10 Reasons Why Paladin’s Strategy Mitigates the Effects of Rising Interest Rates and Recession

Here are the Top 10 reasons why we believe our strategy is well-positioned to weather the next market downturn.

1. We follow a conservative approach towards debt, with fixed-rate loans that match the length of our business plans.

   Look no further than our last four transactions. The amount of debt financing arranged for these acquisitions was 50% or less. This is considered conservative in an industry where many buyers rely on 65-75% leverage.

   Moreover, we typically utilize fixed-rate debt with loan durations that match the length of our business plans. This helps to ensure that rising interest rates and/or a loan maturity does not impact our value-add business strategy ahead of property stabilization and exit.

2. There is less buyer competition today as many value-added investors who are more reliant on higher leverage are forced to sit on the sidelines.

   During the past several years, many value-added investors became accustomed to utilizing short-term, variable rate bridge financing to acquire properties at loan-to-values of 70% or more. Higher inflation, the War in Ukraine, rising interest rates and general economic uncertainty caused this type of bridge financing to largely evaporate. Less well-capitalized buyers can no longer compete for Class B/C apartments in Los Angeles, putting Paladin in a good position to find and secure the most attractive investments.

3. Higher interest rates put pressure on highly-leveraged owners, increasing the potential for motivated sellers in the coming months.

   We alluded to this above, but let’s elaborate. Higher interest rates are going to put increased pressure on buyers who took advantage of 70-75% bridge financing in recent years. Those loans will start coming due soon and these borrowers will be forced to refinance at substantially higher rates. Some owners will not be able to afford the higher debt service payments and, in turn, will be forced to sell. This will create opportunities for well-capitalized buyers like Paladin who are positioned to acquire assets at attractive pricing.

4. While higher interest rates have eliminated bridge financing options, there are still plentiful financing options for SoCal multifamily assets among traditional banks and other conventional sources.

   Many investors do not realize that banks are required to meet certain quotas or thresholds for lending in certain geographic areas. Large multifamily agency lenders, Fannie Mae and Freddie Mac, are evaluated based upon their loan footprint in various markets. It has been challenging for these institutions to grow their SoCal multifamily portfolios given the disaggregated and small-scale nature of buildings in SoCal. However, bank and agency debt is still readily available and at relatively attractive rates and terms for borrowers like Paladin—despite rising interest rates and general economic unease.

5. Inflation may actually provide a tailwind for the rent-controlled assets we target.

   Whereas most mom and pop owners are afraid of, or confused by, California’s rent control regulations, including State Assembly Bill 1482 or (“AB1482”), we see this as an opportunity. Paladin targets properties that have a 20-30% “loss-to-lease” which means that, at the time we buy the property, the in-place rents are well below market rents, with room to grow in nearly every economic environment.

   Here's what that means in practice. During a recession, many landlords are unable to raise rents, especially for Class A properties. Sometimes, their rents actually decline. However, because we acquire properties where rents are already 20% to 30% below market , we can increase our rents during a recession and still prove to be competitive even if market rents were to fall. This high “loss-to-lease” that we target allows us to raise rents in compliance with AB1482, allowing increases of CPI+5% up to 10% annually. And, in doing so, we have the potential to increase our cash flow despite economic turbulence. Meanwhile, because our rents would still be below market, this creates a “sticky” tenant base that is less likely to move, keeping occupancy rates high and turnover costs low.

6. Rising Net Operating Income helps offset the effects of a likely rise in exit cap rates.

   Typically, cap rates tend to lag interest rates. As interest rates begin to rise, many sellers still have last year’s pricing in their minds when they bring their property to market. However, buyers, brokers and lenders are generally more attuned to the higher cost of capital today. They understand what the inflationary impact is on investors and how this impacts investment return requirements. As a result, pricing expectations of buyers and sellers tend to diverge as interest rates start to rise. This is what we started to see in the second half of 2022: a fairly wide bid-ask spread between buyers and sellers, leading to few transactions.

   Eventually, cap rates will adjust to respond to the higher cost of capital and current market conditions. Higher cap rates place less value on the same amount of Net Operating Income and, thus, negatively impact asset prices. Fortunately, Paladin’s strategy, which is centered on increasing Net Operating Income by capturing the large loss-to-lease described above, helps us offset the impact of a likely future rise in exit cap rates.

7. Renter demand for Class B/C apartments in Southern California has historically been resilient, including during economic downturns.

   This is true even during recessions that followed interest rate hikes. For example, occupancy rates for Class B/C apartments in Los Angeles remained close to 95-98% during the 2008-09 Global Financial Crisis and the 2020-2021 Covid pandemic.

   The reason for this cannot be overlooked. The Class B/C apartments we target provide an essential need for the large population of Southern California seeking affordable infill housing located near centers of employment. This “workforce housing” is targeted towards working class and middle-income households who have been priced out of home ownership by Southern California’s notoriously high housing costs and, therefore, have become “renters by necessity.” Indeed, a permanent renter class. Regardless of economic conditions, these folks need somewhere to live. Class B/C apartments are much more affordable than Class A properties, with rents typically half that of newer properties. Therefore, Class B/C properties tend to attract Class A tenants seeking value, especially during economic downturns. This keeps our average occupancy rates well above industry standards—something that is unique to Southern California relative to almost any other real estate product in any other market.

8. Higher interest rates make homeownership even less affordable in Southern California’s chronically supply-constrained market, thereby heightening demand among the renters Paladin targets.

   Nationally, the homeownership rate is around 65%. The remaining households are renters. In Southern California, it’s the inverse: 63% of the households in Los Angeles are renter-occupied. The region’s low homeownership rate reflects decades of practical and policy-driven barriers to new supply, resulting in exorbitant housing prices and a region-wide shortage of affordable housing.

   Rising mortgage interest rates only exacerbate this problem, making homeownership that much more expensive and unattainable for a majority of households in Los Angeles.

   As described above, the lack of affordable home ownership opportunities in Southern California has created a permanent renter class in the region. These renters by necessity are growing in size —and looking to live in the relatively affordable types of workforce housing that Paladin provides.

9. Construction cost inflation further heightens the many barriers to new housing supply in greater Southern California, widening the competitive cost advantage of our SoCal apartment strategy.

   Southern California is already one of the most challenging markets to develop new housing supply. It takes several years and an enormous amount of speculative capital investment to assemble the land, obtain development approvals, and defend against inevitable environmental lawsuits and neighborhood opposition before a developer can even put a shovel in the ground. Meanwhile, material and labor costs have continued to climb, as has the cost of debt. This makes new construction that much more prohibitively expensive for most developers. Those who do succeed in launching construction on a new housing project are often forced to target rents at the highest price point in order to make any reasonable return on their investment. This market targets “renters by choice” rather than “renters by necessity.”

   The high barriers to entry of the SoCal housing market give Paladin’s Class B/C rental apartments a significant competitive advantage. The all-in cost basis for our typical apartment property, including renovation and repositioning costs, is often a 50% discount to replacement cost (i.e., the cost of building a new property). For context, it can cost $750,000 or more per unit to build new rental apartments in Los Angeles. By contrast, our cost basis is typically closer to $250,000 to $375,000 per unit, including renovation costs.

10. Assets acquired in a high interest rate environment today should benefit when rates eventually decline.

    Interest rates have more than doubled over the past year, but rates will eventually come down and stabilize. Investors who buy properties at higher cap rates in the coming months should benefit when rates decrease and normalize – even if not back to the historically low levels we saw over the past decade. The combination of lower cost of capital and possible cap rate compression should have a powerful effect on equity returns for recently acquired properties when today’s cycle begins to moderate.