Five Reasons Why Paladin’s SoCal Apartment Strategy is Recession Resilient

Currently, many investors are understandably fearful. They are worried about high inflation, rising interest rates, and a possible recession, and how the combination of these economic factors will impact their real estate portfolios.

As famed investor Warren Buffett once said, “When the tide rolls out, you see who’s been swimming naked.”

In short, we don’t swim naked. Paladin’s three decade-long focus on value-added Class B/C apartment buildings has proven to be highly resilient even during the depths of previous recessions. This has been especially true among our Southern California apartment investments, which has been far less dependent on market timing as a determinant of performance, unlike most other U.S. markets and product types.

Here are five reasons why our SoCal apartment strategy has historically provided strong downside protection compared to other property types and markets, no matter what stage of a market cycle we may be in.

1. We buy existing assets that already have strong in-place cash flows that can be improved.

This approach is very different compared to investing in developing a new apartment project, where it can take several years to assemble the land, obtain development approvals, construct the improvements, lease it up, and stabilize operations. A lot can happen during that timeline, which, in addition to construction risk, generally makes ground-up development much more risky than investing in existing properties in need of renovation and repositioning.

Few developers can time the market perfectly every time, and it’s often anyone’s guess where the market will be by the time construction is complete and lease up begins. As a result, many investors may see their equity wiped out during a downturn, not realizing that they invested at what turned out to be the height of a market cycle. During a recession, it can be very challenging to lease a newly constructed Class A apartment, which typically command premium rents relative to older, already stabilized assets.

We’ve never been very comfortable with the risk of developing new apartments in the U.S., generally a highly competitive space with relatively narrow profit margins that requires just about everything to go right. Instead, we buy existing, older Class B/C assets that already have durable in-place cash flow streams which have rents (i) typically 20% to 30% or more below their market potential (known as the “loss-to-lease”), and (ii) 50% or more below the rents of newer Class A apartments. Not only does this provide attractive value-added upside potential, but it also reduces our risk during a downturn, a strategy that is further boosted by the other factors listed below.

2. We take a relatively conservative approach towards debt.

Variable interest rates continue to be a canary in the coal mine for inexperienced investors. Many investors are often drawn to initially low variable rates with an eye in the rear view mirror (i.e., the naive assumption that interest rates will stay at historically low levels forever) or the belief that they will have sufficient time to execute their business plans and exit before rates rise.

However, we know that things often do not go according to plan. Unforeseen circumstances, such as a global pandemic or war, can quickly disrupt a business plan, leaving sponsors with variable rate debt at the mercy of the capital markets. In worst-case scenarios, many highly-leveraged borrowers with variable-rate debt can see their invested equity evaporate.

In general, Paladin prefers a more conservative approach towards debt. Most of the assets we buy are typically 45% to 55% levered with fixed interest rates. Moreover, we always try to ensure that our loan durations are closely aligned with our anticipated holding periods to avoid having to refinance (at potentially higher rates) ahead of business plan completion and exit. Simply put, we try to take as much risk off the table on the right side of the balance sheet as possible.

3. Our strategic focus on Class B/C workforce housing keeps occupancy high even during the depths of a recession.

We’ve invested in over 90 value-added apartments across the U.S. during the past three decades. Through this experience, we have found that Southern California’s chronically undersupplied housing market bodes well for workforce rental housing, especially during downturns. The region’s notoriously high housing costs have created a permanent renter class, i.e. those who are “renters by necessity”. These are hard-working middle-class households who were priced out of homeownership long before interest rates spiked. They simply have no other affordable housing choices nearby without facing prohibitively long commutes.

In other words, the Class B/C apartments we target provide an essential need – affordable infill workforce housing in a market where a staggering 63% of households are renters (vs. closer to 35% nationally).

This affordable housing shortage creates resilient demand for our apartments, even during downturns. In fact, we often see cost-conscious renters move out of Class A apartments (where rents are typically twice our rents) and into our renovated Class B/C apartments during recessions. Indeed, during the last two major economic recessions, the 2008-2010 Global Financial Crisis and the 2020-21 pandemic, occupancy at Class B/C apartments in Los Angeles remained steady in the 95 to 98% range.

The durability of occupancy in Class B/C apartments, combined with our conservative approach towards debt and the large loss-to-lease we target, helps ensure reliable cash flow streams for our investments, which is especially important to investors looking for downside protection.

4. We have pricing power to raise rents at our properties, even if market rents decline.

As noted above, the Class B/C apartment buildings we target typically have a 20% to 30% loss-to-lease (i.e., the difference between current rents and market rents). Further, our all-in cost basis, including planned renovations costs, is typically a 50% discount or more to replacement cost, with pro forma rents that are at a similar cost advantage to Class A apartments.

These factors give our properties tremendous pricing power, even during market downturns. For example, if market rents were to decline by 10% during a recession and a unit with a 30% loss-to-lease becomes vacant, we can still capture the remaining 20% loss-to-lease and increase our rental income.

5. We view rent control as an opportunity, not a hindrance.

While many apartment investors are afraid or confused by rent control and its various complex regulations, we view this as an opportunity. Each time a unit becomes vacant, we can re-rent that unit at prevailing market rents. Further, under certain types of rent control a large loss-to-lease gives us the pricing power to raise rents even if no unit turnover occurs, providing a valuable hedge against inflation.

For example, a 10% rent increase at an asset with a 30% loss-to-lease would still represent an attractive value proposition to our tenants who would be paying rents that are still 20% below market. Further, because our rents are typically half of the rents at Class A apartments, we often see value-seeking “renters by choice” (some of whom, after job losses, become “renters by necessity”) move into our buildings during severe or prolonged recessions—again, creating resilient demand for our assets.

In our experience, the considerable cost advantages described above are unique to the SoCal apartment market, which is why our current U.S. strategy is primarily focused on this market. It is very difficult to replicate this same degree of cost advantage and pricing power in other U.S. markets where ownership is typically dominated by sophisticated institutional investors who often buy large properties at escalated prices in markets where auctions are the norm and the shortage of affordable housing is not as acute.