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Redfin (RDFN)

Updated: 4 days ago

Investment Thesis

  • The U.S. real estate brokerage industry is large and highly fragmented but commissions paid to agents have not faced similar competitive pressures from technological innovation as experienced in other industries



  • Redfin is lowering the frictional costs of the real estate transaction by offering an end-to-end real estate services platform by integrating its web portal, brokerage, and ancillary businesses. It employs agents on a full-time basis and funnels demand to agents generated from its website which increases agent productivity and provides them the ability to focus on customer service instead of prospecting or demand. Further efficiencies are achieved by pursuing a team approach to helping customers throughout the transaction, integrating with ancillary service offerings, and consistently investing in technologies that remove frictional costs throughout the transaction.


  • Most traditional brokerages are focused on serving real estate agents by maintaining the status quo of high commissions. Redfin is building a flywheel focused on the end-consumer. As Redfin lowers transaction costs through integrated technologies and grows transaction volume/market share, it benefits from scale efficiencies which are then passed on to customers through lower commissions, driving further demand and scale efficiencies.



  • Current valuation looks very attractive. Despite consistent historic growth and building the infrastructure for continued growth into the future, Redfin sells for 13x its trailing Real Estate Services gross profits, below its historic average of 18x. Even if one assumes future growth rates are below historic trends (despite still having a long runway with only having ~1% market share) and that operating costs will benefit from scale advantages, it could provide a 10-year expected IRR in the high teens to low twenties.

Industry Background


~$2 trillion of the estimated $36 trillion in U.S. residential property will be bought/sold in 2021, and ~5-7 million of the ~120 million housing units transact each year.


During a transaction, ~90% of homeowners hire a real estate agent to help them buy/sell a home because it can be a complicated/cumbersome process. It is a high-risk transaction, typically the single most valuable asset, and an infrequent event occurring about every 10 years for the average homeowner. In exchange for a real estate agent’s services, sellers and buyers each typically pay a commission of 2.5%-3.0% of the sale price of the home, totaling 5-6% commission on a transaction, providing an estimated ~$100B in commissions paid to agents and their brokerages in 2021.


As a result of technology and largely the onset of the internet, intermediaries in many other industries, such as media/newspapers/magazines (Google, Facebook), retail (Amazon), stock brokerages (Charles Schwab), travel agents (Expedia, Priceline), taxis (Uber), or used car dealerships (Carvana), have either faced disintermediation or transaction fees have been competed down.


It seems strange that the 2.5%-3.0% commission paid to the real estate agents has remained persistently high and uniform despite internet technology that helps disseminate information in what appears to be a highly fragmented industry. There are over 3 million active licensed real estate agents who work as independent contractors and split their commission with one of the ~130,000 real estate brokerages.


In the U.S. the supply of homes, or at least access to the data for the supply of homes, has been kept and controlled by Multiple Listing Services (MLSs). MLSs originally started in the late 1800s as local exchanges where brokerages and their agents gathered to share information about properties they were trying to sell. Brokerages that were members of an MLS agreed to tell each other about properties for sale and then compensate other agents a certain commission for those who helped sell those properties by finding a willing buyer.


MLSs essentially became local natural monopolies that controlled access to the supply of homes for sale in a certain geography. Buyers typically go to the MLS as the first and often only source of inventory. For that reason, sellers list on the local MLS due to the source of potential buyers with ~90% of homes transacted each year being listed on their local MLS. If a home seller wanted to increase access to demand to try and get the highest price for their home, they had to hire an agent to list their property on the local MLS. Buyers had to hire an agent to get access to the data on homes available for sale.


There is no single authoritative MLS but the National Association of Realtors (NAR) governs and sets standards for most of the ~800 MLSs spread across the U.S. MLSs are private entities typically owned and operated by individual REALTOR® associations or independent cooperatives of real estate brokerages. As an aside, one can look no further than the financials of publicly traded Costar Group Inc (CSGP) for an example of the power of the MLS. Costar is essentially the commercial property equivalent to the MLS but on a nationwide scale vs. the highly fragmented MLSs.


In order for brokerages and their agents to get access to supply, they had to join the local MLS. The local MLS requires the listing agent to bundle the commission payment for both the seller and the buyer and therefore set the commission rate paid to the buyer’s agent. Structurally, the seller pays the entire commission based on the selling price of a home and then sends the buyer agent’s commission through the escrow process after the sale. This prevents price competition among agents by preventing the buyer’s ability to negotiate commission rates since they are already baked into the seller’s contract. Buyers become less price-sensitive towards commission since they are removed from directly paying the commission out of their pocket.


While agent commission rates are technically negotiable, a study performed by the Consumer Federation of American found that rates are fairly uniform within each metropolitan area, with commission splits received by the buyer agent even more uniform. Rates are typically determined by the brokerage and not the agent, but the study found that nearly three-quarters of agents are not willing to negotiate their commission.


Last July the Department of Justice backed out of a settlement with the NAR requiring sellers’ agents to publicly disclose the commission they offer buyers’ agents for properties listed on the MLS. The DOJ is still expected to push for greater commission transparency but is also investigating other potential anticompetitive real estate industry practices such as the bundling of the buyers fee into the listing contract. While no further updates have been provided, if the DOJ is successful in increasing commission transparency and unbundling the buyers fee, it would likely make buyers more price sensitive and favor any brokerage that already operates as a low-cost provider and charges industry low prices relative to competitors.


Traditional Brokerage/Agent Model


Historically there has been little differentiation or benefits from economies of scale between traditional brokerages. The local MLS provides participating brokers with similar access to inventory, similar geographical reach in each locality, charges uniform commission rates, uses the same third-party customer relationship software, and typically follows the same agent contractor business model. There may be some name brand recognition from franchisors or more established local brokerages within certain areas, however, customers often pick the agent not through brokerage brand recognition, but by the reputation of the individual agent often referenced to by a family member or friend. This lack of differentiation or relative competitive advantages leads to high fragmentation with over 130,000 brokerages across the U.S.


Traditional brokerages typically operate either independently or as franchisees affiliated with national or local brands such as RE/MAX, Keller Williams, Century 21, Coldwell Banker, etc. Below is a list of the top 10 brokerages which made up ~20% of 2020 real estate transaction volumes. The brokerages below do not include franchisee sales for companies that have franchising businesses. Realogy Brokerage Group is the largest brokerage with 5% market share.

Source: Realestatealmanac.com


The list below includes real estate sales based on the enterprise level, which includes the holding companies that can own a brokerage company, a franchisor, or both. A franchisor such as Realogy Holdings, which owns Century21, Coldwell Banker, Corcoran, Sotheby’s, and better Homes and Gardens, can own multiple individual franchise brands. Companies such as Keller Williams and RE/MAX are almost solely franchisors and do not own/operate their own brokerages.

Source: Realestatealmanac.com


For an industry where commission rates are fairly uniform and not as susceptible to pricing competition, the brokerages and franchisors do not appear to significantly benefit financially. Realogy’s revenues and gross profits have grown at a modest rate over the last decade with mid-single digit operating margins.

Source: Company fillings, Factset


Other companies such as RE/MAX, charge agents a fixed fee and let them keep closer to 95% of commissions, allowing highly productive agents to make more money compared to the traditional model. RE/MAX is 100% franchised therefore does not operate any of its own brokerages offering agents support in brand, marketing & training. Rather than the brokerage determining commission rates, agents are able to set their own rates with clients.

Source: Company filings, Factset


Real estate agents, as a whole, are also not benefitting from elevated commission rates because there is an oversupply of agents relative to demand. Since nearly all brokerages hire agents as contractors there is relatively little risk in adding a new agent. Since there are relatively low barriers to entry to becoming a real estate agent, it has led to an excess of agents relative to the demand for their services. There are over 3 million active real estate agents and ~1.6 million who are registered with the NAR. That compares to ~6.2 million existing home sales expected in 2021 and ~1.1 million homes currently available for sale. There are ~2 existing home sales a year for every registered agent and ~3 registered agents for every home that is available for sale.


Commissions are spread across too many agents. Data from the NAR finds that the typical member agent closes 10 transactions a year and the industry average transactions per agent also skews heavily towards longer tenured, top-performing agents. In a survey performed by Redfin, 40% of agents closed 0-6 transactions over the last 12 months while 19% of agents closed more than 22 transactions.

Source: Redfin Investor Relations


In the same survey Redfin found that 50% of agents earned less than $50,000 after work-related expenses, with nearly 40% of agents having a second job.


Real-Estate Agent Income After Work-Related Expenses

Source: Redfin Investor Relations


These results are in line with NAR’s data that states 54% of members make less than $50,000, and nearly a quarter of members make less than $10,000 compared to the median gross income of $43,330 in 2020.

Source: National Association of Realtors


The residential real estate industry has elevated and uniform fees protected by industry practices set by the MLSs, although no players within the value chain really benefit with the exception of the local MLSs and the National Association of Realtors. Despite the high fees, it’s a competitive industry for agents, brokers, and the franchisors.


Impact of the Internet


The spread of the internet has impacted all industries to various degrees, often disintermediating middlemen of the pre-internet era who were previously gatekeepers to the access and distribution of information. The first industries to get disrupted were those that had digital intangible supply such as media. For supply of digital content, distribution and transaction costs could essentially go to zero with the power of the internet. When there are no marginal costs of supply, supply becomes abundant, and the problem to solve for users is help to filter and find supply. Platforms such as Google and Facebook naturally emerge that aggregate the supply and users.


When frictional distribution and transactions costs are low, the platforms do not have to own or control supply and can follow an asset-light business model. As frictional distribution and transaction costs go up in certain industries, such as delivering real-world products and services, the problem to solve becomes less about filtering supply (though still important) and more about being able to lower the distribution and transaction costs at scale. For example, Amazon benefited from integrated logistics/distribution with its online portal while eBay pursued a less integrated approach and therefore had a smaller addressable market.


The internet opened up access to information on which homes were available for sale through online web portals. Companies such as Zillow.com and Realtor.com aggregated home listings to provide users with free detailed information on properties.

Source: Company filings, Saga Partners


These real estate web portals transformed an industry where knowledge was previously concentrated among real estate brokers due to their association with MLSs. The Internet has become a major lead generation method for real estate marketing, displacing local newspapers and all other sources as the consumer's most preferred method to learn about homes for sale. According to a study by the National Association of Realtors (NAR), ~90% of recent home buyers say they used the internet as an information resource during their home-buying process.


However, these online portals did not guide users through the transaction. They monetized their website as a lead generator for real estate agents that paid for ad impressions delivered to users in specific zip codes. While these online portals may be providing value through aggregation and transparency, these asset-light, non-integrated players are not lowering industry costs and are effectively creating an additional layer of costs. They are focused on preserving the status quo business model of the traditional brokerages rather than lowering the transaction costs to transfer property.


Despite increased access to housing information and consumers taking on more of the work historically performed by agents, the well-ingrained industry practices surrounding commissions can only be disrupted by a brokerage within the industry that lowers the transaction costs by integrating technology with the high-touch services of an agent and then passes on the costs savings to customers.


Redfin Business Model


Redfin was started in 2002 as the first map-based search website. In the S-1, Redfin states its mission is to “make real estate better for consumers, not just ourselves…in a sales-mad, baloney-gorged world, to be the truth-teller, the fee-squeezer, the game changers.” Since its beginning, rather than quickly scale an asset-light web portal that essentially preserved the status quo of the industry by serving the existing players, Redfin decided to focus on the much harder problem to solve, making the residential real estate transaction more seamless by reducing the frictional costs.


Its initial attempt was by offering Redfin Direct, a technology to automate the real estate transaction by making it possible for people to make offers on homes through its website without the help of a buyer’s agent. Unfortunately, initial attempts were unable to gain traction because Redfin didn’t control the home listings. The listing agent was the one who controls the property, decides who sees the house, processes the offers, and typically wants to negotiate with another agent on the buyside to broker a deal. Sellers were unwilling to accept digital offers and buyers were not quite ready to place digital offers on such a high risk, infrequent transaction.


Redfin discovered that in order to disrupt the residential real estate market they had to gain market share of property listings by becoming a full-fledged brokerage. Redfin was committed to lowering the commissions charged to customers, charging 1.5% to home sellers (or 1.0% for sellers that also buy with Redfin within 12 months) vs. the 2.5%-3.0% typically charged by traditional brokerages. For homebuyers, since the commission that is paid to the buyer’s agent is already baked into the seller’s contract, Redfin refunds part of the commission back to the buyer depending on conditions and restrictions in certain states.

Source: Redfin Investor Relations


In order to charge less than competitors, hire and pay agents competitive wages, and earn attractive returns for its investors, Redfin had to lower the costs of the transaction by increasing productivity and reducing frictional costs. Rather than follow standard industry practices by hiring agents as independent contractors, Redfin decided to employ real estate agents as full-time employees with a salary and benefits, hiring its first agent in 2006. While this service and operationally intensive strategy undoubtedly slowed Redfin’s early growth, by integrating further down the funnel, Redfin is better able to control the quality of the customer experience and increase productivity by fully integrating its agents with its technology offerings.


In addition to typical brokerage services, there are numerous other services required when buying or selling a home that involve multiple parties which all have varying incentives. As Redfin has grown, it has integrated other services such as mortgage, title, iBuying, and concierge services (charges 2% to listing properties for premium services).


Role of the Agent


Historically the job of the agent was to be everything to everybody. Agents offered a bundled set of services priced at a standard fixed fee. Customers who wanted to buy or sell a home depended on agents for access to information, negotiating contracts, and seeing the customer through to the close. There were few alternative options if customers only wanted some of these services, however the blanket 2.5-3.0% fee was unchanged regardless of the level of service a buyer/seller demanded.


Agents typically operate independently with some support from their brokerage and are expected to generate their own demand by prospecting for clients. Traditional real estate agents spend significant amounts of time and resources prospecting for customers through traditional advertising channels and networking activities. Agents often become frustrated and unable to make attractive incomes because they are too many agents, prospecting for too few customers.


In a real estate agent survey performed by Placester, agents ranked where they spent the most time as follows: 1. marketing/advertising, 2. prospecting/lead generation, and 3. showings, appointments, and travel. Agents spend much of every single day solely on prospecting/lead generation.


Redfin is unbundling the job of the agent in order to increase both customer service and productivity by utilizing a team model and eliminating the need for agents to prospect for demand. Lead agents are responsible for each customer’s success, who are then supported by associate agents, marketing assistants for getting a home photographed and promoted, and transaction coordinators for closing paperwork.


Redfin has adapted the role of the agent from one that is sales-oriented to one that is service-oriented. The lead agents’ primary responsibility is not generating demand but advising customers throughout the process of buying and selling homes. The Internet is more efficient at connecting consumers with agents than the prospecting activities of most agents and the efficiency gains benefit the consumer most when a website is operated by the brokerage representing that consumer in a purchase or sale. Redfin sources demand through its web portal and funnels it to the right place based on the level of services that the customer may need.


By hiring lead agents as employees, Redfin can set data-driven best practices for selling homes and tailor software to those practices. Constantly building technologies that improve the customer experience and increase productivity leads to consistently better customer service at a lower cost which can then be passed on through savings to customers.


Lead agents were on average three times more productive, earned twice as much money, and had higher retention rates than agents at competing brokerages.


Source: Redfin Investor Presentation


Below is a chart ranking brokerage by agent productivity as measured by transaction sides per agent. Redfin ranks far higher than any other brokerage.

Source: Realestatealmanac.com, Saga Partners


The chart below plots both the average number of transactions per agent and the average sales volume per agent which shows how much of an outlier Redfin truly is compared to other brokerages.

Source: Realestatealmanac.com, Saga Partners


Financials


Redfin reports in four segments: Real Estate Services (brokerage and partner transactions), Properties (RedfinNow’s iBuying transactions), Rentals (RentPath acquired Aril 2021), and Other (primarily mortgage and title businesses).


Gross profits, as opposed to revenues, provides a better picture of the relative earning power of each segment, particularly because RedfinNow’s sales disproportionately impact total sales since the entire value of the home is accounted for as revenue, while only the commission fees earned for each transaction are recorded in the Real Estate Services segment.


As the chart below shows, Real Estate Services is the oldest and by far the largest segment making up over 80% of total gross profits. Since there are only two quarters of Rentals gross profits in the TTM, it will continue to grow its share of gross profits; however, the Rentals segment in total still operates at a loss when considering its operating costs.

Source: Company filings, Factset, Saga Partners


Real Estate Services


Real estate services include the Brokerage and Partner businesses. Brokerage revenue is commission earned by Redfin’s employed agents and Partner revenue consists of the fees earned from partner agents (~30% of commission) that Redfin refers business to from Redfin.com. Real estate service sales have grown at a 28% compounded annual growth rate (CAGR) over the last five years.

Source: Company filings, Factset, Saga Partners


Brokerage and Partner businesses are reported together under Real Estate gross profits. Gross profits have grown at a 33% CAGR over the last five years. Gross profit margins have remained between 28%-35%.

Source: Company filings, Factset, Saga Partners


Cost of revenue primarily consists of personnel costs (agent base pay, benefits, stock-based comp), transaction bonuses, home-touring and field expenses, and other expenses related to listing properties.


While Redfin reports Brokerage and Partner gross profits together, the Partner business is higher margin since Redfin simply receives their portion of the commission after a partner agent closes a transaction with relatively few associated costs of revenues. If you assume that Partner business has a ~85% gross profit margin, similar to other online lead generators and in line with RentPath segment margins, it would provide a ~28% gross profit margin in the Brokerage business. While Brokerage is lower margin than the Partner referral business since Redfin has to pay agents when they broker a deal, gross profit per transaction is much higher, as discussed in the Unit Economics section below.


The most significant lever to improving Brokerage GPM is agent productivity which has remained between 30-35 transactions per agent over the past five years. In 2018, productivity was impacted when Redfin lowered the average number of homebuying customers that its agents served by 10% which didn’t fully achieve the goal of increasing close rates, combined with a generally softer housing market towards the end of the year and into early 2019.

Source: Company filings, Factset, Saga Partners


By mid-2019, Redfin had studied the whole cohort of 2018 website visitors who requested tours and saw that service improvements had been offset by the chances a prospective buyer bought any home at all at Redfin or any other brokerage. This inefficiency pressured brokerage gross margins. Redfin has since run a six-market pilot for 18 months, testing 24% lower homebuyers per agent. While closes per agent were lower, the close rates per client were higher, with the service improvements yielding more sales and gross profit. The lower loads also improved agent satisfaction and retention. Redfin is rolling out this new agent load nationwide by the end of 2022.


When COVID spread and demand for brokerage services plummeted, Redfin laid off a quarter of their agents. As demand unexpectedly skyrocketed, Redfin was able to rehire most of their agents while trying to keep up with demand. During Q3’20 and Q4’20, transactions per agent increased as agents were working at unsustainable levels from increased demand and limited capacity of available agents. Redfin referred more customers they were not able to serve to Partner agents which elevated gross profit margins during those quarters.


Redfin has been hiring agents at the fastest rate since 2018, growing average lead agents by 500 or 30% higher year over year in an effort to meet demand. It has led to increased turnover in new agents, partly due to it being a tight labor market for service-oriented jobs and because of the historically lows housing inventory available for sale, making it difficult for newer agents who typically serve buyers to close transactions and therefore earn an attractive income.

Source: Company filings


In response to a more difficult labor market and new agent turnover, management started paying $1,500 retention bonuses for new agents who could guide customers to the point of bidding on a home, regardless of whether those bids win. The bonus will be offset by lowering the savings rebate returned to homebuyers, therefore not impacting Brokerage gross profit margins. Management decided to give new agents more value from home buyers since buyers have proven less price sensitive compared to sellers and presently value service over cost savings.


Below is an example composition of Redfin agent’s income. More tenured principal agents get increasing income from repeat business and equity compensation.

Source: Redfin Investor Relations


Management has historically managed Redfin to near breakeven in order to invest in growing the business. Operating expenses as a percent of sales (excluding rentals) have ranged between 32%-44%.

Source: Company filings, Saga Partners


The chart below breaks out operating expenses by line item. Q2’21 and Q3’21 are not included because they include ~$100M in RentPath opex and impact analysis of operating expense trends.

Source: Company filings, Saga Partners


Technology and Development costs have historically been between 12-14% of sales (excluding Properties revenues). Redfin has invested heavily in both supporting its core Real Estate Services segment that includes improving its website, writing software, and other related brokerage services, but also include investing in building the Mortgage, Title, and RedfinNow businesses which are still very early in their life and do not contribute materially to gross profits.


Similarly, marketing/advertising is a major expense item that depresses income today with the expectation it provides a return in the future. Direct marketing to potential home buyers/sellers has a longer return horizon than direct advertising for other products/services since the average sales cycle to buy a house is 6 months. If a potential customer sees an ad and then hires a Redfin agent, it will be about half a year before that investment provides a return.


There is also value to brand marketing to a consumer who isn’t planning on buying or selling a home in the near future (the average homeowner buys/sells a home every 10 years), but those investments won’t pay off for several years. Redfin tested mass media across 15 markets over a five-year period and found there was a sustained lift in demand from an ad that was run only in year one on TV and not in subsequent years.


Marketing spending is a more variable expense as experienced from increased investments made in 2019 and then significantly reduced in 2020 because of the spread of COVID and Redfin’s inability to service the jump in demand during the second half of the year. Marketing spend is ramping back up in 2021 and into 2022. Management has remained committed to growing through attractive returns on marketing spend but expects it to grow at a slower rate than gross profits into the future and likely scale to somewhere between 10%-20% of gross profits, or 4-7% of Real Estate Service revenues assuming a gross profit margin of ~35% in the Real Estate Service segment at scale.


Real Estate Services Unit Economics


As Redfin operates today, the basic unit of analysis for Redfin is the real estate transaction which consists of Brokerage and Partner businesses.


Revenues are driven by transaction volume and revenue per transaction. Transactions are a product of the number of lead agents and the transactions per agent. Total TTM transactions have grown at a 23% CAGR over the last five years, and brokerage transactions closed by Redfin agents have grown at a 25% CAGR.

Source: Company filings, Saga Partners


Brokerage transactions have higher revenue per transaction compared to Partner transactions where Redfin earns part of the commission for partner agents closing a transaction that Redfin referred to them. Changing home prices will impact revenue per transaction since it is determined by a percent of the value of the home.


Brokerage revenue per transaction has grown at a 2% CAGR over the last five years while total revenue per transaction has grown at a 5% CAGR, which when combined with the growth in transactions, provides the Real Estate Services business a five-year 30% revenue CAGR.

Source: Company filings, Saga Partners


Brokerage and Partner gross profits are reported together under Real Estate gross profits. If you assume that Partner has a ~85% gross profit margin, you can back into the gross profit per brokerage transaction and per a Partner transaction.


TTM Brokerage transactions have a $3,500 gross profit and Partners would have a $2,600 gross profit. It is more profitable for Redfin to close transactions with their own agents than to refer business to partner agents, especially since agents are a fixed cost when not closing transactions.

Source: Company filings, Saga Partners


The chart below includes total Redfin operating expenses (excluding Rental) per total Real Estate Service transactions. Opex includes investments in growing the other businesses such as Mortgage, Title, and RedfinNow (although all RedfinNow transaction costs are in its RedfinNow segment COGS). While those businesses are expected to provide material gross profit in the future, they are currently supported by the Real Estate Services business.

Source: Company filings, Saga Partners


Historically, Redfin lost a few hundred dollars per transaction. As agent productivity increased during H2’20, Redfin sent more business to its higher-margin Partner agents, and management decreased marketing spend, Redfin had a few quarters of operating income per transaction. More recently, transactions per agent have returned to more average levels and the company started to increase marketing spend pushing operating income per transaction negative.


Source: Company filings, Saga Partners