Paladin’s Asymmetrical Risk-Reward Proposition
Not long ago, Howard Marks, founder of Oaktree Capital and a widely respected institutional investor, wrote a memo in which he discussed the concept of “asymmetry”. In short, he described asymmetry as “[his] word for the essence of investment excellence and a standard against which investors should be measured.”
According to Howard, “investment excellence lies in the asymmetry between the results in good times and bad times.”
Here at Paladin, that struck a chord. When it comes to real estate investing, we believe our Southern California value-added rental apartment strategy delivers a compelling asymmetric risk-reward proposition for investors that is unique among U.S. real estate strategies.
Let us explain why.
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Our Investment Strategy Stands the Test of Time and the Inevitable Market Cycles
Many real estate investors will tout their ability to achieve strong returns regardless of economic conditions. But what does their track record actually say? As importantly, do they have the longevity to have weathered multiple economic cycles?
We are proud of the track record we’ve built at Paladin. We have invested in more than $7 billion of real estate in 8 countries across the Americas over the past three decades, with an emphasis on workforce housing. Nearly $1 billion of that investment has been in U.S. value-added rental apartments. Half of those investments were in Southern California.
Workforce rental housing in Southern California has proven to be among the most consistently profitable and cycle-resilient of all our strategies. In good times, it has earned outsized value-added returns more akin to the returns you’d expect with far riskier ground-up developments. More importantly, during recessions, it means that investors’ equity has been preserved, as these assets have proven to maintain resilient occupancy and durable cash flows.
In short, our SoCal apartment strategy has delivered exactly the kind of asymmetrical risk-reward proposition that Howard Marks was talking about – in good times and in bad.
3 Reasons Underpinning Our Asymmetrical Risk-Reward Strategy
There are several factors that support Paladin’s asymmetrical risk-reward proposition. The three primary reasons are (1) the abundance of value-added opportunities that exist in the SoCal apartment market; (2) the superior cost advantage we can achieve for our assets that provides inherent downside protection; and (3) the pricing power we have to increase rents even during a downturn.
1. Abundance of value-added investment opportunities in the Southern California apartment market.
In greater Los Angeles, there are very few institutional investors like Paladin investing in Class B/C apartment buildings. This is because most existing properties were built in the decades after World War II when land was cheap and widely available. As a result, the vast majority of the existing rental housing stock consists of smaller, low-density properties.
The typical apartment in this market is a two-story walkup building or buildings with fewer than 50 units in total. These properties usually have few if any amenities other than, perhaps, a small pool or interior courtyard.LA’s existing rental housing is highly fragmented and primarily owned by small, unsophisticated “mom and pop” investors. Institutional investors find it very difficult to achieve scale by investing in properties this small. Instead, they tend to focus their investments in larger apartment communities (i.e., 150 units or more) typical in cities like Dallas and Phoenix.The lack of institutional ownership in the LA market means that apartments are often poorly managed, outdated and run down, and are sold with current rents anywhere from 20% to 30% below market (which the industry refers to as “loss-to-lease”).
Paladin acquires properties at what we believe is a fair price that will achieve our target returns. We avoid auctions and bidding wars that are common for institutional investors. Upon taking ownership, we implement a value-add strategy and business plan focused on capturing the loss-to-lease to increase cash flow and residual value. In a 4% to 5% cap rate market like Los Angeles, a $1 increase in cash flow, whether through operating efficiencies or property improvements, translates into $20 to $25 worth of appreciation in market value.
2. Paladin’s focus on Class B/C workforce housing provides a unique cost advantage with inherent downside protection.
The smaller, older Class B/C rental apartments we target in Southern California are truly irreplaceable assets. With land, labor and material costs at all-time highs, you literally could not build similar properties today for a fraction of what we pay for them. Since L.A.’s housing market is notoriously supply-constrained and barriers to new development are prohibitively high, this gives investors like Paladin a major cost advantage. We typically buy properties at a 50% or more discount to replacement cost (i.e., the cost of new construction).
Developers of new apartment buildings typically must charge luxury rents to get any type of reasonable return on investment. Further, L.A.’s chronic housing shortage and resulting high housing prices have created a “permanent renter class”. Our investment strategy is tailored to this demographic. Our Class B/C apartments provide an essential need by offering relatively affordable housing in areas close to employment centers to “renters by necessity” who have long been priced out of home ownership.
This, in turn, provides resilient renter demand for our properties. Our tenants have few other affordable housing choices nearby without facing prohibitively long commutes, and therefore, our occupancy levels at our Class B/C properties stay high even during recessions. Indeed, during the last two recessions, the occupancy rate of Class B/C apartments in Los Angeles was anywhere between 95% to 98%.
3. Our strategy gives us pricing power to increase rents even during a downturn.
The combination of buying value-add properties with a huge loss-to-lease, and our focus on workforce housing targeting a permanent renter class with cycle-resilient demand, gives us considerable pricing power. In short, we have found that we can increase rents even during a market downturn.Consider this: during the depths of the Covid pandemic, market rents dipped as much as 15-20% in some markets.Because we target properties with a 30% loss to lease, we were still able to increase rents at our Class B/C assets whenever a unit vacated, while Class A properties faced the market’s downward pressures. Indeed, we could increase rents by 10% to 15% and still be priced below the market average during the depths of that most recent recession.
While no investment strategy is foolproof, we believe that our focus on demand-driven workforce rental housing in Southern California provides the exact type of asymmetrical proposition that Howard Marks describes: one that does well in the good times, and one that protects invested equity during the bad times.
Over the past 30 years, our U.S. apartment strategy has delivered exactly that type of asymmetrical return to our investors across multiple market cycles. We’ve made over 90 apartment investments, and upon stabilization, have sold 83 to date. These investments averaged a 21% IRR to investors, with the 45+ properties in SoCal among the best performing due to the reasons described above.
Investors may have trepidation about investing in real estate today given the economic uncertainty that lies ahead. And yet, we have shown that strategic investments in asymmetrical strategies can indeed outperform, even in a bear market.