OpenDoor.com has been getting a fair amount of press, and for good reason. First, they seem to have raised a fairly significant chunk of money. Second, they are bringing some of the change that the real estate market has needed for a long time. A new real estate ecosystem appears to be emerging and OpenDoor is a big part of it. Click To Tweet
Much of the initial press on OpenDoor focuses on one critical point. OpenDoor must, by its nature, hold a decent sized inventory of homes at all times. As fast as they might be in buying and selling, they cannot sell homes they don’t yet own, so they will have to own homes pretty much all the time. This leaves them with an exposure to downturns in real estate prices. Depending on the size of the inventory, the level of leverage they use and the volatility of the markets in which they operate, they could have a dangerous exposure to real estate.
In the analysis that follows, certain statements are made regarding OpenDoor’s operation. Some come from publicly available information, but some are assumptions based on public information and logic. Nothing here should be considered a definitive statement of the inner workings of the company.
OpenDoor buys homes quickly and has developed methods that will allow them to sell quickly, as well. If their model for valuing homes is good, and I would bet it is, they will be offering homes at something close to the right price. They offer 24-hour self-guided open houses. Finally, having bought for a good price, they can even offer the home for a bit less than they think it is really worth. But with all this, they will still have a few homes that don’t move and they will always have an inventory.
What the rapid turnover of inventory really does is reduce the level of price risk relative to revenues. It does not reduce risk relative to inventory. The faster homes can be disposed of, the higher the revenue in any given time period, hopefully creating an acceptable ratio of revenue to risk. But, all the same, there is an inventory and a risk.
Another advantage they have is a constant stream of information about the market. At any given moment, they will know how many homes are being offered to them. One imagines that this data is being fed into their valuation algorithms, giving them a better sense of value at a very high frequency. Similarly, they will know how quickly homes are selling, which can also be fed into the algorithm. They should end up with a better sense of the market than any other player.
Even with this information, there are drivers of price exogenous to their data and model. Political and economic events can push prices. Given the speed with which information is disseminated now, buyers could potentially dry up more quickly now and in the future than they have in the past. We might reach a point where something like the “flash crashes” that occur in securities markets begins to occur in real estate. And, in a rapidly declining market, lowering your offering price quickly is no guarantee of a sale. Perhaps, the model accounts for this, but perhaps it does not.
None of this is to suggest that OpenDoor’s is a bad model. Far from it. In fact, it is a great model, especially given the tools available.
Which brings us the next tool they need, an effective hedge. The need for a market for real estate derivatives, in which market participants could either hedge or acquire real estate exposure has been recognized for a long time. (See: Pricing and Index Considerations in Commercial Real Estate Derivatives, by Geltner and Fisher,
This market’s value to companies engaged in the algorithmic buying and selling of homes has not been recognized simply because such companies did not exist. But clearly, with a market in which it could hedge or transfer away its real estate exposure, OpenDoor would see both risk reduction and possible profit opportunities.
The most obvious use of a hedge is that the company could protect itself against calamity, in the form of significant and sharp drops in price. So, with an effective tool for hedging the price risk in its inventory, OpenDoor would avoid bankruptcy or, if not outright failure, the sort of huge hits to earnings and capital that cause stock prices to plummet.
But hedging would do more than avoid the worst. It would allow the company to optimize its cash flows. First, the company is using debt now, but the potential price risks in the model must be constraining the level of debt assumed to some degree. With protection from price drops, the company could assume a higher level of debt. Second, the company could, if it would be beneficial, hold some of its inventory longer in search of a higher sales price. If you always need to sell quickly, you will not realize the optimal price on your sale. There would still be a value in rapid turnover of inventory, but price protection could allow for a long holding period when it would be appropriate. At the moment, according to recent articles, the company is holding some homes that have not sold immediately.
Another use of a hedging market that is perhaps overlooked is seeking trading profits. If a liquid market for real estate derivatives existed, OpenDoor would have an informational advantage over other players. With the constant and real-time flow of offers to sell homes and buyers of homes, the company should have a better read on the direction and condition of real estate prices. But the information flow could go in both directions. Declines and rallies in the prices of real estate derivatives could, if OpenDoor were an active market participant, give them another timely input to their valuation model. Given how central their valuation model is to the business, any improvement should translate to more successful and less risky buying and selling in the market for real, physical homes.
OpenDoor has a great model, given the tool set available to them now. Clearly, the market is expecting success, given the way investment funds are flowing to the company. But with a market for real estate risk at their disposal, they could do even better, avoiding risk, optimizing timing and debt, and trading both physical and synthetic real estate effectively.
Online real estate service OpenDoor raises $210M Series D despite risky financing model:
Startup Pays Cash to Buy Homes, Flip Them:
Pricing and Index Considerations in Commercial Real Estate Derivatives, by Geltner and Fisher: