Until the dust settles and we see what DOUG can earn in a 'new normal', I recommend staying on the sidelines for now.

Back in April, I wrote a cautious update on Douglas Elliman (NYSE:DOUG), warning that the outlook for the company was still precarious, as housing remains unaffordable, and the real estate market remained in a slump. However, in the past few weeks, DOUG's stock has experienced a strong rally, as expectations for a Fed rate cut built (Figure 1).

With the company recently reporting its Q2 financial results, I thought it would be a good time to review the quarter and discuss how the macro environment could change for Douglas Elliman.

On the positive side, a pending rate cut cycle from the Federal Reserve should help to alleviate pressures on the real estate industry, as mortgage rates are already more than 1% lower than in late 2023.

However, balanced against the positive are recently enacted changes to agent commissions. Buying agents are no longer compensated out of the selling agent's commissions and must strike deals with buyers on their own. This could reduce overall industry profitability as homebuyers may experience 'sticker shock' from paying thousands of dollars for buying agents to take them to showings.

Overall, I believe industry profitability is set to decline, and am hesitant to get involved until the dust settles. I maintain my hold rating on DOUG's shares.

For those unfamiliar, Douglas Elliman is the fifth-largest real estate brokerage company in the United States, serving markets like New York (including the NY suburbs), Massachusetts, Florida, California, Texas, and Colorado. DOUG has approximately 6,900 affiliated agents across 120 U.S. offices (Figure 2).

Douglas Elliman has a reputation for servicing wealthy clients, as its average transaction value of $1.6 million in 2022 is the highest in the industry (Figure 3).

As mentioned above, Douglas Elliman recently reported second-quarter financial results which were not as bad as feared. The company recorded $286 million in revenues from advising on $10.6 billion in real estate transactions in the second quarter (Figure 4). This was a 3.6% increase YoY compared to $276 million in the prior year's second quarter when Gross Transaction Value ("GTV") was $9.9 billion.

However, despite higher revenues, the company still reported a $3.7 million operating loss, although operating losses have halved compared to $8.3 million in operating losses in Q2/23.

Part of the improvement in operating losses has to do with tight cost controls, as Douglas Elliman has been able to cut more than $21 million in operating expenses out of its business without impacting its service level to customers or agents. For example, G&A expenses in the 6 months to June 30, 2024 was $51.9 million, compared to $63.6 million in the same period in 2023.

Looking forward, management is hopeful for a continued improvement in financial performance, as the company is seeing the number of listings in its core luxury markets increase after staying moribund for the past 2 years due to elevated interest rates. In the second quarter, listing volumes increased 23% YoY, following a 6.7% YoY increase in Q1 and 25% YoY in Q4/2023.

Management also highlighted that the company was able to win exclusive listings for several $100 million+ properties in Orange County, California, Snowmass, Colorado, and Coral Gables, Florida.

Douglas Elliman's listings experience appears to be significantly better than the industry, as the National Association of Realtor's Pending Home Sales Index is still stuck at multi-year lows (Figure 5).

What has gotten management and real estate investors excited in recent months is the expectation that the Federal Reserve will begin cutting interest rates at the September FOMC meeting.

Already, investors have priced in 100 bps of policy rate cuts into year-end (Figure 6).

The 30-year mortgage rate has declined in sympathy, from close to 8.0% in late 2023 to a recent low of 6.5% (Figure 7).

However, so far, existing home sales and listings have yet to respond to lower mortgage rates (Figure 8).

Another concern I have regarding Douglas Elliman is whether recent changes to real estate agent commissions will impact Douglas Elliman's financial performance?

For those not aware, last year, the real estate brokerage industry lost a landmark class action lawsuit claiming the real estate brokerage industry was anti-competitive and inflated commission rates. Historically, the standard commission rate for residential real estate transactions has been 5 to 6 percent, paid by the home sellers and then split between real estate agents for the seller and the buyer.

The crux of the class action lawsuit was the former standard industry practice whereby home buyers did not pay an 'explicit fee' to their buying agents. Instead, their fee is 'wrapped' in the selling price. Furthermore, selling agents used varying commission rate splits to entice buying agents to bring their clients to view listed properties.

The class action plaintiffs argued this practice inflated real estate commissions since buyers are not aware of how much commissions they are paying. Furthermore, the practice raises conflicts of interest concerns, since buying agents may steer clients to homes that pay a higher commission split.

However, under the class action verdict, "the sellers would no longer be required to pay their buyers' agents, and agents would be free to set their own commission rates". So far, real estate brokerages are adapting to the new rules by asking their buying clients to sign agreements to compensate them 2.5-3.0% of the transaction value. However, it is unclear whether buyers will balk at having to pay tens of thousands of dollars in 'extra' fees to their brokers, in addition to the cost of the home.

Already, some enterprising brokers and agents are trialing new service models like being paid a flat fee or an hourly fee for their services in bringing clients to view listings. If this trend continues, Douglas Elliman's revenues when they act in a buying agent capacity could be significantly impacted.

For reference, Douglas Elliman's average commission revenue rate is 2.57% of transaction value in Q2/2024.

Even with the stock's recent rally, Douglas Elliman's valuation remains low, with an enterprise value of only $219 million or $31,700 / agent (Figure ).

I continue to believe Douglas Elliman may appeal to another brokerage firm like Berkshire's HomeServices Of America as a luxury distribution channel. However, I believe it will take time before Berkshire or someone else makes a move, as the whole industry is still trying to figure out the financial implications of the commission rate changes mentioned above.

If Douglas Elliman is able to maintain its ~2.6% commission rate when the dust settles, I expect someone like Berkshire will snap them up.

For now, I remain cautious on Douglas Elliman and maintain my hold rating. Although listings are starting to thaw for the DOUG, the commission rate change overhang clouds the outlook for the stock and makes the real estate brokerage industry hard to value. Will Douglas Elliman be able to maintain its ~2.6% commission rate, or will competitive forces reduce its profitability? That is the key question.