Seeking Asymmetrical Returns in Uncertain Times
2023 Outlook & Investment Thesis for Workforce Rental Housing in Southern California
With growing uncertainty surrounding the U.S. economy, rising interest rates, a war raging in Europe, and the stock market in bear territory in 2022, defensive investment strategies are on every investor’s mind right now. Paladin Realty believes superior, asymmetrical risk-adjusted returns can be achieved by investing in the renovation, repositioning, and efficient management of older Class B/C rental apartment properties in the greater Southern California region, with a primary focus on the Los Angeles metro area.
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Unique Attributes of the Southern California Apartment Market
There are several distinct characteristics that set the Southern California apartment market apart for value-added strategies compared to other U.S. markets, and which make the greater Los Angeles metro area a very attractive market for sophisticated investors like Paladin Realty – particularly today. The unique attributes of the Southern California apartment market include:
- Fewer institutional competitors than most other U.S. markets due to the preponderance of smaller assets that make up the existing rental housing stock in greater Los Angeles.
- Abundance of value-added opportunities due to the lack of institutional competition in a market dominated instead by smaller, less sophisticated “mom and pop” owners who typically lack the knowledge, resources or desire to invest in their properties.
- Varied and complex rent control regulations that require sophisticated and experienced investors to navigate.
- Asymmetrical risk-adjusted returns, characterized by attractive value-added upside potential in a relatively low cap rate market like Los Angeles, combined with unparalleled downside protection for invested equity.
Less Institutional Competition
Most of the infill rental housing in Los Angeles County was developed in the decades after World War II, when vacant land was relatively cheap and plentiful. As a result, the existing rental housing stock is largely comprised of smaller, older properties. The typical rental apartment property is a low density, two story, walk-up building, constructed around a central courtyard or pool with few, if any, amenities. Indeed, 85% of the existing housing stock in Los Angeles County is comprised of properties consisting of 50 units or less, and 92% is over 20 years old. With new construction costing at least twice the all-in cost of acquiring and renovating existing properties, these older Class B/C assets are truly irreplaceable today. Given the region’s high land and construction costs, and other substantial barriers to new development, it is likely that this substantial discount to replacement cost will endure well into the future.
Importantly, the smaller asset sizes that comprise the bulk of the Southern California apartment market also make it very challenging for larger institutional investors to achieve desired portfolio scale. For example, an institutional investor might have to acquire 10 individual properties in Los Angeles to achieve the scale (in terms of number of units) compared to markets like Phoenix, Dallas or Atlanta where the typical property is much larger (150 to 300 units or more). For this reason, the Southern California apartment market is viewed by many institutional investors as simply too management intensive. As a result, the market remains dominated largely by smaller, less sophisticated “mom and pop” investors.
Abundance of Value-Added Opportunities
The typical “mom and pop” investor that dominates the Southern California apartment market has very different motivations that a typical institutional investor. Most “mom and pop” property owners lack the experience, resources or desire to optimize the full market potential of these older assets. In addition, such owners often face cash flow pressures and confusion from rent control regulations, earthquake retrofit requirements, the impact of the pandemic and, more recently, higher interest rates.
As a result, the urban landscape of greater Los Angeles is filled with many older, run-down Class B/C apartment buildings that are significantly under-performing their full market potential, as evidenced by:
- Current rents 20-30% below market rents (also known as “loss to lease”)
- Tired, run-down appearance
- Significant deferred maintenance
- Lack of modern amenities
- Poor management
- Poor tenant relations
- Fear of dealing with local municipalities to take advantage of rent control regulations to increase rents
- Stressed capital structures (e.g., loan defaults, partnership and family generation disputes)
Paladin believes that the ability to buy irreplaceable under-performing assets at steep discounts to replacement cost from a large and fragmented pool of “mom and pop” owners (oftentimes by avoiding costly auctions) represents a compelling market opportunity for experienced investors like Paladin, who has a proven track record of navigating complex rent control regulations (more on this below), increasing cash flow and adding substantial value and renewed longevity to these older properties.
Further, the upside from a value-added strategy can be particularly rewarding in a large, chronically supply-constrained market like Los Angeles where, due to strong demand and barriers to new supply, apartment capitalization rates or “cap rates” (i.e., Net Operating Income or “NOI” divided by a property’s market value) tend to be relatively low compared to other U.S. markets. For example, every $1 of increase in NOI in a 4% to 5% cap rate market generates $20 to $25 of incremental value.
Complex Rent Control Regulations
Virtually every residential rental property in California is subject to some form of rent control, ranging from the Statewide AB1482 ordinance that went into effect in January 2020, to more restrictive local regulations such as the 1978 City of LA Rent Stabilization Ordinance (see Paladin Realty’s “Rent Control – Impediment or Opportunity” white paper, December 2022). In general, regardless of any local rent control, all residential units in California can be rented out at market rents upon the occurrence of any vacancy, a landlord right codified into statewide law since 1995. Still, most unsophisticated “mom and pop” owners view rent control as confusing and an impediment to owning and managing apartments in California. Indeed, the existence of rent control discourages many such smaller owners from investing in their assets, further contributing to the region’s affordable housing shortage and other conditions leading to the abundance of value-added opportunities, as described in the preceding section.
For sophisticated investors like Paladin, who have considerable experience navigating the complexities of California’s various ordinances affecting residential rental properties, this knowledge creates a competitive advantage. Paladin’s primary strategy in dealing with rent control regulations has been to encourage vacancies during the renovation period through a combination of voluntary tenant buyouts, more rigorous lease enforcement and natural unit turnover (which tends to increase during any major building renovations). Further, AB1482 provides a direct and relatively low-cost pathway to achieve unit turnover for owner’s intending to make substantial remodels and upgrades to unit interiors and building systems. As such, Paladin views rent control as a neutral to positive contributor to the market opportunity for its value-added strategy in Southern California, not an impediment.
Asymmetrical Risk-Reward Proposition
Perhaps the most unique and compelling attribute of Paladin Realty’s Class B/C apartment strategy in Southern California is the downside protection such investments can offer due to their resilience to economic downturns, combined with the large cost advantage they have relative to new supply, providing a substantial comparative rent advantage to Class A assets.
Unlike newer, higher density Class A apartments (which are typically less than fifteen years old and have various upscale amenities that target more affluent “renters by choice”), the older and smaller Class B/C properties that dominate the landscape of greater Los Angeles and Southern California overall are typically occupied by a mix of moderate-income, working-class residents, retirees, and other tenants who are “renters by necessity” – in other words, a large permanent renter class in Los Angeles who cannot afford to buy a home of their own and who are attracted to the lower rents offered by these infill Class B/C rental properties.
Indeed, for a variety of reasons, including their low-density design, older construction, accumulated deferred maintenance and lack of amenities, Class B/C apartments typically trade at large discounts to replacement cost, often 50% or more, and their market rents may be 30% to 40% or more below those of newer Class A properties. As such, Class B/C apartment properties provide an essential need – critically needed affordable “workforce housing” to the 20+ million population in the greater Los Angeles area. And, because these renters by necessity have few other affordable housing alternatives nearby, Class B/C apartments have historically remained occupied during recessions and market downturns. For example, Class B/C occupancies in Los Angeles County remained in the 95% to 98% range during the last two major downturns, the 2008-09 Global Financial Crisis and 2020-21 Covid pandemic. Oftentimes during recessions, renters by choice become renters by necessity, and will move out of more expensive Class A apartments into more affordable Class B/C assets.
These unique qualities of Class B/C apartment buildings in Southern California – (1) a huge competitive cost advantage relative to Class A apartments, combined with (2) resilient demand from a large permanent renter class – can offer unparalleled downside protection compared to most other U.S., particularly during market downturns, provided such investments are not burdened by aggressive amounts of debt financing. Further, even if market rents were to decline for all classes of apartments during a market downturn, the 20-30% “loss to lease” mentioned above provides Class B/C assets a cushion to maintain cash flow and the pricing power to even increase rental income throughout all market cycles.
2023 Outlook & Strategy Implications
The markets shifted significantly in 2022. While the rental outlook for Class B/C apartments in Southern California remains relatively healthy compared to other U.S. markets and property types, we expect market rents to soften and likely decline in the event of a recession in 2023, the possibility of which we are underwriting into all new investments. Assets are in the midst of a repricing in response to rising interest rates, more conservative underwriting by lenders, and a general contraction of debt and equity capital flows. These repricing conditions will continue well into the New Year, creating some attractive buying opportunities for us in 2023 and beyond, particularly as more recent owners struggle to refinance their debt in a higher interest rate environment. This promises to deliver discounted acquisitions to our portfolio, providing opportunistic acquisitions that will put our investors on the right side of the wealth transfer equation in the coming year. As such, we’re being very selective in the opportunities we’re pursuing today, believing that patience, combined with disciplined and conservative underwriting, will pay off in 2023.
Paladin Realty believes the distinct attributes of the Southern California workforce rental apartment market described above – (1) fewer institutional competitors, (2) abundance of value-added opportunities, (3) complex rent control regulations, and (4) asymmetrical risk-adjusted returns – continue to create a compelling market opportunity for sophisticated investors like Paladin Realty to acquire, renovate, reposition, and more efficiently manage existing older, under-performing Class B/C apartments in Southern California.
The supply-demand fundamentals underpinning this opportunity (i.e., a chronically supply-constrained major gateway market with huge barriers to entry; resilient demand from a larger permanent renter class; large cost advantage relative to new construction; complex rent control regulations that help perpetuate a large “loss to lease” on Class B/C properties) are all structurally imbedded in, and unique to, the Southern California apartment market. As such, a value-added strategy focused on Class B/C workforce rental housing in the Southern California market is less reliant on market timing and is relatively well-insulated from economic downturns that have a much greater effect on most other real estate markets. Paladin believes that the resulting combination of strong downside protection and attractive upside potential in a low cap rate market results in an asymmetrical risk-reward proposition for Paladin Realty’s workforce rental housing strategy that is difficult to replicate in most other property types and U.S. markets.
