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Soaring inflation in the U.S. has rocked the stock market for the last 12 months. The COVID-19 pandemic triggered the largest stimulus response in history from the Federal Reserve and the government during 2020 and 2021, and it’s almost impossible to avoid inflation when so much money is being pumped into the economy in a short time.
In June 2022, the core Consumer Price Index (CPI) soared to 9.1% on an annualized basis, which marked a 40-year high. Rising prices have been felt everywhere, from the grocery store to the gas pump, prompting the Fed to raise interest rates. This chain of events is placing further pressure on household finances.
But here’s the good news: It’s working.
CPI has declined every single month since the June peak, coming in at 6.5% in December. It’s still well above the Fed’s 2% target, but the rate is certainly trending in the right direction.
The real estate sector will be one of the biggest winners when inflation falls far enough for the Fed to stop raising interest rates. This is because consumers have a smaller borrowing capacity when rates are high, which serves as a cap on house prices.
It’s little surprise, then, that the recent declines in inflation have reignited the share prices of real estate technology companies Redfin (RDFN 0.33%) and Zillow Group (Z 0.51%) (ZG 0.38%). Here’s why both stocks are buys now.
Redfin stock is off to a hot start to 2023, surging 42% in January so far. But context is important. The stock is still down an eye-watering 93% from its all-time high, so Redfin has a lot of work to do.
The company has made some drastic changes over the last few quarters, mainly centered around cutting costs and shifting the business into survival mode to weather this tough period for the real estate industry. Redfin slashed 13% of its workforce in November and simultaneously announced the closure of its RedfinNow iBuying business, which purchased homes directly from sellers to flip them for a profit.
It’s a business that requires truckloads of capital, and typically only works when house prices are rising. So in a falling market, Redfin would risk holding hundreds of homes in its inventory that would be losing value, potentially resulting in a financial catastrophe.
The company has refocused on real estate brokering, which is what it does best. It has 2,293 lead agents covering 96% of the American population, so it’s able to complete a greater volume of deals than independent agencies. As a result, it can charge listing fees as low as 1%, far below the industry average of 2.5%.
iBuying was a core piece of Redfin’s revenue, so closing that business will affect its results. For example, the company generated an estimated $2.2 billion in revenue during 2022, but analysts expect that to drop to $1.1 billion in 2023. However, it will be a much cleaner revenue stream, and it could pave the way for Redfin to start making a profit.
Investors value Redfin at just $640 million right now, so that’s a forward price-to-sales ratio of just 0.6 based on that downsized 2023 revenue projection. In other words, it’s trading near rock bottom, and the risk-reward equation makes a lot of sense, especially if inflation keeps falling.
Zillow Group is taking real estate technology to the next level. The company has had no choice but to reinvent itself. In 2021, it was forced to shutter its iBuying business, which was responsible for the overwhelming majority of its total revenue. Zillow stock remains down 79% from its all-time high, but it has jumped 28% to start 2023.
The closure of the Zillow Offers iBuying business was a real black eye for the company, because it was the industry leader. When all was said and done, the company absorbed a loss of $970 million on its inventory throughout 2021 and the first nine months of 2022 combined, so cutting bait and moving on was the only real option.
Zillow’s future is all about its housing super app — a mobile-first platform delivering a portfolio of real estate services to customers. It’s in a great position to do so because it has amassed a 63% industry market share, with 236 million unique monthly visitors across its digital platforms. The app will give buyers and sellers all the tools they need to transact, from arranging tours to accessing closing services.
The company estimates that each home sale attracts $17,000 in fees, including listing costs, mortgage financing, and referrals. Still, Zillow was only capturing a small fraction of that under its old business model. Now, it’s solely focused on chasing that $300 billion transaction market, and management estimates that doing so could generate $5 billion in annual revenue by 2025. That’s more than double the $2.2 billion Zillow brought in from services in 2021.
Zillow is a turnaround story, so it won’t always be smooth sailing for investors. But the company now has a clear strategy, and if inflation continues to subside, it could be a green light for strong gains in its stock price as investors get ahead of the next wave of growth in the real estate market. Plus, Zillow stock might also benefit from a bounce in the broader technology sector.
Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Redfin and Zillow Group. The Motley Fool recommends the following options: short February 2023 $7 calls on Redfin. The Motley Fool has a disclosure policy.
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
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