4 Lessons from a Real Estate Disaster

Never send an algorithm to do a scout’s work.

There’s a reason why I spend six months a year traveling the world, putting boots on the ground…and why my team and I spend over a million dollars a year on scouting and researching real estate.

We do it because, well, there is no other way to find true real estate deals…

And last week, we saw half a billion dollars’ worth of proof.

As you might have heard, the real estate listings firm, Zillow, got into serious trouble recently with its so-called iBuying business. And now the company is trying to offload around $2.8 billion worth of houses and is expected to make a loss of half a billion dollars. All because they thought an algorithm could make smarter investment decisions than a human.

So, what the heck is iBuying?

Essentially, it’s a form of large scale real estate flipping that hands bots (or an algorithm) the power to make huge investment decisions.

Here’s how it works: Homeowners go to Zillow to check their “Zestimate,” a tool on the Zillow website that gives an approximate value of the home. If the home is in an area that Zillow is interested in buying, the owner can click a button, fill in a few details, and within 48 hours Zillow with make an offer based on its data. Boom!

But it’s not all machine. They use broker partners to make sure the offer is appropriate. Then, if the owner likes the offer, Zillow sends out an employee (not a licensed inspector) to look at the house in person and adjust the offer depending on repairs needed. At which point, the owner can accept the offer or not.

In all, the process takes less than a week.

Zillow’s goal is to then fix up the property and resell it at a profit—more commonly known as flipping.

Speaking as a seller, this sounds great to me. The initial offer is based on data that the seller provides! The local broker, who is supposed to be the failsafe against a glitch in the machine, doesn’t even visit the property. And then, the only real inspector isn’t even a professional.
If I wanted to offload some shoddy real estate, I’d go to Zillow.

However, from the point of view of an investor, I think this whole thing is nuts!

In fact, in March 2020, while iBuying was still being hyped as the next big thing in real estate, I was calling it one big mistake.

Here’s what I wrote at the time:

“I think it’s nuts. Algorithms should be used for helping you decide what to watch on Netflix…not as the sole assessor of the value of a home.

Don’t get me wrong…I’m all about the data. But there is no substitute for boots-on-the-ground experience and true local knowledge—it’s an essential element to any real estate analysis. While iBuying technology might work with new cookie-cutter homes in an established market, once any variables are introduced it can fall short.”

And guess what? It has…

Last week Zillow reported a $330 million quarterly loss and said it planned to end its house-flipping business. The second quarter of the year was even worse!

Zillow is now sitting on18,000 houses that it needs to offload. And it expects to sell them at a 5% to 7% loss. It also expects to lay off a quarter of its workers.

Disaster!

But as outside observers, this whole debacle provides some interesting lessons for us, aside from the obvious lesson that we shouldn’t put all our faith in an algorithm.

In fact, if anything, this is a lesson in human error, and how hubris overtook good judgment. The thing is, Zillow didn’t start out as a real estate business. It had no experience buying or selling real estate before it poured billions into it. It was first and foremost a tech company that made its money through advertising fees.

Yet, because it saw the opportunity to enter the market, and because it had collected so much real estate data, it thought it could simply throw its hat in the ring and do it better than experienced investors.

Here’s why it failed:

1) It paid too much. Zillow’s model was to pay market value for a home in good condition, then polish it up with some paint and fresh carpets, and sell for a profit. The problem is, in a hot market the “fair market value” can be overblown.

For instance, one of the homes Zillow now needs to offload was bought for 56% above the original asking price.

Maybe this purchase made sense to an algorithm with limited data on market cycles. But as we know, prices don’t only go up all of the time. And if you’re heavily leveraged in the house flipping game, as Zillow was, even a market cooling can be enough to topple you.

The key to coming out strong even during turbulent times is to find exceptional deals. That’s what I do for members of Real Estate Trend Alert. We use our group buying power to negotiate deals for well under retail cost so that they maximize our gains at the point of buying.

2) Zillow played fast and loose with tight margins. House flipping is a risky game and profit margins are usually tight. You work under the assumption that someone else will pay more than you did for the same property. That’s why most house flippers spend so much of their time searching for overlooked and undervalued properties. They know that if they overpay they could come out at a loss.

In a booming real estate market, the risk of house flipping is less visible. Every purchase starts to look like a winner. And Zillow got blindsided by this. They purchased recklessly because data showed them prices only going up. Then, when the music paused, they were caught without buyers willing to pay more than them.

My real estate strategy takes the complete opposite approach. I prefer to invest in long-term macro trends rather than quick flips. For instance, I follow and buy ahead of Paths of Progress that can boost the value of real estate over the medium- to long-term. This strategy takes more patience, but it’s also far less risky and can hand you far bigger gains in the long run.

3) Zillow didn’t hedge against bad times. Even new investors know that you should never go all in on a single strategy. Yet, this is exactly what Zillow did. Because it’s margins were tight, the idea was that the sheer volume of purchases it made could still deliver big profits. This meant the company was overleveraged and all its eggs were in one basket.

But there are a number of ways to hedge against bad times as a real estate investor. The most obvious is to tap into rental income. Even if your property isn’t appreciating as quickly as you’d like, if you have a tenant sending you a check each month, you can still pay off your mortgage and then some.

Better still, you can buy real estate in an internationalized destination that has multiple rental markets, with tourists from different parts of the world, permanent and seasonal expats, as well as work-from-home and long-stay visitors. Places where, no matter what happens, people always come and you can always find renters once you buy well. These places are far more resilient to crises.

4) Zillow didn’t put boots on the ground. As I said up top, there’s no substitute for real boots-on-the-ground research. And that has become very self-evident.

While I’m not totally against the iBuying concept. Its limitations need to be recognized. There is only so much data can tell you about a property. The only way to get a true picture is to go and see it for yourself.

That’s why I spend six months of the year traveling and viewing proposed sites and construction projects. I consider it invaluable research, even if I already have tons of data on an opportunity. It gives me the full picture, and reveals things that would otherwise be missed…right down to the quality of light and the ambient sound.

And it allows me to firmly stand behind the recommendations I make to Real Estate Trend Alert members. (If you’re not yet a member of RETA, you’ll find more info about what membership offers, as well as the chance to take it for a 3-month test drive here.)

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