Record foreclosures and soaring home values will change home-buying in 2021

After 25 years in frigid Minnesota, Colleen Mulcahy decided to retire and move back home to Rhode Island (not much warmer, but better seafood). The pandemic complicated her plans: selling a home is already a logistical nightmare without social distancing in the mix.

"We didn't want to deal with people coming into the home, especially during COVID," Mulcahy told Protocol. "We have a small dog; we knew it wouldn't work."

Mulcahy and her partner decided to try something new: Zillow Offers. After they filled out a form expressing interest in selling, Zillow sent an inspector out to take pictures and check on the overall condition of their home. That was the only time Mulcahy dealt with anyone in person. A few days later, Zillow paid for the house in cash, based on an estimate that blended pricing algorithms and the in-person appraisal.

"Being in the driver's seat, we could sell when we wanted to," Mulcahy said. "Usually the closing is seven to 10 days, which is really nice. But then if you weren't ready to move for another three months, you could still stay in the house."

Zillow took less than a month to resell the house. Mulcahy, who kept tabs on her Minnesota home even after selling it to Zillow, said she feels she got a fair price. "They made a little profit, obviously," she said. "We were just so happy being able to get everything done … They took care of all the paperwork, every single thing."

Hundreds of U.S. homeowners have sold their homes to Zillow, Opendoor and Redfin during the pandemic. The companies, known as iBuyers, act as market-makers: They aren't trying to buy low and sell high, but generate profit through transaction fees. iBuyers aim to flip homes as quickly as possible to avoid tax and upkeep costs.

iBuying is still only a blip on the radar of the overall U.S. housing market. Some 5 million homes were sold nationwide in 2019, meaning the iBuyers like Opendoor, Zillow and Redfin altogether accounted for less than 1% of total transactions. Nevertheless, the companies have achieved extraordinary valuations on the disruptive potential of their business model. At the time of writing, Zillow has a $32 billion market capitalization (nearly five times what it was in March); Redfin has $8 billion; and Opendoor went public through a SPAC in December that valued the company at around $18 billion on opening day.

While the pandemic has made their upside more apparent than ever, iBuyers have struggled to capitalize on the opportunity due to the shortage of sellers in the U.S. market. But 2021 could prove to be a landmark year for iBuyers as the pandemic abates and real estate transaction volume rises. It may also prove to be a particularly treacherous year — home valuations are skyrocketing against the backdrop of significant economic hardship, and U.S. homeowners have deferred $1 trillion in mortgage payments during the pandemic through forbearance programs. iBuyers have yet to prove their resiliency against a market downturn, and they aren't beholden to the same regulations institutional lenders have faced since the 2008 financial crisis.

Making markets

The traditional process of selling a home is fraught with uncertainty. Say a seller is lucky enough to find a buyer the first day their home goes on the market: That buyer will still need to secure a mortgage, which typically takes upwards of 45 days . The seller doesn't actively seek another buyer during that period, even though it is still possible the sale falls through because the first buyer changes their mind or the bank denies the mortgage. At the same time, sellers are often in the process of finding a new home as well, so they may decide to pull the plug on the deal if the move-in dates don't align or they have trouble securing their own mortgage.

Traditional transaction costs in the U.S. residential real estate market are also exceptionally high, even compared to the U.S. commercial real estate market and residential markets abroad.

"There are noncompetitive pressures among realtors to keep their transaction fees high," Benjamin Keys, a professor of real estate and finance at the University of Pennsylvania, told Protocol. "The seller pays broker fees and those are subsequently divided between the broker's agent and the seller's agent. That uniquely inhibits competition on the fees. Suppose you post a house and you are only going to charge a 2% fee instead of a 5% fee — as a buyer's agent, I'm just going to look at other houses instead."

iBuyers entice sellers with convenience and certainty, but their fees are often higher relative to the traditional model. That doesn't mean it is necessarily cheaper to sell through the traditional model, since sellers also need to factor in the costs of staging a home, property taxes, upkeep costs and various transactional fees. But sellers may just want to avoid the hassle: iBuyers have cash on hand, so sellers don't need to wait for a bank to approve a sale. And unlike a traditional home buyer, iBuyers don't need to move in to the home, so they can offer flexible move-out dates.

"What the pandemic did was add a third benefit, maybe more short term, [with] the idea of safety," Jeremy Wacksman, the president of Zillow, told Protocol.

Zillow, along with Opendoor and Redfin, froze home-buying operations at the onset of the pandemic due to uncertainty in what laid ahead. However, it soon became apparent that with record-low interest rates and the shift to remote work boosting the appeal of suburban living, demand for homes would not only recover but reach new heights.

"What that pause did for us was allow us to retool a lot more digitally," Wacksman said. "Zillow has always been pushing for more digital transactions tools, more online. [The pandemic] forced everyone to go, 'Wait, can I possibly sign in remotely? Can I notarize remotely?'" he said. "They're interested in the idea that, 'Hey, if I need to sell, I could sell without anyone coming into my house.'"

Supply crunch

Despite their supposed heightened appeal during the pandemic, iBuyers didn't actually perform all that well in 2020. In the three months that ended Sept. 30, 2020, revenue from Zillow Offers dipped 52% compared to the same period last year, from $384.6 million to $185.9 million. In that same period, Redfin generated only $19 million from its properties segment (which encompasses its iBuying service RedfinNow), representing a 76% year-over-year decline. And in its S-1, Opendoor disclosed $2.3 billion in revenue for the first nine months of 2020, a 33% dip from the same period in 2019.

The freeze in iBuying activity certainly contributed to this downturn, since it disrupted the home inventory pipeline. But when operations resumed, iBuyers faced a market in which demand far exceeded supply. "I think the housing market is the clearest indication of the economic divide at the moment," Keys said.

"You have people who have been working from home, who are actually spending less disposable income — they're not going on trips, eating out, going to shows; they are actually saving money to buy a down payment on a house," Keys said. Consumers' priorities have also varied wildly. "On one hand, you have a group of people who have potentially heightened demand for houses, especially for houses with a yard," Keys added. "On the other side, you have very tight supply, because who wants to move in the middle of a pandemic unless you have some good reason to do so?"

The U.S. housing supply (a measure of how long the current supply of homes would last at the current rate of demand) plummeted to 3.5 months in August and September , down from 6.8 months as recently as April, according to U.S. Federal Reserve data collected since 1963. Only once before, in June 2003, has housing supply been as low as 3.5 months. As recently as April 2020, the housing supply was 6.8 months.

"Our supply is extremely low and we're seeing sales still quite high," Kerry Melcher, the head of sales and brokerage at Opendoor, said. "It's like a chicken or the egg: It is difficult to stick your house on the market when you want to buy in that same market and there's just so little supply."

There is only so much iBuyers can do when faced with such tight demand. Their business model already has slim margins, so there's not much wiggle room to attract sellers with lower fees. One of the most frequent online complaints about iBuyers is the amount of unsolicited mail they send to homeowners, aiming to entice a sale. Though sometimes the outreach efforts do work; one seller in Arizona told Protocol that she had only heard of Opendoor because they advertised on NPR so frequently.

With limited means of boosting transaction volume on their own, iBuyers are at the mercy of the broader economy. As Opendoor explained in its S-1: "This transaction volume affects all of the ways that we generate revenue, including our ability to acquire new homes ... to sell homes that we own, ... our brokerage business, ... our mortgage business, and the number of transactions our title and settlement business closes."

The shadow of '08

There are many reasons for iBuyers to be optimistic about 2021. It could even shape up to be a perfect storm: The pandemic has normalized buying and selling everything, including homes, online; the vaccine could bolster consumer confidence in an already booming housing market; and cash-strapped homeowners could turn to iBuyers to unlock their record-high home equity. With companies adopting permanent work-from-home policies, would-be renters in places like San Francisco and New York can instead choose to become homeowners in places like Park City, Charlotte, Columbus or Austin.

"[We believe] 2021 will go down as the strongest year for home sales since 2005," Matthew Speakman, an in-house economist at Zillow, told Protocol. "The outlook from the sales side of things took a pretty big dive in the early part of the pandemic as so much uncertainty set in. It's improving in fits and starts, but it has rebounded quite consistently overall. We expect that to continue into 2021."

But soaring home values and record-low interest rates only tell one side of the story. For millions of Americans — particularly those who were already struggling before the pandemic — 2021 is poised to usher in a full-blown housing crisis. The government programs that allowed many renters and mortgage holders to keep a roof overhead are set to expire in March. A short extension on the moratorium passed as part of Congress's Dec. 21 stimulus bill will only act as a Band-Aid to a much larger problem: Of U.S. adults who weren't up to date on their mortgage payments, 20% who responded said they were "somewhat likely" or "very likely" to be foreclosed on in the next two months, according to the Census Bureau's recently Household Pulse Survey. And then there's the fact that forbearance rates reached nearly 60 times the baseline rate in the U.S. this year, with a peak of $1 trillion in mortgage debt in forbearance during the pandemic.

"Fortunately, the government has put in place a ban on foreclosures and a ban on evictions," Adena Hefets, the CEO of the rent-to-own startup Divvy told Protocol. "But at some point, when there's a vaccine and it is expected that people go back to work, if payments don't start coming in, those people are going to be at risk. It wasn't forgiveness, it was a delay. And so now they're going to have a ton of money due."

The magnitude of the housing displacement will determine the fortunes of iBuyers. If demand holds up during a foreclosure spike, then the market could normalize to some extent, with prices lowering, housing supply increasing and transaction volume rising. If the foreclosures extend far beyond demand, however, it could usher in a downward spiral in home prices. Banks may freeze lending activities in such a scenario, creating a cascading effect down the market. iBuyers finance their operations in part through low-interest loans — often in the tens of millions of dollars — from banks such as Goldman Sachs, Crédit Suisse, and Citibank.

"To the extent that we're going to have any sort of echo of the 2008 crisis, it's going to come through a wave of foreclosures," Keys said. "So the question is: What is in place to prevent another wave of foreclosures when the moratoria expire? And how flexible are we going to see both government players and the private market in modifying loans in extending mortgages out so there aren't a lot of back payments due?"

iBuyers only represent a fraction of the U.S. real estate market, so they aren't held to the same regulatory standards as banks. But iBuyers have significant housing inventory on their books at any given time: At the end of September, Zillow reported $193 million in housing inventory, Opendoor reported $152 million and Redfin reported nearly $25 million. That housing inventory could easily grow five or six times over in 2021 as iBuyers go back to buying as usual. At the beginning of 2020, for instance, Zillow had nearly $837 million in housing inventory on its books. The fees iBuyers charge sellers are based on the duration they expect to hold a home: This means that a steep decline in housing prices could force iBuyers to either sell inventory at a loss or hold onto it for a long time while accruing related costs.

Quinn Hawkins, the VP of investments and renovations at Redfin, is confident in iBuyers' ability to withstand a market downturn. "Most housing recessions have been very mild: 2008 was the obvious [outlier] that looked like none other," Hawkins said. "Even then, it took two years for the housing market to lose 50% of its value, and that was only a few markets like Phoenix, Riverside County and Las Vegas where there had been a lot of speculation. [In] places like Seattle, things went down maybe 10[%] or 15%."

Hawkins added: "We do price in risk — you can think of us like a quantitative trader, where we're assessing the value of that asset and what we think the risk is [associated] with it."

However things pan out, 2021 promises to teach us a great deal about the long-term viability of iBuyers. If transaction volume soars to all-time highs, we will find out whether their business model can turn a healthy profit in near-ideal market conditions. Should housing prices plummet, we'll see if iBuyers are resilient and sustainable. Both scenarios could test investors' faith: iBuyers' ability to forgo near-term profits for market expansion has so far been justified to investors as a strategy akin to what Amazon did in the early 2010s. But as Opendoor itself disclosed in its S-1, "We have incurred losses during our history and do not expect to become profitable in the near future, and may never achieve profitability." For all that iBuyers have going in their favor — the broken agent fees system, an influx of millennial homebuyers, a target U.S. real estate market with $1.6 trillion in annual transactions — sooner or later investors will ask them to pay the piper.