Morgan Stanley Analyst Swaps Research for Home Rehabs

Oliver Chang quit his job as head of housing strategy at Morgan Stanley last year to follow his own advice and invest in distressed homes to rent. He’s since become one of the largest landlords in Atlanta.

Chang, 37, has more than $500 million for his company Sylvan Road Capital LLC to acquire and rehabilitate homes and expand into other cities across the U.S., according to a letter sent this weekend to investors obtained by Bloomberg.

The former analyst has gained investors including Carlyle Group LP after writing a six-page report in July 2011 detailing how the worst real estate crash since the Great Depression was moving America toward a “rentership society.” While he foresaw that leasing single-family homes could become a large-scale business similar to apartments, he didn’t predict how fast private equity firms backed by cheap borrowing from Wall Street would flood regions hardest hit by the foreclosure crisis to help fuel the fastest home-price gains in seven years.

“I’ve certainly been surprised by the pace of acquisitions,” Chang said in a telephone interview from Atlanta. “There has been a rush of capital into the space.”

Blackstone Group LP has spent $5 billion on almost 30,000 properties across 13 metropolitan areas since last April to become the largest rental buyer in the U.S. It’s obtained $3.6 billion in loans from banks including Deutsche Bank AG.

Largest Landlords

Other large-scale landlords include Public Storage founder Wayne Hughes, who’s bought more than 14,000 properties though his American Homes 4 Rent, using $600 million from the Alaska Permanent Fund Corp. and a $500 million credit facility with Wells Fargo & Co. They’re joined by hedge funds and former bankers, including Donald R. Mullen Jr., an ex-Goldman Sachs Group Inc. executive, whose Progress Residential LP, formerly known as Fundamental REO LLC, plans to spend as much as $2 billion by 2016.

Institutional investors are trying to turn what has traditionally been a mom and pop business into a new asset class after more than 5 million Americans lost their homes to repossession since the real estate crash of 2008. While they’ve dominated some foreclosure auctions and complete the biggest bulk purchases, the pool of institutional ownership is still less than 1 percent of the $2.8 trillion rental market, according to Goldman Sachs estimates.

Chang recognized the opportunity while touring neighborhoods in Phoenix in 2011, where prices were down 50 percent from the peak in 2006, compared to the national average of a 35 percent fall. Broad housing market data wasn’t telling the story of what was happening on the ground, he said.

‘Something New’

“That’s when the light went off,” Chang said. “I thought this was the beginning of something new, and that if I was right, I would prefer to be a part of it rather than just write about it.”

He resigned from Morgan Stanley last May and made his foray into property ownership by co-founding Sylvan Road, named after a street in Atlanta, with Robert Lee, Sarah Lee and Gavin Kleinknecht, principals of Delmar Realty Advisors, a homebuilder that already owned an assortment of rentals in Atlanta.

Chang was “a central node in this business early on because he sought out the local real estate operators that were the first people executing the strategy,” said Carl Bell, a mortgage bond manager at Smith Breeden Associates. “Obviously he knew the data and through networking with local operators and flippers he built a large web for sourcing ground level information that combined with the data put him in a unique position when he jumped to the buy side of this industry.”

Attracting Investors

Sylvan Road hasn’t been on a buying spree like many of its competitors, said Chang, who declined to disclose exactly how many homes the firm owns or their cost. The firm has instead focused on building operations and software platforms, putting major renovations into the several hundred homes it has purchased.

His firm avoids foreclosure auctions -- where buyers can’t inspect inside the houses before the sale -- and doesn’t compete for the same properties as the majority of investors, who target three-bedroom homes built since 1990 that need few repairs.

Chang has attracted investors such as Ron Mass, who considered giving money to at least 10 other rental businesses before investing in Sylvan Road.

“Some of the companies I was looking at wanted to just buy as quickly as possible,” said Mass, who oversaw as much as $90 billion of fixed-income investments at Western Asset Management Co. which he left last year. “I liked the fact that Sylvan Road was going at a slower pace and building out while some folks in the market were five or more times their size, had less developed infrastructure and were taking months longer to lease out their properties.”

Declining Yields

Even as demand for rentals rises amid a falling homeownership rate, yields are declining and companies formed to buy the homes that have gone public have yet to show a profit because they acquired houses faster than they can fill them.

Colony American Homes Inc., a division of Thomas Barrack Jr.’s Colony Capital LLC with 13,000 homes, has found tenants for only about half of its properties, according to a regulatory filing last month.

Jonathan Gray, Blackstone’s global head of real estate, said last month during a conference call with investors that while about 85 percent of the firm’s renovated homes were leased they have “an awful lot of homes to continue renovating.”

Purchases by investors, including individuals, declined to 20 percent of sales in May, from 22 percent in April, as home prices rose and competition increased, according to the Campbell/Inside Mortgage Finance HousingPulse Tracking survey released today.

Rising Prices

Sylvan Road spends on average $30,000 to $40,000 to repair homes. American Homes 4 Rent spent about 5 percent or $8,762 per house on renovation and acquisition fees, while American Residential Properties Inc., a Scottsdale, Arizona-based single-family real estate investment trust, invested an average $4,222 per house on capital improvements, regulatory filings show.

“Because we are trying to add value through renovations, a lot of the times we are buying houses that nobody else will buy,” Chang said. “When we put an offer on it we’re the only ones, and it’s a house that is typically in the condition that nobody wants to live in it either. In some cases it’s falling apart and basically uninhabitable. We’ll take that and fix it up and if we do this for several houses within a neighborhood, it’s helping improve that community.”

Even though Chang’s expertise is in analyzing data, starting as a summer associate with Morgan Stanley while he was still at Columbia Business School in 2004, his first experience into being a landlord came as a youth in Toronto. His parents owned a few investment homes that they rented out and often recruited him to help tidy up between tenants.

Giant Weed

“One resident didn’t take care of the lawn,” Chang said. “I was around 10 years old, and I remember there was a weed that was as big as I was tall, and it took me about two hours to get it out of the ground. And what stuck with me, even when I first started writing about this at Morgan Stanley, is just how difficult it is to manage these properties.”

Sylvan Road houses come with an electric lawnmower, because many renters want their children to cut the grass as a chore, Chang said.

Landlord profits depend on finding efficient ways to change locks, turn on utilities and reduce tenant turnover, according to Aaron Edelheit, a former hedge fund manager whose American Home Inc., owns 2,500 rental houses in the U.S. Southeast.

“The difference between earning 8 percent and 2 percent is all in the details,” Edelheit said in a telephone interview. “It’s death by 1 million paper cuts.”

Big Test

The big test for rental companies is showing they can manage scattered-site properties that have their own lawns and roofs, unlike multifamily apartment buildings, many of which have been under institutional management for years.

“The multifamily industry has had several decades of a head start to refine processes and this industry has not even had two years,” Chang said. “So some of the challenges still lay ahead.”

Companies building rental businesses are facing the biggest increase in home prices since 2006. The S&P/Case-Shiller index of home values for 20 cities probably rose 10.6 percent for the year ended April after a 10.9 percent increase in March that was the biggest year-over-year advance since 2006, according to the median forecast in a Bloomberg survey of economists before a June 25 report.

Investor buying is pushing up prices that are also recovering as the economy improves and the Fed for now keeps mortgage rates near record lows.

Later Stages

It’s unclear how long the buy-to-rent acquisition boom will last, as rising home prices make it a less-profitable pursuit. Blackstone’s Gray said June 10 in an interview with Bloomberg television, “for our type of capital and the returns we hope to generate, my guess is we’re in the later stages of this.”

For Chang, it’s less important for Sylvan Road to grow big than to prove his analysis of the housing economy is the basis to create a sustainable company.

Chang is “one of the best known people in this industry and certainly has a reputation as one of the best analysts,” Bell said. “Whether or not he is one of the best at executing this strategy remains to be seen. It’s still early for everyone.”