I suppose I appreciate the efficiency with which Techcrunch expressed its skepticism for tech’s latest unicorn, Opendoor; it’s right there in the headline: Online real estate service Opendoor raises $210M Series D despite risky financing model. And, to be fair, Opendoor’s approach is risky. Here’s a summary from a feature in Forbes magazine:

Opendoor is betting that there are hundreds of thousands of Americans who value the certainty of a sale over getting the highest price. The company makes money by taking a service fee of 6%, similar to the standard real estate commission, plus an additional fee that varies with its assessment of the riskiness of the transaction and brings the total charge to an average of 8%. It then makes fixes recommended by inspectors and tries to sell the homes for a small premium. Buyers get to shop on their own timetable, using key codes for access to the properties, and they receive a 30-day guarantee that Opendoor will buy it back if they’re not satisfied and a two-year warranty on the electrical system and major appliances… To succeed, it has to price the homes it buys accurately, without seeing them, and it has to sell them quickly to minimize the costs of carrying them. As interest rates rise or housing prices fall, Opendoor will have to figure out how to respond. When market risk increases, the company may charge a higher fee, its own version of surge pricing.

To paraphrase that Techcrunch headline, what were those investors thinking?

Zillow and Redfin

Real estate has long been an appealing market for investors, and for good reason: there is a lot of money at stake. The United States alone has $25 trillion worth of housing, and $900 billion of that changes hands every year; that means well over $50 billion in real estate fees and even more in mortgage interest. It is a market tailor-made for those ubiquitous “If we get X% of the market” pitches that have characterized many a startup business plan.

And yet, the most successful real estate startup, Zillow (which acquired its largest competitor Trulia a couple of years ago), is little more than a glorified marketing tool: the company makes most of its revenue by getting real estate agents — the ones collecting 6% of fees, split between the buying and selling agents — to pay to advertise their houses on the site. Certainly a free tool that makes it easier to find houses in a more intuitive way is valuable — Zillow has acquired the sort of userbase that allow it to build an advertising business for a reason — but at the end of the day the company is a tax on a system that hasn’t really changed in decades.

Redfin, meanwhile, which came up with the original houses on a map idea, is taking real estate agents on directly by being a real estate agent itself: their hook is that other tech monetization favorite, being cheap. Redfin keeps half as much as a typical selling agent and pays its agents a salary instead of commission. Both limit growth: regular agents with a stake in the current system steer home buyers away from Redfin properties, and hiring and training agents who aren’t interested in the upside from commission takes a lot of time and money.

The Opendoor Model

Opendoor is unique in two respects:

First, Opendoor is focused on sellers, the party with the least leverage in a typical residential transaction. Real estate agents sell lots of houses, buyers can choose from lots of houses, but sellers only have a single house to sell, which means the cost of any delay or complication falls on their shoulders. Opendoor relieves that burden by making an offer for the house based solely on an address and questionnaire; if the seller accepts Opendoor will send an inspector to verify the house, agree on any necessary repairs (which are paid by the seller), and close the deal as soon as the seller wishes.

Second, Opendoor explicitly charges sellers for having replaced total uncertainty with a bank wire: not just the same 6% that typically goes for buyer and seller agent fees, but also an additional 0-6% for “market risk” — i.e. dealing with the uncertainty of actually showing and selling the house — along with the aforementioned repair costs.

After that the house is on the market like any other, listed in the Multiple Listing Service (MLS), and freely accessible to regular real estate agents to whom Opendoor will pay the customary 3% fee a selling agent pays the buying agent. There are some additional niceties uniquely enabled by technology that both enhance the buying experience and keep prices down, particularly 24-hour access to listed homes with only a smartphone (and cameras to keep a watchful eye), but unlike Redfin, Opendoor isn’t seeking to compete with agents on price, giving them no reason to retaliate; remember, Opendoor actually charges more!

The Ingredients of Disruption

This is a dynamic that Redfin never understood: using technology to list houses was a sustaining advantage that was trivially co-opted by Zillow et al working hand-in-hand with realtors, while competing on price incentivized independent realtors to effectively collude against Redfin without any overt organization.

More broadly, technology alone is rarely sufficient when it comes to entering existing markets: at best a company focused on technology can skim a tax from incumbents, either through advertising like Zillow or service fees; taxes, though, by definition only capture a slice of the value being generated. To truly disrupt a market requires both a differentiated means of meeting the needs of an underserved market and a new business model.

Given that, look again at Opendoor’s two unique features:

Sellers are uniquely disadvantaged under the current system, which is another way of saying they are an underserved market with unmet needs

Opendoor has a new business model: taking advantage of a theoretical arbitrage opportunity (earning fees on houses sold at a slight mark-up) by leveraging technology in pursuit of previously impossible scale that should, in theory, ameliorate risk

Unlike Zillow and Redfin, Opendoor has the pieces in place to actually disrupt the market over the long run.

Opendoor Risk

There’s no question Opendoor’s approach is, to use Techcrunch’s term, risky. The company needs to accurately price homes sight unseen, carry them on the balance sheet while waiting for them to sell, and bear the risk of market collapses, and that’s above-and-beyond the usual startup risks: finding customers, scaling the product, dealing with regulations and paperwork that differ in every market they enter. It’s a whole lot less risky to just build a fancy search engine and charge advertising, or try to win on price.

Risk, though, is not only about downside; it’s about upside. More than that, the level of downside risk is correlated to upside risk: Opendoor has many more reasons why it might fail than Zillow or Redfin, but its potential upside is far greater as a result. First is the immediate opportunity: sellers who can’t wait. However, as Opendoor grows its seller base, especially geographically, its risk will start to decrease thanks to diversification and sheer size; that will allow it to lower its “market risk” charge which will lead to more sellers. More sellers means both less risk and an increasingly compelling product for buyers to access, first with a real estate agent and eventually directly. More buyers will mean lower marketing costs and faster sell-through, which will lower risk further and thus lower prices, pushing the cycle forward. It’s even possible to envision a future where Opendoor actually does uproot the anachronistic real estate agent system that is a relic of the pre-Internet era, and they will have done so with realtors not only not fighting them but, on the buying side, helping them.

Or, in the next downturn, the entire company might go bust.

Opendoor’s Potential Impact

There is a deeper reason why I am excited about Opendoor, and it too is related to how the company’s approach differs from Zillow’s and Redfin’s. While Zillow makes it easier to look for new houses, and Redfin promises to save sellers a few bucks, making it trivial to sell a house has the potential to fundamentally impact our economy at a time we desperately need exactly that. Many, including myself, have written about how globalization and technology are upending the job market; one particular challenge is that often new jobs are created in different geographic areas than where job seekers are located.

To that end the potential for Opendoor to dramatically increase liquidity in the housing market by buying direct from sellers is not just a business opportunity, but one with the potential to increase dynamism in the job market. Granted, it will take a long time for Opendoor to move into the towns where this sort of service is most needed, but the idea is very much a move in the right direction.

I suspect that this positive impact is related to Opendoor’s business model: by identifying a market need and offering a paid service to alleviate that need, Opendoor is creating value as opposed to taxing a few bucks off the top of an existing market or simply trying to be cheap. While I am hardly anti-advertising, the fact of the matter is that it is a zero-sum market: advertising has been just over 1% of U.S. GDP for a century, which means advertising-based businesses are by-and-large stealing value from other advertising-based business, not creating their own, at least from a dollars-and-cents perspective (end users have been the real beneficiaries, as most of the value creation of services like Google and Facebook is consumer surplus). Meanwhile, simply being cheaper is certainly a viable business model, but it is on the whole deflationary, which is to say value-destructive; sure, money saved can be deployed elsewhere, but the long-term benefits are much more difficult to trace.

To that end I hope Opendoor succeeds simply so it can be a role model for tech: taking on big risks for big rewards that create real value by solving real problems is the best possible way our industry can create benefits that extend beyond investors and shareholders; for too long too much money and talent has been poured into low-risk digital-only businesses that aspire to little more than leeching off of value creators that already exist, or at best cut them off at the knees with low prices, with the assumption that someone else will pick up the pieces. And while I am all for appropriate skepticism, to not consider upside is to be just as oblivious to risk as those who don’t consider what might go wrong.

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