When Houses Turn Into Lemons – A Curious Case of Zillow Group (NASDAQ: ZG)

After warning our readers about the potential problems with the Zillow Group's, Inc. ( NASDAQ: ZG ) internal and external environment, the bad news arrived one after another. Since then, the stock has lost over 25%.

Yet, there might be more than meets the eye – especially with Zillow Offers, arguably the most controversial business they operated.

Check out our latest analysis for Zillow Group

Third-quarter 2021 results

• Non-GAAP EPS: -US$0.95 (miss by US$1.12)
• Revenue: US$1.74b (up 165% from 3Q 2020).
• Net loss: US$328.2m (down US$367.7m from profit in 3Q 2020).

Over the last 3 years, on average, earnings per share have increased by 19% per year, but its share price has risen by 30% per year, which means it is tracking significantly ahead of earnings growth.

After these catastrophic results, the company also issued downbeat guidance for Q4, expecting losses between US$240m and US$265m, and other costs associated with shutting down Zillow Offers operations, in the ballpark of US$175m to US$230m. Also, approximately 25% or 2,000 people have been laid off.

Juggling With Knives

The Model of Zillow Offers relied on the so-called ibuyer model. The company would make instant offers on houses, fix them up and flip them for a profit.

The catch? Heavy lifting in price estimation would be done by AI, thus reducing the costs of labor.

However, estimating value is a peculiar task – as Zillow soon found out. They used to work with 2 main predictions: current value and value after 6 months.

Failing in any step of the way could create problems down the road.

Consider the following problem matrix:

	Low initial estimate	High initial estimate
Low 6 - month prediction	Homeowners would likely not accept the offer.	The company should not make an offer, as they're taking the risk of overpaying.
High 6-month prediction	Homeowners would not accept the offer. Even if they do, the profit margin might not be worth it.	The company should not make an offer - if it does, they are certainly overpaying.

Operating in such an environment is a lot like knife juggling. You need to get it right, every mistake hurts, and it can eventually bleed you dry.

However, the market of the last 1.5 years has been anything but ordinary – first, the COVID-19 crisis froze the market, and then inflationary fears sent it to overdrive. The fact that homeowners accepted only 5% of Zillow's offers speaks to the company's lack of ability to understand the market and adjust to the new conditions.

Yet, one wonders what owners accepted those 5% offers, which brings us to the concept of "Market for Lemons."

Lemons, Peaches, and Information Asymmetry

In 1970, economist George Akerlof published a widely-cited paper, " The Market for Lemons: Quality Uncertainty and the Market Mechanism ." He described the tendency of the quality of goods traded in a market to degrade in the presence of information asymmetry between buyers and sellers, leaving the less-desirable items on the market (so-called lemons).

According to Akerlof, if buyers cannot distinguish between a high-quality car (also known as a "peach") and a low-quality one (a "lemon"), then they are only willing to pay a fixed price for a car that averages the value of those 2 together. However, sellers know whether they hold a "lemon" or a "peach."

Given the fixed price, sellers will sell only when they hold a "lemon" and leave the market when they have a "peach." As the average quality on the market decreases, it creates a positive feedback loop since "peaches" holders are now even less inclined to sell. For his contribution, Mr.Akerlof shared a Nobel Memorial Prize in Economic Sciences in 2001.

But, with the real estate market, this effect can only be more pronounced. Houses are significantly more expensive than cars, thus having a lower turnover rate and increased risks for sellers.

A Lesson to Remember

Zillow's ambitious plan for diversification into a house flipping business ended in a disaster. After the attempt to capture a lucrative market, the company is now trying to offload over 7,000 properties worth US$2.8b. It also lost about 25% of its workforce and certainly damaged its brand as well.

Speculating about the reasons for such demise, we turned to economic research for an explanation. Thus, we assume that one of the reasons for such an outcome is that the majority of the people who sold those 7,000 homes sold "lemons" – properties that were sold for more than they could get on the traditional real estate market.

A combination of the workforce shortages ("lemons" require significant work) and rising mortgage rates (negatively influencing the demand) only added oil to the fire. Overall, it looks like Zillow committed a mistake that we saw over 20 years ago with the Long-Term Capital Management.

When models diverge from reality, do not double down on the models.

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Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.