Zillow: the models underneath a housing hedge fund did not hold

A rogue trader’s losses can get them fired. In the worst instance, they can sink a company. For Zillow, its experience falls somewhere between those extremes.

The online property company’s app hooked American users who scrolled through endless home listings. Three years ago it opened a new door, effectively becoming a hedge fund that traded houses. In the quarter that just ended, it purchased nearly 10,000 homes. Unfortunately, it only sold about 3,000.

Zillow admitted that it had “unintentionally” overpaid for houses and that it would record a $300m inventory writedown as a consequence. Worse, a quarter of the company’s workforce will go. It has decided to abandon property speculation.

Executives spun its misfortune as good luck. The principal investing business was still small so the losses from poor underwriting did not sink the entire business. Tell that to investors. Zillow’s market value of $20bn has dropped 60 per cent from its peak. Zillow deserves credit for pulling the plug quickly and retreating to its successful core. Still, the shortcomings of acting as a property trader were obvious.

Zillow saw an opportunity as a “market maker”, flipping houses within months to earn a modest profit. In the quarter to March, purchases and sales roughly balanced at about 2,000 apiece. The company hoped initially to approach break-even, eventually transacting enough to make money. In the first quarter, Zillow earned an average gross profit of $30k on an average house selling price of about $300k.

Its proprietary data and price modelling was to make the difference. But this year’s housing market defeated Zillow’s nerds. Holding illiquid houses for a thin profit opportunity proved too much, even with a reasonable balance sheet. Assets are less than two times equity.

The legacy Zillow business remains highly profitable with operating margins near 50 per cent. But as the company has admitted, the absolute market size in advertising and listing fees looks limited relative to a humming property trading market. Yet in this case, safety must come first.