The Importance of Market Timing
There’s an old adage in real estate investing that it’s all about “location, location, location”. While we agree with the critical importance of location, our experience would argue that another important key to success in real estate investing relates to “timing, timing, timing”.
Investor psychology tends to follow a predictable pattern at different stages of a market cycle that, in turn, impacts cap rates and value. During economic recessions, investor sentiment turns pessimistic which translates into less risk appetite, higher cap rates and lower values. During a subsequent recovery, sentiment becomes more optimistic, resulting in greater risk tolerance, lower cap rates and higher values. As markets recover and begin to grow, investor optimism increases to the point of unsustainability, what Alan Greenspan famously referred to as “irrational exuberance.” At this peak of a market cycle, ready access to relatively cheap capital drives cap rates down and elevates prices.
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In our experience, prolonged periods of economic expansion bring significant development activity and new additions to supply in U.S. markets with low barriers to entry. The Phoenix, Dallas and Atlanta metro areas are prime examples. During good times, these markets typically boom with new real estate development. However, easy access to capital and significant additions to new supply often result in a painful hangover after the peak of a market cycle. When new supply exceeds tenant demand, investor risk appetite falls and lenders become more conservative as markets correct and enter downturns, resulting in a substantial impact on cash flow and cap rates. Prices start to fall and over-leveraged investors may need to exit their investments as refinancing existing debt becomes cost prohibitive or requires additional equity.
In other words, for most U.S. markets, successful real estate investing is about both location and market timing.
At least that’s the case in most U.S. markets.
The one exception we’ve seen, having invested almost $1 billion in apartment transactions across the U.S. over the past 30 years, is the Southern California apartment market. The SoCal apartment market is different. And, as it turns out, successfully investing in the SoCal apartment markets is far less dependent on market timing than other markets for experienced investors.
Why the Southern California Apartment Market is Different
The SoCal apartment market has unique attributes that help it to outperform similar investment strategies in other markets, especially during market downturns. This is particularly true of workforce rental housing, which is the primary focus of Paladin’s U.S. value-add investment strategy. We have found this market segment to be one where timing is less critical to success than elsewhere.
Why is this? There are a few reasons.
First, Class B/C apartments provide an essential need – an affordable place to live in L.A.’s expensive and chronically supply-constrained housing market. In Southern California, where 65% of people are renters, Class B/C apartments are vital to a large, and growing permanent renter class. Namely, a “renter by necessity” who has long been priced out of homeownership, even before the increase in mortgage rates. Paladin’s properties provide badly needed housing at relatively affordable prices. Upon completion of renovations in accordance with a property’s business plan, the renovated units are typically leased at about 50% of the rents charged by newer Class A properties. Such renters by necessity, as well as value-seeking renters by choice, are attracted to the exceptional value provided by our renovated apartment properties. As such, Class B/C apartments have historically remained between 95 to 98% occupied, even during the troughs of recessions.
Second, we target properties where current rents are 20% to 30% below market rates (also known as the “loss to lease”). Capturing that loss to lease is the essence of our value-added business plans. During downturns, that large loss to lease provides a resiliency of cash flow that is difficult to replicate in other property types and markets. Indeed, it can provide our properties considerable pricing power during market downturns. For example, if we had a loss to lease of 30% and market rents decline by 10%, which has occurred during the last two major recessions, there would still be a 20% loss to lease that we can capture. Therefore, we can actually increase rents while many other landlords have to drop their prices. As units turn over, we can increase our rents to market rates.
The resulting durability of our cash flow, and the ability to increase rents, even during market downturns, are both rare and unique to the Southern California Class B/C apartment market. In fact, workforce housing tends to maintain its value even during the worst of economic conditions.
Three Key Drivers of Successful Investing in the SoCal Apartment Market
As described above, we believe the SoCal Class B/C apartment market is unique. Unlike most other U.S. markets and property types, where success is highly dependent on market timing, there are three key components to our investment approach that have historically yielded strong performance throughout different stages of a market cycle. These are: (1) investment selection; (2) conservative capitalization; and (3) skillful execution of value-added business plans.
- Investment Selection: Not all real estate investments perform well during market downturns. Just look at how severely the office, hospitality and retail sectors were battered during the COVID pandemic. Further, technological disruptions and larger trends, as exemplified by consumers’ growing preference for online shopping, can also impact sectors like retail, well beyond a property owner’s control. Workforce housing, on the other hand, such as the Class B/C apartments we target in Southern California, provides an essential need that is in high-demand (people always need an affordable place to live) and therefore more resilient throughout the course of economic cycles.
- Conservative Capitalization: Properties can become distressed when there are issues with how the investment has been funded. This typically occurs when buyers minimize their equity investments, becoming over-leveraged with variable rate debt. Such borrowers will have a much harder time refinancing their assets in a higher interest rate environment. If interest rates rise and rental income declines, this creates a perfect storm that can cause invested equity to evaporate.
At Paladin, we typically acquire assets using about 50% leverage with fixed-rate debt having durations that align well with our anticipated holding period. With our most recent acquisitions, we have been funding renovations with equity instead of debt. This takes much of the financing risk off the table.
- Skillful Execution of Value-Added Business Plans: Two identical properties, under different management, can have drastically different investment returns. How well a Class B/C asset performs during a market downturn is often a function of the owner’s experience and ability to execute value-add business plans that increase cash flow and value, regardless of economic conditions. We have a proven track record in this regard. Over the past three decades and through multiple market cycles, Paladin has made 90+ value-added apartment investments in over 15,000 units, totaling nearly $800 million in acquisition cost plus renovations. and over These investments have generated a 25% + net IRR to our investors on the 83 assets sold to date.
Taking Advantage of Buying Opportunities During Economic Recessions
While the market opportunity for Class B/C apartments in Southern California has never been dependent on market timing for the reasons described above, attractive buying opportunities do often arise during economic downturns.
In our experience, when the SoCal market is going through a recession, which we believe is likely to happen in the next 12-18 months, there is less capital chasing deals. As it is, there are few institutional buyers in the Los Angeles market due to the preponderance of smaller assets and the region’s highly fragmented Class B/C housing market, making it difficult for institutional investors, who need to invest very large sums of investment capital, to achieve scale. Meanwhile, over-leveraged owners will find it difficult to refinance in a higher interest rate environment, leading to a sale for those owners who do have the resources to pay down debt. These factors will likely create attractive buying opportunities over the next few years, especially for well capitalized buyers like Paladin.
We expect cap rates to continue to rise, at least through 2023. Apartment cap rates in the SoCal market have already risen by 25 to 50 basis points. We think cap rates will continue to increase over the next 12-18 months. However, our investment strategy – one focused on creating value investing in well-located Class B/C workforce housing throughout Southern California – gives us the pricing power and cash flow durability needed to weather the storm with respect to our existing portfolio, while providing excellent acquisition opportunities for additional investments.