This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
CPI Hits 9.1%… And Other Bad News
On Tuesday, I wrote that exorbitant home prices are driving even relatively well-off professionals out of top markets.
No matter how successful a doctor, lawyer or programmer you become, it’s hard to make $450,000 per year — Fidelity Bank’s estimated buying price for the average apartment in New York’s Upper East Side.
Right on cue, the Bureau of Labor Statistics (BLS) released even more bad news:
Inflation hit 9.1% in the month of June.
And as shocking as the figure might be, it actually understates the problem. According to data from Zillow, the average cost to rent has risen 14.7% in the past 12 months. But because only one-third of Americans rent (and making some adjustments for homeowners), the BLS only recorded a 5.6% increase in real estate spending among all Americans.
But jumping into real estate today is also risky at best. Rising mortgage rates, slackening commodity prices and unaffordable prices point to prolonged stagnation in house values. Real estate prices cannot go to the moon unless wages do too.
Instead, investors need to buy companies that benefit from real estate markets without the pricing risk. And today, we will cover five of these fast-growing tech firms that are upending the traditional real estate market.
5 Stocks to Outrun the Housing Market
Earlier this month, Zillow revealed housing prices have risen 19.4% over the past year. Many homeowners are nervously asking themselves how they’ll afford a new house if they ever need to move.
Meanwhile, renters are in even worse shape. Wages have risen at just one-third the rate of rent increases. And Google’s 30 million results for the question “how much does a cardboard box cost to live in” yield very little helpful advice.
At first glance, homebuilder stocks seem like a natural winner. As I mentioned on Tuesday, companies like America’s largest home builder D.H. Horton (DHI) are earning 4x their operating income compared to five years ago.
If home prices are going up, shouldn’t homebuilder stocks too?
But such conclusions fall into the trap of “first-level thinking,” a term coined by Oaktree Capital co-founder Howard Marks.
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.
That’s because homebuilding is a low-margin business with virtually no barriers to entry. Excess profits only materialize when home prices are rising, since most of the company’s assets are tied to land, partial builds and completed houses. It’s a business that hemorrhages value the moment home prices drop or stagnate.
How to Profit from Real Estate
Many foreign homebuilders have overcome these risks by pre-selling homes. Buyers put down a hefty deposit for an agreed-upon price, and homebuilders act more like contractors than buy-and-sell developers. These firms tend to be slow-growing, low-risk plays.
Meanwhile, American investors have an even better option:
High-growth tech firms upending the real estate market.
These superstar growth companies tend to be far less capital intensive than homebuilders, meaning that each dollar invested can return multiple back.
That’s the driving force behind my Perpetual Money Machine strategy. When companies avoid capital-intensive production — as is the case with Nvidia (NVDA) or Apple (AAPL) — they can turn $1,000 investments into millions. No homebuilder typically manages that feat.
Today, we’re going to look at five real estate plays upending the traditional world of real estate. And join me on Friday, when I reveal which firm makes it into the core Profit & Protection list.
eXp World Holdings (EXPI)
Growth: A | Value: A+ | Quality: B+ | Momentum: A+
Overall Score: A+
eXp World Holdings (EXPI) is a cloud-based real estate brokerage firm lowering costs for real estate agents nationwide. Revenues have grown from $500 million in 2018 to around $5.3 billion today, about the same rate that Amazon (AMZN) managed in its early days.
eXp provides clear benefits to real estate agents — the company’s online-only model means brokers can keep anywhere from 80% to 100% of their commissions, compared to a typical 70/30 split. And homebuyers also have some upside — the company’s cloud-based transaction processing reduces costs for all parties involved.
At its core, however, eXp has grown thanks to a revenue-share model that incentivizes real estate agents to recruit new talent. Much like Amway, Mary Kay and other direct-selling firms, eXp rewards existing agents with commission earned by those they’ve recruited. It’s a controversial practice to be sure, but one that’s worked before.
Many investors will chafe at investing in an alleged pyramid scheme. And indeed, the company’s “B+” quality rating reflects these concerns. So make sure you join me on Friday to see whether eXp’s rapid growth is enough to earn it a place in the Profit & Protection list, or if its internal risks are too much to bear.
Growth: A | Value: A | Quality: A+ | Momentum: B+
Overall Score: A
Homesharing site Airbnb (ABNB) has become a Covid-19 pandemic darling. Revenues rebounded far faster than at traditional hotel firms — rising from $3.3 billion in 2020 to $6 billion in 2021.
Analysts now expect Airbnb to double revenues again by 2024.
But such growth has failed to translate into momentum. Shares are down 45% since the start of the year, earning the company an average “B+” in its momentum score. The travel industry is cyclical at best.
Competition from Expedia (EXPE) and Booking Holdings (BKNG) is also starting to worry investors — both travel behemoths have unveiled plans to enter the vacation rental industry.
Yet Airbnb is one of the strongest companies in the real estate market, earning an “A+” for quality and “A” in growth and value. Its proven business model spins off cash with little investment required, making it a tempting play that any Profit & Protection reader should watch.
Redfin Corp (RDFN)
Growth: A | Value: A+ | Quality: C | Momentum: A+
Overall Score: A
Redfin (RDFN) is a fast-growing real estate company that covers brokerage, rentals, mortgage, title services and instant offers. It’s a diversified platform that handsomely rewards successful real estate agents.
Redfin’s investment draw is clear: the company is a foothold into the real estate market that avoids real estate pricing risks. Analysts expect the firm to grow another 30% this year and generate EBITDA profitability by next year despite a slowdown in real estate transactions.
But the company scores a poor “C” grade in quality. Gross margins declined from 26% in 2020 to 21% in 2021 and lost 6 cents for every dollar of revenues. High overhead costs have only exacerbated the issue.
But these factors have also pushed Redfin into deep value territory. Shares are down almost 80% for the year, pricing the firm at 0.37x price-to-forward-sales. By that metric, it’s the cheapest real estate play among the fast-growing tech names.
Zillow Group (ZG)
Growth: A | Value: B | Quality: B+ | Momentum: A
Overall Score: B+
In 2021, Zillow (ZG) found itself on the wrong side of real estate history after losing $880 million from its home-flipping business. It turns out there’s a reason why most tech firms like Amazon largely avoid sinking money into buying third-party products for resale.
Fast forward a year and Zillow’s management seems to have learned their lesson. The firm is winding down its iBuying program, with only another 1,280 homes to sell in its most recent earnings.
In its place, the firm has refocused itself on its Internet Media and Technology (IMT) segment — a lucrative core business that earned almost 30% net margins in 2021. Analysts now expect free cash flow to improve from $340 million in 2020 (the year before its iBuying program took off in earnest) to $1.1 billion by 2024.
Zillow’s momentum is also flagging a potential turnaround. Shares are trading at levels not seen since the depths of the 2020 Covid-19 pandemic.
Join me tomorrow to see whether Zillow’s renewed focus on returns is enough to land it on the core Profit & Protection buy list
Growth: A | Value: B | Quality: B+ | Momentum: A
Overall Score: B+
Then we have Appfolio (APPF), a tech-based property management firm that helps property managers run their businesses. It’s a firm with the blue-chip real estate exposure of a Jones Lang Lasalle (JLL) or CBRE (CBRE) with the high returns of a tech-based company.
The odd combination has created an equally strange outcome. The company generated a 57% return on capital invested (ROIC) in 2020 before earning just 0.3% ROIC the following year. When you run a capital-light business in a cyclical industry, the small denominator of an ROIC formula causes some wild swings.
Yet Appfolio has a stunningly strong business. In 2019, the firm received the top value score in Gartner’s review of residential property management. And even as real estate markets wobble, Appfolio’s stable business in managing the properties should remain firm. Analysts expect 20% growth in 2023 and 27% in 2024, giving the firm a solid “A” grade.
Bonus Pick: Luke Lango’s #1 Real Estate Play
Finally, Luke Lango reveals the “Amazon of houses” in one of his latest presentations. The firm has managed to succeed where Zillow has failed — using superior buying strategies to build a massive real estate portfolio.
Analysts now expect EBITDA earnings to rise 10x by 2024.
And the best part? Shares trade for less than $6.
The Hidden Risks of Real Estate
In 2008, the Case Shiller Index of home prices dropped 14%.
Ordinarily, a 14% fall in asset prices would cause little alarm. The Nasdaq Composite Index fell almost that much in April this year alone.
But real estate markets have a habit of taking on too much leverage. The average mortgage REIT (mREIT) has a total debt-to-equity ratio of 4.1x — three times higher than the average S&P 500 firm.
That makes mREITs prone to blowing up. The average mortgage REIT rose 50% between November 2020 and 2021 before giving up virtually all its gains over the following several months.
That’s why the Profit & Protection system didn’t flag a single one for investment. And as real estate markets continue to show cracks, investors too should continue focusing on the faster-moving tech firms that avoid such outsized risks.