The Value of Avoiding Competition When Investing
Greater Los Angeles is one of the largest and most dynamic metro areas in the United States. In fact, if Los Angeles County were a standalone country, its $750 billion GDP would make it the 19th largest economy in the world.
Given the scale of the LA market, many investors naturally assume that most apartment buildings are owned by large institutional investors. Prospective investors are often then surprised to find out that, unlike most other U.S. markets, there is far less competition from institutional investors in Los Angeles for the types of Class B/C apartment properties that Paladin targets.
In this article, we’ll explain why that is the case and how this creates an important value proposition for Paladin.
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Challenges in Achieving Scale
It would seem to defy logic that there’s relatively little institutional competition for value-added Class B/C apartments in Los Angeles, a market that has experienced a chronic shortage of affordable housing and resulting steady rent growth for decades. It’s especially surprising given that Los Angeles is a major gateway city, home to more than 10 million people.
The primary reason most institutional investors shy away from value-added apartment properties in greater Los Angeles is that it’s a very management intensive proposition to scale up an institutional-sized portfolio in this market. This is because the existing infill rental housing stock was largely constructed in the decades after World War II, when land was plentiful and cheap. As a result, the apartment market here consists mostly of smaller, low-density properties. Indeed, 85% of the existing rental housing in Los Angeles comprises buildings that are 50 units or less in size.
Because of the predominance of these smaller apartment buildings, an institutional buyer would need to identify and acquire approximately 10x as many assets in Los Angeles to achieve the same scale (i.e., total number of units) that they could get by buying a small handful of larger apartment complexes in Atlanta, Phoenix, Dallas, or many other major U.S. markets where the typical multifamily asset is 250- 300 units in size.
In addition, there’s a variety of due diligence and structuring costs associated with each acquisition that can multiply when scaling up portfolios of smaller assets if not managed efficiently. These acquisition costs typically include legal expenses relating to negotiating and drafting purchase agreements; costs to arrange, structure and document debt financing; costs related to property inspections, title surveys, environmental and zoning studies; lease audits; and the like. Each of these pre-closing transactional tasks requires time and money. As a result, most institutional investors tend to target larger assets, 150 units or more, which are very hard to find in the Los Angeles metro area.
Not only is it time-consuming to acquire and scale up a portfolio of smaller Class B/C apartments in greater Los Angeles, the sheer number of assets acquired will ultimately be more management intensive to operate than a comparable-sized portfolio (i.e., same number of units) consisting of a smaller group of larger properties. While there are certain common characteristics to the value-added business plans that Paladin implements across its Southern California portfolio, each property has its own unique physical and operating deficiencies that need to be addressed. A portfolio with 10x the number of assets will require that many more individually-tailored property-level business plans to execute. Furthermore, at any point in time, multiple properties across the portfolio will be at different stages of their respective renovation and repositioning plans.
As a result, the most successful apartment investors in the Southern California market tend to have very robust, institutional-quality asset management systems and teams tailored to achieve efficiencies and economies of scale across large portfolios of smaller assets.
Many institutional investors simply find that process to be too management intensive and would prefer to acquire larger assets in major markets other than Los Angeles.
Paladin sees that as a prime opportunity to invest in a local, less competitive market.
Lack of Institutional Competition Adds Value for Paladin
So, if most institutional investors don’t own the smaller, older apartment properties in Los Angeles, who is?
The Southern California apartment market is dominated by a completely different kind of owner and investor. Because of the predominance of smaller property sizes – which are deemed to be too management-intensive by most larger institutional investors – apartment buildings in this market are primarily owned by smaller “mom and pop” investors. These are often relatively unsophisticated individual investors or small-time local syndicators who have owned their assets for decades. In many cases, the real estate is passed down from one generation to the next.
Many of these mom and pop owners lack the real estate knowledge and sophistication to realize that their assets are significantly underperforming the market. They view rent control regulations as a nightmare and don’t want the municipality involved in their business. Paladin, on the other hand, views rent control as an opportunity, creating under-market opportunities that, given our track record and experience, we can take advantage of by successfully navigating these complex regulations.
Additionally, many of these smaller investors also lack the financial resources to improve and manage their properties to create additional value. In fact, many of these long-time mom and pop owner prefer to focus on the status quo - maintaining steady cash flow by deferring repairs and maintenance, keeping rents low and minimizing unit turnover. This cost saving strategy is a completely rational approach for an individual investor whose cost basis is low, who may own the asset debt free, and who prefer to utilize their properties to simply collect monthly cash flow rather than invest in the future.
This creates an opportunity for investors like Paladin whose goal is to maximize value, with the skill and experience to do so.
Driving around Los Angeles, it is easy to see the market opportunity. There are literally thousands of older, rundown Class B/C apartment buildings with current rents 20% to 30% or more below their market value.
Here are some of the ways we capitalize on this opportunity;
- We buy properties with a high “loss-to-lease”. We target fatigued, poorly-managed Class B/C apartment buildings where current rents are 20% to 30% or more below their market potential. Capturing this “loss-to-lease” (under-market rent differential) by renovating and upgrading the property is the primary objective of our value-added business plans.
In addition to creating the potential for attractive value-added profits, this large loss-to-lease also provides strong downside protection. For example, if market rents were to decline by 10% during a recession and an individual apartment unit with a 30% loss-to-lease becomes vacant, we can still capture the remaining 20% loss-to-lease and increase our rental income. 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 properties with a 30% loss-to-lease, a 10% rent increase would still represent a value proposition to our tenants who would be paying rents that are still 20% below market. We have found this strategy to be particularly compelling when buying rent-controlled assets in greater Los Angeles.
- We implement professional management, like ratio utility billing systems (RUBS). We bring thirty years of experience managing real estate investments on behalf of institutional investors to every asset we acquire. The vast majority of the apartment investments we’ve made to date in Southern California did not have a ratio utility billing system (RUBS) in place when we acquired the asset. RUBS is one of the most basic and important ways to more effectively manage water and power usage, and pass through such utility costs to tenants. Virtually every apartment property owned by institutional investors has RUBS in place. Not surprisingly, given the lack of broad institutional ownership in Los Angeles, RUBS is a rarity in this market. This is one of many things we do as soon as possible to maximize the operating efficiencies of our properties.
When we are able to increase rents by capturing a large loss-to-lease, and keep operational costs under control through RUBS and other professional management strategies, the result is higher Net Operating Income (NOI). In a relatively low cap rate market like Southern California, the value-added reward for increasing NOI can be quite significant. Every $1 of increase in NOI generates $20 to $25 of incremental asset value in a 4% to 5% cap rate market.
- We know that oftentimes local sellers prioritize certainty of closing over price. Paladin has a reputation in the brokerage community as being a well-capitalized buyer that closes deals with reliability and without re-trading (unless, of course some material unforeseen condition arises). This is critically important to many mom and pop sellers who are often planning to roll their sale proceeds into another property using a 1031 exchange. These tax-deferred exchanges have strict timelines that sellers must adhere to in order to reap the tax benefits. If the sale doesn’t close, it can disrupt the entire exchange transaction and can have very negative tax implications to the seller.
Certainty of closing is often more important than obtaining the highest price to these sellers. We utilize this to our advantage.
- We stay firm on price and avoid auctions. Apartment property sales in most U.S. markets are dominated by institutional investors and are typically widely marketed by the listing broker and structured as auction-style transactions with several rounds of bidding by multiple buyers driving up the ultimate sales price. This is good for sellers of such assets, but not so good for buyers.
We’ve never thought that auctions were a smart way to buy real estate. Winning means you paid a higher price than all other buyers were willing to pay for the property. From a buyer’s standpoint, this is not a good feeling.
Because of the lack of broad institutional ownership of apartment properties here in Los Angeles, and because many mom and pop sellers are motivated more by certainty of closing than the highest price, we typically see many off-market and first-look opportunities because of our reputation as a strong, reliable buyer who protects our broker relationships. Additionally, if a listing broker can close a sale with us, that broker will get both sides of the commission that would typically be divided 50/50 between the listing broker and the broker representing the buyer (usually not the listing broker), creating an additional motivation for the broker to want to close the deal with Paladin before it is widely marketed. This frequently gives us a two- to three-week head start to begin due diligence and make an offer compared to other local buyers.
If multiple buyers do start circling around a prospective acquisition, we will typically tell the broker the maximum price we’d be willing to pay and stay firm on that price. If another buyer ties up the asset and the deal falls through a few months later, the broker will often call us first to see if we’re still interested in buying at our original offer price. We’ve closed several recent acquisitions this way and always manage to close at or below our original price.
Avoiding costly auctions is more valuable than people realize. We have walked away from several deals that later went to auction and, when those deals closed, the properties traded for 10% to 20% above what we would have been willing to pay. By avoiding auctions, we inherently have a pricing advantage that creates instant value upon closing.
The Bottom Line
While the lack of institutional competition may come as a surprise to those unfamiliar with the Los Angeles rental apartment market, it’s something that should not be overlooked by prospective investors. Because of the absence of broad institutional ownership, there is an abundance of value-added apartment investment opportunities throughout Southern California due to the fact that we’re buying from a large and fragmented pool of mom and pop owners.
The competitive advantage this unique market provides to an institutional-quality investor like Paladin is one of the main reasons we’re primarily focused on buying Class B/C apartments here in Southern California. It has proven to be a compelling opportunity to date, and we believe it will continue to be so for the foreseeable future.