Redfin: Technology Company or Something Else

Redfin describes itself as a “technology-powered residential real estate brokerage.”

From filings and transcripts:

This ability to deliver better service at a lower fee is the fundamental source of our long-term competitive advantage and that advantage comes from technology.

Our technology lets us meet homeowners and homebuyers without paying for ads or traditional sales force, but it also makes our service better at every turn. In the second quarter we extended our technology for on-demand home tours which lets a customer schedule a tour from a mobile application in much the same way you might ask to be picked up by a ridesharing service.

You cannot open any of Redfin’s SEC filings or read the conference call transcripts without getting the strong impression that Redfin wants the investment community to view it as a technology company.

For the past few weeks, I have been thinking about what actually sets Redfin apart from other real estate brokerages?  In other words, is there anything unique about Redfin apart from their insistence that they are a technology company?

If I had to point to the most unique aspect of Redfin, it would be this:

“Our homebuyers saved on average approximately $3,500 per transaction in 2016. And we charge most home sellers a commission of 1% to 1.5%, compared to the 2.5% to 3% typically charged by traditional brokerages.”  In other words, Redfin is charging consumers on both sides of the transaction lower fees.

Redfin’s unique business is built around the idea that real estate transactions fees are too high.  Redfin has lowered the fees it charges its customers, but the question is whether Redfin has actually lowered the cost of providing these services, thereby allowing it to make a profit.  Lowest cost to consumer does not necessarily mean lowest cost provider.

Redfin pushes the idea that their technology is the reason they are able to lower their fees, however, I believe the unique aspects of their business so far are two fold.

First, Redfin employs its own real estate agents with a salary and bonuses based partially on the number of homes sold.  This differs from the typical real estate brokerages in the U.S. where real estate agents are independent contractors who get paid only as part of the commission with a transaction.

This difference creates a more fixed cost structure for Redfin, however, if scaled appropriately in each geographic region, Redfin could have a lower cost structure, assuming the bonuses paid to the Redfin employees are lower than the commission sharing at comparable real estate brokerages.

This employment structure of its agents is certainly unique, but I can’t seem to understand what advantages this gives Redfin.  If anything, it should put Redfin at a structural disadvantage, similar to the Lemon Problem.  Outside of Redfin, all the best agents will want to remain “independent contractors” who can earn substantially more than Redfin employees.   On the other hand, the agents who are unable to earn consistent income will be attracted to the stability of Redfin’s employment offer with the recognition that stability of income comes at a cost of the higher income potential outside of Redfin.

The second unique aspect of Redfin is its operating losses.  Since 2006, Redfin has had approximately $615m in losses.

These are the financial numbers for the past 3.5 years:

2014

2015

2016

First Half 2017

Revenue

125

187

267

164

Net Income

-24

-30

-22

-24

I think this point concerning their financial losses is probably the most unique aspect of their business model to date.  If Wal-Mart was buying its 12-packs of Coke at $3 and selling these 12-packs for $2.95, but all other retailers were selling these same 12-packs for $3.30, Wal-Mart could not claim its technology as the key source of its ability to save consumers approximately .35 cents per 12-pack.  The technology is irrelevant in its pricing strategy if Wal-Mart or Redfin cannot turn a profit.  Redfin is merely choosing to operate at a loss in order to win business and grow its brand.  At a certain scale, Redfin either needs to be able to show a profit or admit that its key competitive advantage is its ability to divert investor money to its customers through operating losses.

Could Redfin Be Akin to Geico? 

One idea that kept me thinking about Redfin was how Geico was able to change the distribution channel for insurance sales in a way that other competitors had a difficult time matching in the early innings of competition.  Could Redfin potentially change this distribution channel of local real estate agents?

Currently, local real estate agents are perceived as being vital to the process of buying a home.  There are many steps the local agents take part in.  On both the listing and buying side of the process, the local agents arrange for showings, give advice on local pricing strategies, negotiate contingencies in the contractual process, along with other steps.  There is no doubt that local agents want home buyers and home sellers to consider these services essential to the process and that only someone with a physical presence is capable of performing these tasks.

However, someone is going to crack the nut eventually on why these services do not need to be provided by local real estate agents.

Cracking this nut will involve a two step process.  First, Redfin will need a strong and trusted brand.  The brand itself will be the trusted entity in the process, not the local real estate agent.  Think Uber: you don’t actually trust the specific driver who comes to pick you up.  However, you do trust the technology driving the Uber process.  Similarly, it won’t matter who guides you through the real estate transaction process, Sally, John, or whoever, you will trust the name Redfin.

Competitors may be slow to react to Redfin’s growing impact on the market.  The low current market share of Redfin means that other agents do not need to lower or match Redfin’s prices in order to maintain their current business.  If you are a local real estate agent with 30 potential clients in the near future, and Redfin takes 1-2 clients because of its low fee structure, it doesn’t make a lot of sense for you to lower your commissions for the other 28-29 clients to capture those additional 1-2 clients.  However, this could backfire as Redfin gains momentum, Redfin could significantly impact the old-line brokerages, not only because of fee compression, which in theory, these brokerages could match, but because the brand could gain broad acceptance as an alternative to the full price old-line brokerages.

On the other hand, I think Geico’s challenge to the old-line insurance companies was so successful because State Farm (and others) could not significantly compete with Geico’s centralized selling strategy without cutting off its legacy distribution channel of local insurance agents.  However, real estate agents in various local markets have fairly flexible terms and profit-sharing of commissions that these agents can and most likely will amend if Redfin gains a presence in their individual markets.   In other words, I think Redfin may inflict some amount of fee compression in the cities it enters.  However, if local agents match Redfin on price, I do not see how Redfin will be able to gain the scale necessary to operate its business model at profitability.

Earlier this year, Redfin went public and raised around $135m, one of the few IPOs that I can recall where the company itself was raising capital.  Redfin needed this $135m because it continues to burn cash.

I believe Redfin’s prospects to gain significant scale to compete long term are going to be hampered by its lack of competitive advantage.  Redfin indicates that its technology provides it a cost advantage, however, I just don’t see that showing up in their financials or how their business model works.  Their pitch as a technology company continues to provide hope for investors that Redfin is somehow changing the real estate game, but from a review of their business model and financials, it certainly appears that the biggest innovation Redfin has performed over the past 11 years is its ability to divert investors’ money to its customers, a significant win for its customers, however, a big warning for current and future investors.

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