% in fees instead of the 5% to 6% commission charged by traditional agents, and then sell the house for an average of 5.5% more than they paid the home seller, according to one analysis. IBuyers then pay 3% to the eventual buyers’ agent and a great deal more in property taxes, maintenance, HOA fees and other holding costs. So despite charging consumers more than agents, iBuyers’ revenue is much smaller, especially considering the risk and losses they take buying and holding thousands of empty houses.
But big investors don’t like small revenues, so some iBuyers are recognizing the value of the houses they buy, also known as gross market value or GMV, as revenue, despite creating very little in the way of economic substance by the time they sell the houses. Think about it: If an iBuyer sells 1,000 homes a month at an average price of $300,000, that’s $300 million in revenue using this accounting method. Three hundred million dollars is far more attractive to investors than the thousands of dollars in revenue iBuyers actually make on each house when all is said and done.
For those of us who were around during Real Estate Web 1.0, this brings to mind tactics called round-trip revenue that got one company and CEO into big trouble. While round-tripping isn’t always illegal, it is almost always a disingenuous way to bolster revenue and, therefore, the company’s stock.
In the case of iBuyers, it’s pretty easy to argue that reporting the price they pay for houses as revenue is done with a disingenuous spirit. The far more transparent way for iBuyers to recognize revenue would be to only recognize the 5.5% average appreciation from reselling homes at a higher price, and their 10% to 15% fee — the same way that 3% is made when a home is sold or bought in transactions carried out by agents at traditional brokerages and ones with new approaches.
At least three companies currently offering an iBuyer service are publicly traded — their stock prices could increase considerably when the billions of dollars’ worth of houses they buy are recognized as revenue. Inevitably, executives and other employees of these companies could also benefit when selling their own personal stock at the rising stock price. But Wall Street seems to be aware of and okay with the fact that these companies are recognizing GMV as revenue, so what’s the problem?
The problem is that only a tiny percentage of the price of the home, if any, actually hits the company’s bottom line, but that’s not obvious to the average consumer, or even the seasoned trader, buying the company’s stock. From public filings, we can see that iBuyers are selling more and more homes each quarter, which translates into some large GMV revenue numbers. For example, Zillow’s expanding iBuyer “Homes” segment grew from $11 million to over $40 million from Q3 to Q4 2018, an amazing 400% growth. But when you look past the eye-catching top-line gross GMV Revenue, you find that their Q4 Gross Profit for that segment was only $700,000 in Q3 2018 and $2 million in Q4 2018. Said another way, $40 million in GMV revenue cost them $38 million to generate. Zillow did admit recently that margins on “Instant Offers” are “razor thin” and that the actual goal is to sell mortgages. But, investors could get caught up in the massive GMV revenue numbers.
But what happens when the music stops? IBuyers use debt financing from large, conservative financial institutions like banks to purchase all these homes. If iBuyers continue to buy more houses than they sell, stockpiling inventory or deferring mounting losses, banks could stop financing new purchases until old inventory is sold, even if at a loss. Fewer houses purchased will ultimately translate into fewer homes to sell, (perhaps dramatically) less revenue and increased realized losses, which in turn could reduce iBuyers’ public stock price. A lower stock price could further decrease the iBuyers’ leverage or ability to borrow, which would in turn depress the stock further — yet another vicious cycle. Given that both Wall Street analysts and national audit firms are aware of and reporting on this revenue recognition method, iBuying will not likely be deemed illegal. But rest assured, as executives are selling a rising stock, it is the shareholders buying that stock that will be left holding the bag.
Big companies are moving into the iBuying business, becoming some of the meaningful drivers of the Real Estate Web 3.0 transformation of the homebuying and selling transaction. With so much investor money at stake, we need to make sure we don’t go down the disingenuous path that some did in Web 1.0. Instead, as a new wave of innovators, we should challenge ourselves to give consumers certainty, convenience and transparency into the realities of this business.