Why South Park won't help you build a disruptive real estate startup

This post was co-authored with Ruwin Perera (Formerly Softbank, Google, BCG). It's among a series that looks at real-estate startups.

When trying to disrupt a marketplace, most companies use a South Park inspired approach, which consists of three phases:

Phase 1 - Build technology to replace the middleman facilitating the transaction
Phase 2 - ? 
Phase 3 - PROFIT!

In our previous post on the US residential real estate market, we explored the feasibility of this “strategy”. In short, it doesn’t work because agents are so well entrenched that it is irrational for buyers and sellers to eliminate them. While there are companies who continue to approach the marketplace by tackling agent commission, they haven’t seen the exponential growth typical of marketplace disruptors.

Disrupting real estate requires something fundamentally different from merely cutting transaction costs. But how? We have to start with user motivations because the most successful product companies are the ones who meet unmet needs. In this space, there are clear unmet needs relating to creating liquidity for sellers and providing diversification for buyers.

Sellers value a short timeframe and certainty of closing. Having just been through the sale process for our San Francisco properties (a “hot” seller’s market), we can attest to these concerns. The NAR data below shows average days on market, by state:

The time from deciding to sell to finally closing represents very real dollars for a seller. Even in San Francisco, days on market plus closing time will typically exceed two months. In most markets, this time is much longer and carrying costs during sale could easily exceed 2% of a property’s value. 

Even after a house is in contract, there are any number of contingencies that allow the buyer to drop out until almost the last minute, resetting the clock for the seller.  

And of course, that assumes that the home sells at all. Homes don’t always sell, or don’t receive any acceptable offers. In the meantime, a seller is still paying the mortgage, property taxes, and any other related fees on at least one home, if not more. The dollars continue to add up.

Sellers are highly motivated by liquidity. And Opendoor is a great example of a company who builds with this in mind, creating a powerful product and company. 

Their model gives sellers a binding offer on their home within a matter of days, at a price based on comparables. They are fast - a seller could have money in the bank in just a few days. Opendoor then resells these homes using both their own site and traditional channels. In doing so, they eliminate the seller’s agent fee, and could conceivably eliminate the buyer’s fee in the future.

For this service, they charge a 6% fee (which is roughly what a seller would typically pay agents anyway), as well as a 0-6% market risk fee, which they can tweak based on market dynamics. They also finance (and derive the benefit from) staging and light renovations, which can add several percentage points to the value of the home.

The model is capital intensive because they need to purchase the homes outright, and take some market risk. However, they mitigate much of this risk by picking both high-velocity markets (currently in Dallas and Phoenix), and by limiting themselves to mass-market properties that sell in more predictable ways. Assuming they can move the houses within a few months, capital costs can be held to less than a couple of percentage points (in today’s low interest rate environment). 

So, if OpenDoor can charge sellers 6-12%, add a few percentage points of value via renovations and staging, and their costs are a couple of percentage points of interest and a buyer’s agent commission, it follows that an 8%+ gross margin is not inconceivable with this model. 

And it doesn’t end there. On the buyer side, the key unmet need is risk mitigation. Buyers are writing the largest check of their lives, and they are justifiably scared of buying a money pit. In the traditional market, the imperfect solve is a buyers agent and a property inspection. In Opendoor’s case, they provide a “30-day guarantee”, which gives buyers most of their money back if they change their mind. Moreover, they build a brand that stands for quality move-in-ready homes. As they grow in a given market, they could build enough scale that buyers come direct to OpenDoor without agents and their fees.

For investment property owners, there are even greater buyer-side risks. Not only is the investment size significant for most buyers, but it’s also leveraged. A few months of missed rent can make it hard to make ends meet, and a black swan event can bankrupt them. 

What’s more, there’s a huge segment of the broader population that would love to invest in property, but simply don’t have enough cash to make an investment. While some of the more sophisticated ones could invest in REITs, they need to trust the unknown manager’s process  and many investors would prefer to have more control in their property decisions.

There are several new players who want to make it easy to invest in property. Firms like Fundrise, and UK-based Property Partner allow ordinary would-be landlords to invest directly in individual properties and projects while maintaining diversification. They have small minimum investments, and allow investors to crowdfund into multiple property investments online. Fundrise focuses on mid-market projects ($5-100M), and Property Partner focuses on individual dwellings. Property Partner properties are also leveraged, so the investment return profile mimics that of a direct residential investment property, but with added diversification. 

The big challenge for these models today is what happens when a buyer wants to liquidate their investment. Getting the property on the market is far more difficult when hundreds of  investors have a say, each with different investment objectives and holding periods. Not every investor will want to liquidate at the same time, especially when the market turns south. 

We haven’t seen an elegant solve to this problem yet, but Opendoor proves that there’s a market for providing liquidity. At the very least, there’s a banker somewhere that would buy a person’s stake in a property, subject to a liquidity discount. Sounds like a problem waiting to be solved.

In house sales, sale price is treated as the only factor but the reality is that price is comprised of many things for buyers and sellers. So while it’s no easy business, there are huge market opportunities for the companies that truly focus on the unmet needs of buyers and sellers.