10 Reasons to Consider Investing in Real Estate
The vast majority of people invest their retirement savings primarily in some combination of stocks and bonds, typically through ETFs and mutual funds. “Set it and forget it,” they’re often told by their investment advisors. And yet, despite that diversification, when market conditions change, these same people are often shocked to find that the value of these investments has tumbled.
At Paladin, we believe that many investors may be better served by having a more diversified portfolio that includes a range of assets, including private real estate. Specifically, we believe private real estate can offer one of the most effective ways to generate current income and long-term appreciation.
In this article, we look at some of the top reasons we are attracted to real estate investments and why you also may wish to consider real estate as part of an enhanced diversified portfolio.
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Real estate is a hard asset and a long-term store of value.
Hard assets, like precious metals, natural resources and real estate, are widely viewed as a long-term store of value, particularly during times of economic uncertainty. Certain of such investments can also provide an effective hedge against inflation. Real estate is especially useful for investors because real estate can provide current income that can keep pace with inflation as well as long-term capital appreciation.
Unlike most stocks or bonds, certain types of real estate serve basic needs of the populace with steady demand drivers that transcend economic cycles, such as rental apartments. In general, when inflation rises, rental apartments are more likely to maintain rents and occupancy as well as their intrinsic value over time. Indeed, housing is one of the components measured in most government inflation indices; as home values and rents rise, so too does inflation. On the other hand, certain stocks, bonds and other fixed-income debt instruments are frequently ‘victims’ of inflation, rather than drivers of it, and can lose their value as the Consumer Price Index increases.
Land is a scarce resource, especially in our target markets.
This point goes hand in hand with the one above. There is a relative scarcity of developable land in the urban infill markets of Southern California, such as greater Los Angeles, as well as the large, major cities of Latin America where Paladin invests. Most of the infill land in these large, dense urban markets has been developed already. The cost of assembling development sites, obtaining regulatory approvals, fighting legal challenges, and pursuing new construction is very high in these markets, making it challenging for any new developments to pencil out. Importantly, these constraints on new supply tend to support the value of existing rental properties in these markets, which often can be acquired well below replacement cost (i.e., the cost of new construction). As long as local populations continue to grow and along with it, tenant demand, there will be competition for the limited supply of real estate, particularly workforce housing, in our target markets, which we believe drives up the value of our investments and returns to our investors.
Certain real estate sectors, like workforce housing, are essential to daily living.
People need somewhere to live. In many dense urban markets such as Los Angeles, there’s been a housing crisis for nearly half a century; there are simply too few existing affordable housing units. New supply has not been able to keep up with household formation and increasing population. This supply/demand imbalance creates a resiliency of demand for existing workforce rental housing in Southern California, puts upward pressure on apartment rents and, in turn, has made these properties substantially more valuable over time. Unless there’s a massive increase in new housing production, which is unlikely due to land scarcity in these urban markets (see above), demand for existing infill, multifamily assets should remain resilient. This is particularly true for Class B/C apartments in Southern California, which provide the bulk of supply of affordable workforce housing for low-income and middle-income families in the region.
Rental apartments can produce consistent, reliable cash flow.
The relative scarcity of real estate, particularly workforce rental housing in Southern California, can bolster not only its value, but also its cash flow potential. Those who invest in stabilized real estate assets with conservative use of debt have the potential to earn consistent, reliable cash flow distributions on a monthly, quarterly, or annual basis.
Value-added investors like Paladin, with experience in growing a property’s cash flow, have the potential to earn outsized returns and cash flow streams compared to buyers of stabilized assets. This is especially true in low cap rate markets like Southern California, where every $1 of increased cash flow can generate $20-25 of incremental value upon sale.
Finally, because apartment buildings contain many tenants, multifamily property cash flow streams can be especially stable. For example, if three tenants stop paying rent or if a few units sit vacant between leases at a 100-unit apartment building, the owner still collects income from the other 97 tenants. In chronically undersupplied markets like Southern California, where a permanent renter pool is large and ubiquitous, units that turn over can readily be re-leased to ensure steady, durable cash flow year in and year out.
Property management done right is complex (but it’s not rocket science).
Maximizing the value of real estate assets is a management intensive business, especially in Southern California where nearly 90% of the existing rental housing stock comprises smaller buildings of 50 units or less, minimizing potential economies of scale . It requires experience, disciplined management systems, and a deep understanding of marketing, leasing, tax regulations, rent control, tenant rights, eviction and other housing rules and regulation, and labor laws, among other more operational issues.
While property management is not rocket science (after all, many residential property management decisions rely heavily on common sense), the complexity and scale of these issues, and skills required to effectively execute a value-added business plan, can frequently overwhelm smaller and less sophisticated “mom-and-pop” owners that dominate the Southern California market. More often than not, these smaller owners manage their assets with the aim of minimizing unit turnover and cash outlays for capital improvements, resulting in an abundance of older, tiredproperties with significant deferred maintenance and current rents well below their market potential.
Investing based on insider information is not only legal, it is expected in the private markets.
Private real estate is one of the few asset classes where trading on insider information is not only legal—it is essential. In a highly fragmented market with limited institutional ownership like Southern California, current, accurate information about properties and neighborhoods is similarly fragmented. Public records only provide so much detail. Knowing in advance that a property will be coming to market soon through a local neighborhood broker’s “pocket listing” is one of the best ways to avoid auctions and achieve superior pricing as a value-added investor.
Being offered such “first look” opportunities, however, requires a reputation within the brokerage community for being a well-capitalized buyer with integrity that doesn’t re-trade offers and values the brokers in transactions. Earning such a reputation can take decades. Successfully closing a new investment often requires knowing why a particular owner wants to sell. What is motivating the seller? Is it price? Early closing? Certainty of closing? Does the seller still need income, but with less risk, possibly by providing a loan to the buyer and receiving interest coupons rather than continue to manage real estate? In short, having insider information about a market, an asset, or the motivation of a particular seller is a great way to create opportunities where none would have existed otherwise.
There are unique tax benefits associated with real estate investing.
No discussion of private real estate investing would be complete without discussing its potential tax benefits. For certain investors, real estate can be one of the most tax advantaged asset classes. In addition to deducting mortgage interest and other expenses, certain investors may be able to take advantage of depreciation deductions and 1031 tax-deferred exchanges, which are briefly summarized below. To be sure, every investor should consult with an experienced tax advisor before making any investment.
Even if a property may appreciate in market value, the physical improvements also “depreciate” over time due to normal wear and tear and functional obsolescence. The IRS has determined that multifamily properties have a useful life of 27.5 years. Using straight-line depreciation, an investor could increase its annual expenses for tax purposes by 1/27.5 worth of the property improvements as a tax deduction each year (note: only the cost of buildings and improvements can be depreciated; the underlying land cannot). For example, if a particular apartment building was valued by the tax assessor (a typical value metric for tax purposes) at $1,000,000, and further allocated $450,000 of such value to the land and $550,000 to the built improvements, the annual depreciation deduction would be $20,000 ($550,000/27.5 years). If the property was otherwise generating net income of 6% (i.e. $60,000), such income would be reduced for tax purposes to $40,000, saving taxes on $20,000 or one-third of the income. As a non-cash but tax-deductible expense, depreciation can increase an investor’s after-tax income substantially. Note, there are many complexities relating to the applicable methodology of depreciation (e.g., straight-line vs. accelerated), an investor’s eligibility for depreciation deductions (e.g., passive loss rules) and potential consequences upon sale (e.g., depreciation recapture), so it is essential that individuals consult with experienced tax professionals before making any real estate investment.
Another tool that certain real estate investors can potentially utilize is called a tax-deferred or IRS Code Section 1031 exchange. In its simplest form, a 1031 exchange allows investors to defer paying capital gains taxes on the sale of a property if they reinvest their equity into a “like kind” asset of equal or greater value. This can be an effective tool for real estate investors to defer taxes and use the deferral to grow their portfolios over time; however, the rules are complex and should not be undertaken without advice of an experienced tax professional.
Real estate can be an effective hedge against inflation.
We touched on this before, but it’s worth reiterating – certain types of real estate investments can provide a hedge against inflation. Consider Class B/C multifamily assets in Southern California, for example. With respect to properties subject to California’s statewide rent control (AB1482), landlords are allowed to raise rents annually by the Consumer Price Index plus 5%, up to a maximum of 10%. Thus, if you target assets with current rents 25-30% below market, as Paladin typically does, you have both the pricing power and the ability under AB1482 rent control to raise rents in a manner that captures most, if not all, of the rate of inflation. This is what we experienced in the first half of 2022; inflation increased to a staggering 8.5%, and in many markets, landlords were able to increase rents by double digits in response.
The type of multifamily assets that Paladin targets in Southern California can also mitigate some of the inflationary effects on operating expenses. Three of the most significant operating expenses for the apartment buildings we target are property taxes, utilities, and property management, each of which have natural or regulatory hedges built in. Property taxes in California are regulated by Prop 13, which limits annual increases to 2%. A majority of utilities expenses can be passed through to tenants via a ratio utilities billing system or “RUBS” on new leases. Finally, property management expense is typically charged as a percentage of gross revenues collected, so is a variable expense directly correlated to income.
Real estate can also be an effective hedge against recessions.
Owning real estate can provide defensive benefits that help insulate an investment portfolio during a recession. One reason is that private real estate has a relatively low correlation with stocks and bonds. The stock market could tumble while certain types of real estate maintain (or improve) their value. In addition, workforce rental housing in supply-constrained markets like Southern California has historically demonstrated resilient occupancy and rents during economic downturns, resulting in relatively stable cash flow and values compared to the pricing vagaries of the stock market, which may relate more to money flows rather than underlying property income and expenses..
Tenants in Class B/C buildings tend to be “renters-by-necessity” rather than “renters-by-choice” who typically occupy more expensive Class A properties. Existing tenants in Class B/C buildings have few other affordable housing options available. Further, during recessions, many Class A tenants move into Class B/C properties seeking more affordable rents, which helps support the occupancy of Class B/C assets. Indeed, during the 2008-09 Global Financial Crisis and 2020-21 pandemic, occupancy in Class B/C apartment properties in Los Angeles remained above 95%.
Finally, targeting underperforming assets, as Paladin does, with current rents 25-30% below market, can provide pricing power to maintain rental income streams during economic downturns. Even if market rents drop by 10%, any vacancy experienced during economic downturns is typically released relatively quickly, usually at higher rents that are accretive to the bottom line.
Investing in private real estate provides better control.
Unlike stocks and bonds, where individual investors can rarely influence the investment on their own, the performance of private real estate investments is significantly influenced by hands-on asset management and the experience and sophistication of ownership. Savvy real estate investors pay close attention to market cycles and the changing demographics of the tenant base in their neighborhood or sub-market . They follow capital flows, supply and demand-side pressures, and employment or other economic trends. This keen focus on market cycles and specific location allows owners the ability to adjust property business plans accordingly.
We continually evaluate and make adjustments to unit renovation specs and other planned capital improvements taking into account changing market conditions, tenant feedback, cost pressures and the like, all with the aim of optimizing the incremental return (higher rental income) for a particular capital investment.
Such value-engineering is especially important during economic downturns when tenants are more value conscious. The control that astute property owners have to modify their management approach and make real time adjustments to property-level business plans which can directly affect the underlying cash flow and appreciation potential of an asset is one of the unique benefits of real estate investments compared to investments in stocks and bonds.