Firm Buys Up Homes
By the Hundreds

Many people agonize for months before deciding to buy a house. Jonas P. Lee is more decisive: He often buys several in a day.

This year, the 38-year-old Mr. Lee says he plans to buy more than 1,000 homes for Redbrick Partners LP, a New York firm he runs with the help of an MIT economist to invest in single-family rental property. What millions of mom-and-pop landlords do locally, Redbrick is trying to do on a grander scale.

Mr. Lee, a former Web entrepreneur who grew up in New York's posh Westchester County, doesn't see much value in most suburbs at today's lofty prices. Instead, he is buying in working-class neighborhoods in such cities as Baltimore, Philadelphia and Trenton. Even there, however, he is running into tough competition from people determined to cash in on America's decade-long housing boom.

On average, house prices in the U.S. have jumped 85% over the past decade, according to the Office of Federal Housing Enterprise Oversight. Prices have soared largely because low interest rates have cut the cost of financing a home. In coastal areas, the rise has been far steeper. In California, for example, prices have more than doubled in just the past five years.

Mr. Lee's venture is an unusual sign of the investment frenzy now surrounding residential real estate. The National Association of Realtors estimates that 23% of home purchases last year involved investment properties. Redbrick's pitch is that investors can join this gold rush without the ordeals of being a landlord.

Many real-estate investment trusts and other funds invest in apartment buildings. But the complications of owning hundreds of single-family homes are so daunting that large real-estate companies generally shun that market.

One of Mr. Lee's tactics is to find a landlord who owns 20 or 30 houses and has been worn down by the trials of collecting rent and fixing leaky toilets. Redbrick then can buy homes in bulk and hire local managers to take care of the properties. He also uses a formula created by his economist partners to identify markets -- usually low-profile working-class neighborhoods -- that have undervalued homes with potential for high rents.

Redbrick's first fund, which started with $3 million of equity and has used borrowings to acquire about $10 million of properties, has produced an estimated return of 50% after fees since closing to new investors in December 2003, Mr. Lee says. Redbrick has told investors in its first two funds that it expects average annual returns in the 18% range.

Formed three years ago by Mr. Lee and a partner, Redbrick's two funds have now raised about $16 million of equity, primarily from individuals. So far, the firm has bought more than 500 homes in the Northeast.

One recent morning, Mr. Lee spent about five minutes touring a four-bedroom row house on Hewitt Street in Trenton. He noted pipes that needed insulation, a sloping bathroom floor and a basement strewn with cotton swabs and other rubbish.

"You didn't do much work here," Mr. Lee told the owner, Glenn Kramsky, who specializes in buying houses to fix up and sell quickly.

"We did a lot of work," Mr. Kramsky said. "It was nasty."

A few days later, Mr. Lee agreed to buy the house, and four others nearby, from Mr. Kramsky for an average of about $75,000 each. He figures he can find tenants for them paying between $800 and $1,200 a month and eventually sell the homes at a profit.

To choose its markets, Redbrick is turning to economic models. One of Mr. Lee's partners is William Wheaton, an economics professor at the Massachusetts Institute of Technology and former director of the MIT Center for Real Estate. Dr. Wheaton crunches numbers on local economies and housing markets. The firm also has studied the costs of being a landlord, including vacancies, bad debt and management time. Most "amateur" landlords, Mr. Lee says, fail to factor in all their costs and "just don't know what they're doing."

Still, no amount of science can take the unpredictability out of being a landlord. Last year, pipes burst in eight of Redbrick's houses during a cold snap in Trenton. A house Mr. Lee thought would require about $5,000 of work has so far soaked up $11,000, including a new sewer line and 18 window screens demanded by a housing inspector.

One of the biggest challenges is deciding when to believe the tenants' excuses. One tenant told Redbrick she couldn't pay her rent because she had just been diagnosed with cancer. Another said his mother had just died in a car crash. Both stories proved untrue, Mr. Lee says. Then there was the tenant who shot his girlfriend to death in a Redbrick home. One of the company's employees had to wipe the blood off the walls.

Stephen DeNardo, chief executive of RiverOak Investment Corp., of Stamford, Conn., agreed to invest $2 million in a Redbrick fund last year, after spending several hours with the founders and touring some of their rental homes. "I think it's a hard business," Mr. DeNardo says, but "they have a good handle on where to invest and where to stay away from." RiverOak manages a $25 million real-estate fund, mostly invested in office buildings, apartments buildings and industrial property.

Others are dubious about the prospects for turning the tricky, local business of being a family's landlord into a national enterprise. Some have tried similar notions, with less-than-encouraging results.

In the early 1980s, Equity Programs Investment Corp., or Epic, owned by a now-defunct Maryland thrift, managed more than 300 investment partnerships that controlled about 20,000 homes, mostly bought from builders. Epic defaulted on more than $1 billion of mortgages in 1985 and collapsed.

More recently, some real-estate executives have considered investing in single-family housing and concluded it would be too difficult to return a decent profit. Among them is Richard J. Campo, chief executive officer of Camden Property Trust, a Houston-based real-estate investment trust which owns large apartment buildings. He says it would be far more costly to lease and maintain houses scattered over a wide area than it is to deal with large numbers of apartments in a single building.
 

Mr. Campo also says it would be hard for a large company, with overhead and the need to provide attractive returns to investors, to compete with small operators who dominate single-family rentals. "Mom and pop have very low overhead," he says, partly because they often can fix a door handle themselves rather than hire an expensive professional.

Other companies have found different ways to play the single-family housing market. Hearthstone Inc., an investment company in San Rafael, Calif., invests alongside builders in large developments of new homes, putting between $20 million and $50 million into a typical project. Buying homes that are already built and occupied would be hard to do on the scale needed by institutional investors, says James Pugash, chief executive of Hearthstone.

Redbrick says people who rent houses tend to have children and so usually are more settled than apartment dwellers. That means the house renters are likely to remain tenants longer, reducing the costs of finding new tenants, the company says.

Mr. Lee, who earned a masters degree from Harvard Business School in 1993, moved into real estate after leaving his previous start-up, a Web site that sells gift certificates. Real estate attracted him partly because of his experience as owner of a home in a converted Manhattan industrial building. He bought the co-op home in 1999 for $176,000, made improvements and recently had it appraised at more than $1 million. His investments in stock and bond funds never seemed to do as well.

He teamed up with Tom Skinner, a former McKinsey & Co. consultant with a doctorate in economics from MIT. At first, they thought they should concentrate on finding towns with the best potential for house-price gains. But, working with the models of Dr. Wheaton, the MIT professor, they concluded home prices had risen so fast in much of the U.S. that it would be too risky to focus heavily on appreciation.

They found an analogy in the stock market: At the beginning of a bull market, it often makes sense to buy growth stocks, ones with rapidly rising earnings. But if the market looks expensive and could be heading for a dip, many investors prefer stocks with high dividend yields, which promise steady income. The housing equivalent of dividends is rent.

They decided to look for strong rental markets. Redbrick calculates what it calls "rental yield," defined as the annual rent, minus all costs borne by the landlord, divided by the value of the house. In prosperous suburbs, Mr. Lee says, the yield would be about 3% or 4%, because rents are low in relation to home prices in such areas. In thriving working-class neighborhoods, though, yields can reach 6% or more, he says, because rents there are high compared with home prices.

The higher yield can be a "signal of mispricing," meaning the homes are a bargain and eventually will appreciate, Mr. Lee says.

Dr. Wheaton, who is a partner in Redbrick, uses data from the Office of Federal Housing Enterprise Oversight and the Census Bureau to find out where average rents are high relative to house prices. He studies economic data to find cities where job and income growth is likely to be healthy. He also looks at supply, steering clear of Texas, for instance, because "they build houses like rabbits multiply."

Choosing the right city isn't enough. In urban areas, one blighted block may be recovering while the next is a refuge for drug dealers. Redbrick has hired local property managers in several cities to oversee its units and help figure out which neighborhoods are the best bets.

Much of the challenge lies in estimating how much improvement a house will need and how much rent it will bring in. In the basement of the house in Trenton, Michael Davis, Redbrick's local property manager, points to a tangle of pipes. "These will be bursting at some point," he says, unless insulation is applied. In the bathroom, he opens a window only to see it slam back down. Mr. Lee makes a few notes and estimates the house needs $5,000 of work, including a bathroom makeover. The rent, he figures, should be around $1,050 to $1,100 a month.

The next neighborhood they view seems rougher. One house bears a sign reading "Beware of Pit Bull." Two doors down, they tour an unoccupied house where the refrigerator lies on its side in the middle of a pink kitchen spattered with grease. In the attic, they find water damage and crumbling bricks. "This is a gut rehab," Mr. Lee says, crossing it off his list.

Some properties can be ruled out immediately. Standing in front of one Trenton row house, Mr. Davis points to the front porch floor and says: "Got a little slant going there."

"Little!" Mr. Lee says. "Forty-five degrees."

When houses for sale come with tenants, Messrs. Lee and Davis try to size them up quickly, too. Mr. Davis says there are some obvious signs of a good tenant: "There's not food in the corner. There's not bugs crawling all over the walls, and there's not a hole in the wall that wasn't there before."

-- Ray A. Smith contributed to this article.

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