Residential Real Estate Firms: The Truth About High Valuations
An analysis of recent financial reports and valuations of firms.
We’re aware of a real estate services company with gross revenues that grew nearly 40% over the past 12 months. Unfortunately, their gross margin declined by 25%, their interest expense from operating credit facilities grew from nothing to over $2 million. They did not have a profit in the prior year, and the loss more than doubled over the last 12 months. They burned through a significant portion of the cash they had on their balance sheet.
There are actually two firms exhibiting these characteristics. The valuations of these two firms seem to defy normal valuation models and metrics.
Meanwhile, we know of two other national real estate services firms that, although they lack material growth, currently have high gross margins and their cash flow margins are substantial. They both have debt, but at levels that seem manageable. Their valuations are barely above the EBITDA (Earnings before Interest Taxes Depreciation and Amortization) multiples that most local and regional real estate brokerage firms have carried in the past. Most brokerage firms that we are handling as of August 2019 are trading in a range of 3.0 to 4.0 times trailing 12-month EBITDA. A few of the largest brokerage clients are trading at a multiple of 5.0 today.
The first two companies above are Redfin and Compass. The second two are Realogy and RE/MAX. How can one company, Compass, have equity market value of more than the other three combined? As of this writing, Compass’s internal pricing (as of their last round of funding) was $6.4 billion, while the equity values of Realogy, Redfin and RE/MAX together are less than $3 billion. Redfin alone has an equity value of more than Realogy and RE/MAX combined, yet these latter two companies generate more than $600 million in annualized cash flow.
Balance Sheet Vs. Income
We also observe that Redfin and Zillow are counting the prices paid for homes in their iBuyer programs in their revenues. To many, this seems absurd. Isn’t this a balance sheet item rather than an income item? These companies are booking the values of the homes they buy as an income item and offsetting that with the receipts from the sale of the same homes. It jazzes their revenue growth but doesn’t seem like the right way to book these transactions. Then again, we assume their auditors are looking at these transactions carefully.
How to Understand These Valuations
There are a few simple answers. First, according to an article in The Wall Street Journal, there’s more than $12 trillion of excess cash sloshing around the world looking for a return. This excess liquidity was and is still being generated to keep various economies from sinking. Think about the U.S. where Federal deficits are again running more than $1 trillion a year in the red continuing to provide liquidity to an economy that shouldn’t need it.
Here’s Our Take
Investors are looking for growth stories, and Compass and Redfin are telling good growth stories right now—so is Zillow (which is worth more than all four companies listed above combined). So, having a piece of the American residential real estate business is seen as an attractive bet, and that is what it is, one of many chances that investors make with their funds.
Wall Street and Silicon Valley love a great disruption story. They’ve seen many industries disrupted with high returns from early investments in companies that threaten to disrupt large fragmented industries—of which we are a big one.
Wall Street and the global investment community love anything related to technology. Again, many have made solid returns from investing (betting) on technology-based companies.
Some investors think that Redfin and Compass are more technology firms than brokerage firms. They think they are great disruptors or have the potential to be great disruptors. Keep in mind that these investors are betting billions of dollars on a wide range of companies fitting their profile of acceptable investments. It’s not as if they are betting the ranch on Redfin or Compass. These two companies are just two of likely dozens of companies that they are invested in. It’s not that they know something about the industry that makes them want to bet the ranch.
These same investors don’t see Realogy and RE/MAX the same way. They’re not new or interesting, nor do they
(so far) have new or compelling technology or disrupting story. Nor are they growing at 20% to 40% a quarter. So, while Compass and Redfin get the press for their growth, Realogy and RE/MAX don’t.
Investors like the story of Compass and Redfin, along with firms like Zillow and eXp—growth, disruption, and technology.
Forget the Stock Prices
Forget about what’s happening with the stock prices of any of these companies. Their prices are not determined by fundamentals of what their gross margins or profit margins are at this time. It could be years before we know how Compass or Redfin perform from a more traditional story of growth and earnings. They could be home runs or duds. No one knows for sure, currently.
The only thing that should matter to brokerage owners and leaders is that they have to compete with firms that have access to significantly more capital than incumbent realty services firms and that. Also, while the incumbents are measured on growth and earnings, some of these firms don’t have to worry about earnings—just growth, disruption, and technology. At least, that’s what’s happening today