Real Estate Pioneer Zillow Enters the Land of Rising Interest Rates

By Frank DiPietro Markets Fool.com

Zillow Group (NASDAQ: Z)(NASDAQ: ZG) is the largest internet-based real estate marketplace business in the United States. It went public in July of 2011, and for the first time in its public history, will now face a rising-interest rate environment. Let's see if the interest rate headwinds will adversely affect the company's course.

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Image source: Pixabay user skeeze.

Zillow's primary source of revenue is from its Premier Agent program, which is built on a subscription model, plus advertising. It gives real estate agents the tools they need to do their jobs, and allows them to advertise by zip code on the Zillow site.

Real estate agents want to get the most bang for their bucks when they advertise. Agents are contractors working for brokers who, for the most part, run their own businesses and are responsible for finding buyers and sellers to work with. Zillow is an attractive place for them to invest their advertising budget as it's dominating the market in web traffic pertaining to all things real estate.

Zillow's web traffic leads to a virtuous circle

The percentage of web traffic is a key indicator of the proportion of active homebuyers and sellers that are viewing Zillow web pages, which, in turn, attracts real estate agents to Zillow.Zillow boasted 164 million average monthly unique usersfor its most recent quarter, and per comScore, Zillow Group's market share inSeptember 2016was nearly two-thirds of the total online real estate category and 75% of mobile only.

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Year 2013 2014 2015 2016
Average monthly unique users (three months ended December 31st) 54.4 76.7 123.7 164.5

Data source: Zillow Group -- 2016 data for the three months ended September 30th, all numbers in millions.

This type of web traffic is creating a need for agents to advertise on Zillow to generate leads. The leads are then tracked using Zillow's subscription services, and the payoff is recorded. The result is commission for the agents, which then can be budgeted to buy more advertising and create more leads. It becomes a virtuous circle where agents are glad to keep advertising on Zillow to receive more leads, close more sales, and receive additional commission dollars.

Here's how CEO Spencer Rascoff described it on the 2015 Q4 earning's call.

In 2015, we estimated based on our traffic and lead volumes that Zillow Group helped our agent advertisers close around 3.9% of the residential real estate transaction sides in the U.S., which drove roughly $3.2 billion in commissions to these Premier Agent advertisers. This compares to an estimated 3.1% of transaction sides and $2.3 billion commissions in 2014. This is an important metric that we seek to grow, by increasing lead volumes to agents and brokers who convert leads effectively, and by providing them with tools and training to improve their lead conversion.

Zillow has a long runway

The good news is that Zillow has a long runway ahead of it. Over 96% of 2015 transaction sides were not represented by a Zillow Premier Agent, and that's good news for investors. The extraordinary potential for Zillow to grow its advertising revenue is massive, as the company estimates a total of $11 billion in real estate advertising will be spent in 2016.

Here's how the spend by Premier Agents with Zillow looks against the backdrop of Zillow's total revenue. Zillow started providing this information on its 2015 fourth-quarter earning's call.

Year Revenue Premier Agent Spend Premier Agent Spend as Percentage of Revenue
2014 $325.9 million not provided prior to 2015 not provided prior to 2015
2015 $644.7 million $466.5 million 72%
2016 forecast $839.5 million $602 million 72%

Data source: Zillow Group.

Looking at mortgage rates on the rise, one might think that this will become a headwind for housing and a monumental problem for Zillow. Not so fast. According to historical mortgage-rate data, our current rate of 4.18% is at the low end of the scale. From 1975 to 2000, mortgage rates rarely were below 7.5%, and in the early 1980s, peaked above 17.5%.

The chart below shows examples of home sales during periods of higher interest rates. The year 2000, as an example, had 30-year mortgage rates that were more than double the average rate for the last 12 months, yet total homes sold were similar.

Year 30-Year Mortgage Rate Existing Home Sales New Home Sales Total Home Sales
1975 9.05% 2.476 million 550 thousand 3.026 million
1980 13.74% 2.973 million 545 thousand 3.518 million
1985 12.43% 3.134 million 688 thousand 3.822 million
1990 10.13% 3.219 million 535 thousand 3.754 million
1995 7.93% 3.888 million 665 thousand 4.553 million
2000 8.05% 5.152 million 877 thousand 6.029 million
Nov. 2015 thru Oct. 2016. 3.64% 5.384 million 557 thousand 5.94 million

Data source: Average 30-year mortgage rates -- Freddie Mac. All other data the U.S. Census Bureau.

Zillow Premier Agents are today only participating in a tiny fraction of the $80 billion in commissions generated by the U.S. housing market.If mortgage rates continue to rise, the most likely effect will be a decline in the selling price of homes, which would have a marginal impact on overall commissions. Even if the number of houses sold exhibited a slight decline, the overall effect would be negligible in comparison to the overall opportunity in front of the company.

Foolish investors should remain focused on Zillow's comScore for real estate web views, Premier Agent spend with Zillow, and the percent of deals involving Premier Agents to get a better idea of prospects for this company.

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Frank DiPietro owns shares of Zillow Group (A shares) and Zillow Group (C shares). The Motley Fool owns shares of and recommends Zillow Group (A shares) and Zillow Group (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.