Is This Time Different?
We have seen it happen time and time again. There is a prolonged bull market that keeps investors believing it will last forever. Looking in their rearview mirror, they begin to think that asset prices will continue to rise indefinitely, that there has been some fundamental, structural change that will prevent a future market downturn.
This thinking quickly distorts the capital flows for most asset classes, eventually creating unsustainable price increases and eventually, asset bubbles. We experienced this result with the Dot.Com bust in 2001 and the Global Financial Crisis in 2008 and 2009.
We have witnessed a similar pattern of “irrational exuberance” over the last few years, whether it be in the prices of stock, bonds or real estate. And yet, people are still asking – could this time be different?
Do not be fooled.
This time is no different.
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Why People Think “This Time is Different”
If real estate cycles are so predictable, then why do some people still fall for the notion that this time around will be different? There are a lot of different factors that cause this to happen.
The first has to do with human psychology. Most of us are inherently wired to be optimists. Some would argue that it is the survival instinct in all of us. There is an innate longing for good news, a better life, and more wealth. This makes people prone to believing that good news, such as real estate’s constantly increasing values, can last forever.
The second factor has to do with greed. In early childhood, we are all taught that we should strive to better ourselves. That if we work hard and pay our dues, we can realize the “American Dream.” This causes a lot of people to take big chances. With any investment, they might swing for the fences—but in doing so, they ignore the very real downside risks. When the market dips, many deals succumb to these risks.
A third factor, which is relatively new, has to do with social media. Today, any Tom, Dick and Harry can have their voice amplified on social media. Social media creates these echo chambers where the loudest – but not necessarily the most educated or experienced – are heard. When they tell people that “this time is different,” it creates a herd mentality that proves to be quite powerful.
Similarly, social media and online news has made it easier to filter news by our preferences and ideologies. People can more easily tune into news that supports their positive outlook on the economy. This is what psychologists call “confirmation bias.” Instead of getting well-balanced, neutral news, people are easily steered toward media that tells them what they want to hear.
At Paladin, We Do Not Think “This Time is Different”
Our view is simple: economic growth is cyclical; markets and asset prices are cyclical. Asset prices are especially dependent upon investor psychology. This, in turn, influences capital flows. Investors need to be very mindful of the capital flows for both the debt and equity to ascertain where the market is likely headed and what risks are likely to be encountered in the future.
How We Get Ahead of Market Downturns
At Paladin, we constantly monitor the market. We watched closely as real estate values, particularly in the housing sector, skyrocketed in 2020 and 2021. When interest rates hit record lows a year ago, we worked to lock in low-cost, fixed-rate debt. We knew this time wasn’t different, and in turn, we started to prepare for what we believed would be the inevitable downturn. Downturns can be good for the economy. They squeeze out less efficient, inexperienced, and often under-capitalized operators and investors that tend to sprout up in droves when money is cheap and markets are strong. After all, everyone looks smart in a bull market; and maybe not so smart in a downturn.
Downturns can create distress as marginal operators collapse and investors refuse or are unable to throw good money after bad, thereby creating opportunities for well-capitalized, experienced operators to pick up the pieces. Here is how we manage risks to weather the ups and downs of the inevitable changes in the real estate cycle.
Avoid markets with high competition.
This is one of the reasons we have focused on rental workforce housing in Southern California and entry-level homes for purchase in Latin America. Due to certain barriers to entry and their management-intensive nature, these markets have relatively limited institutional (i.e. professional) competition. There are smaller competitors, but few that have the same combination of institutional credibility and wherewithal as Paladin.
Be cognizant of investing in the most cyclical markets.
Phoenix and Dallas are prime examples of highly cyclical real estate markets. There is still plenty of land to develop and few regulatory barriers to new construction. Those investors who have had the greatest success in markets like Phoenix or Dallas have either learned to time their entry and exit from these markets well, or just been plain lucky. They could just as easily have lost their shirt had their timing been different.
Contrast these markets with a market like Southern California, where the supply of land and new housing are both highly constrained. During a downturn, asset values in cities such as Phoenix or Dallas can drop 20 to 30 percent or more. In Southern California, a chronic housing shortage means that workforce housing, namely Class B/C apartments, tend to exhibit more durable cash flow even when the market otherwise dips. Homeownership costs are so high that even if values come down at the margins, the vast majority of workforce households in Los Angeles still cannot afford to buy their own homes without facing long commutes to work and daily traffic gridlock. This creates a permanent renter class or Class B/C apartments that helps ensure our units remain occupied even during a downturn. Our tenants are “renters by necessity.”
Target assets with a high “loss to lease.”
The Class B/C apartments we buy in Southern California tend to have a 20 to 30 percent “loss to lease.” This means that current rents for existing tenants are being leased at significantly under-market rents. This, in turn, creates a relatively sticky tenant base. During a recession, most tenants at our properties will avoid moving out – after all, they are paying below market rent. If they have to move, for employment reasons or otherwise, because of the high loss to lease, we can upgrade and re-lease their units at much higher market rents. Indeed, where other real estate property types or markets often see their cash flows decrease during market downturns, it is not uncommon for our investments to experience growing rental income due to the high loss to lease properties we target.
Assess what costs can be passed through to tenants.
In Southern California, most 30 to 50-unit apartment buildings are owned by smaller “mom and pop” owners who often have held these assets for many decades. Our experience is that very few have implemented what is known as a Ratio Utility Billing System (RUBS). RUBS allows owners to allocate the vast majority of the cost of various utilities (gas, electric, trash, etc.) to tenants based on their pro rata share of the building’s consumption. Implementing a RUBS program helps property owners insulate themselves against rising utility and service costs during inflationary periods and also protects owners when, during a recession, tenants tend to double-up in units, cuasing utility consumption to rise.
At Paladin, virtually none of our properties have had a RUBS program in place at the time of acquisition. Wherever possible, this is one of the first things we do upon taking over ownership of a property.
Carefully consider the type, structure, and duration of your debt.
For a variety of reasons, we believe the days of extremely low interest rates are over. In fact, we will probably look back on the past 20 years as a “golden era” of easy, cheap money. Rising interest rates eventually force asset prices to adjust downward—we are already starting to see that happen (Q4 2022). This will take some time, as there is still an estimated $1 trillion sitting on the sidelines in real estate “opportunity funds” waiting for distressed opportunities to arise. An influx of capital at the macro-level will eventually bring down interest rates to some degree, but unlikely to the levels we have grown accustomed to in recent years. Those who locked in low-cost, fixed-rate debt in recent periods will be well positioned to weather the downturn.
At Paladin, we always prefer to use fixed rate conventional debt (i.e., from banks, life companies and/or agencies such as Fannie Mae and Freddie Mac), which historically has been among the lowest cost debt financing available for our strategy. We never utilize floating rate debt unless interest rate caps are readily available and affordable, as interest rate risk creates too much uncertainty for our risk appetite.
Finally, it is not wise to overlook the duration of your loans. We always try to make sure our debt maturities match the duration of our business plans, with a little extra cushion. The benefits of this conservative approach are quite evident today. Investors with loans coming due in the near term will likely need to refinance with new debt in the 6 to 8 percent range. Not all deals will be able to sustain those significant higher debt payments and, in turn, this will force some over-leveraged investments into default.
It is easy for inexperienced investors to buy into the hype that “this time is different.” We have heard it from economists, central bankers, and other so-called experts. But it’s not different.
We must look past our collective penchant for feel-good stories and focus on what has actually been happening. A decade of unprecedented, low-cost debt has fueled a surge in asset prices that is finally starting to falter. We are in the midst of another inevitable market correction.
Here at Paladin, while our crystal ball is not accurate enough to predict exactly when another downturn is coming, however, we do know it will come and take appropriate steps to prepare accordingly. As a result, we are confident our Southern California apartment investments will weather the downturn and achieve attractive returns in the process.