The Paladin Investment Thesis

Passively investing in commercial real estate has never been easier. Recent changes to Federal securities regulations allow sponsors to widely solicit investment from people all around the world. This has created tremendous opportunity for individual investors looking to access institutional quality real estate. However, greater access has also made it more challenging for investors to navigate this large and growing investment landscape.

Conducting thorough due diligence on sponsors is a critically important step before investing. There are thousands of real estate sponsors looking for investors. Comparing one strategy or sponsor from another can be exceedingly difficult.

Anyone who is considering investing in real estate should take the time to learn about the sponsor. Their track record is obviously important. But equally important is their investment thesis and strategy. A sponsor’s investment thesis and strategy are what drive day-to-day decision making—each of those decisions can have a critical impact on ultimate investment performance.

In this article, we examine Paladin’s U.S. investment thesis and strategy. As you will see, these factors are the North Star that guides where and how we invest.

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Paladin’s Investment Thesis & Strategy – In a Nutshell

In short, we BUY, FIX and HARVEST apartment properties in Southern California.

More specifically, we…

Acquire older, rundown Class B/C apartment buildings throughout Southern California, typically 20 to 50 units in size, in stable working class and middle-class locations.
Target properties that are significantly under-performing the market, with current rents 20% to 30% below market rents (aka the “loss-to-lease”).
Execute a value-add strategy that entails substantial renovations to modernize the building exterior, common areas and unit interiors, as well as to upgrade building systems and address deferred maintenance. In some cases, unit interiors are completely gutted and modernized. All of this done with the objective of capturing that large loss-to-lease by renting out renovated units at higher market rates to tenants who prefer a better living experience.
Deploy institutional-quality professional management to stabilize and optimize Net Operating Income.
Harvest the increased value through a refinance or sale, typically in 3-5 years.

We have a proven track record executing this strategy for the past three decades. Since our inception in 1995, we’ve invested in more than 90 apartment properties across the U.S. totaling over 15,000 units. More than half of those properties were in greater Los Angeles. The returns for our SoCal portfolio have been the best performing, with an average IRR (net to investors) of over 25%.

Paladin’s Target Property Profile

We typically target smaller apartment properties, 20 to 50 units in size, located in stable working class and middle-class neighborhoods with good access to schools, retail and regional transportation. Most are older properties, at least 20 years old. The typical property is a low-density, two-story walkup building that may have a central courtyard or pool, but otherwise very few amenities. These properties are generally considered “Class B” and “Class C” buildings.

The typical seller is a local “mom and pop” investor, usually a relatively unsophisticated individual investor or small-time syndicator. Most view complex rent control regulations as a nightmare, rather than the opportunity we see. Few of these owners utilize institutional-quality professional management. For example, it’s rare to acquire a property where a RUBS (ratio utility billing system) program has been in place. RUBS is a relatively basic but important way to better manage water and power usage at apartment properties, and to pass those utility costs on to tenants, however, it requires certain expertise to execute effectively.

Oftentimes, the properties we target have been passed down by these mom and pop owners to heirs who have little interest in managing the assets to maximize returns. Many of these mom and pop owners lack the financial resources to manage their properties effectively, and those who do often lack the desire to make the necessary capital investments to optimize value. In fact, many of these long-time mom and pop owners focus instead on 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 relies on the monthly cash flow.

This creates an opportunity for investors like Paladin who have the necessary resources and know how to maximize value.

Driving around Los Angeles, you see the market opportunity everywhere. There are literally thousands of older, rundown Class B/C apartment buildings with current rents 20% to 30% or more below market rents for renovated and modernized efficiently run properties.

Our Formula for Adding Value

Central to our investment thesis is the fact that the vast majority of Los Angeles-based renters are not simply looking for the cheapest place to live. Rather, they are looking for the safest and best quality apartment they can afford - what we refer to as “workforce housing”.

We define “workforce housing” as essential housing targeting those earning 80% to 120% of area median household income (MHI). In Los Angeles County, the MHI is approximately $76,000. This is the primary target demographic we have in mind as budget value-add property improvements (more on this below). We always try to underwrite our investments such that the proforma market rents for our renovated units are about 30% to 40% of the submarket’s MHI.

Our value-add strategy starts by addressing the property’s deferred maintenance. This often includes replacing the roof, HVAC systems, electrical panels, plumbing upgrades and more. We also upgrade the building’s exterior and curb appeal with contemporary facade improvements and new paint, and, where feasible, includes landscaping and hardscape upgrades, enhanced amenities and common areas, including BBQ areas, dog runs, play areas, festival lighting, and security fencing.

Inside the units, we spend upwards of $20,000 to $30,000 or more per unit to renovate and modernize the interiors. Oftentimes we replace the kitchen and bathroom cabinets, and install new quartz countertops, stainless appliances, new wood laminate flooring, and contemporary light fixtures, among other improvements. We utilize contemporary paint schemes such that the units feel fresh and modern.

All of these investments are aimed at capturing the 20% to 30% loss-to-lease mentioned above, by upgrading and re-leasing units at higher market rents to tenants looking for a better living experience.

Importantly, we have experience navigating the complexities of various rent control regulations affecting our investments. We mainly focus on properties subject to the statewide AB1482 regulations that went into effect in early 2020, which provide a relatively clear line of sight towards achieving the objectives of our business plans. We provide relocation assistance to tenants who wish to vacate during construction and generous incentives to existing tenants who desire to move into upgraded units.

Lastly, we typically capitalize our investments with relatively conservative amounts of debt. Our most recent investments were about 50% leveraged with fixed rate financing for the duration of our business plan. In short, we try to take as much risk on the right side of the balance sheet off the table as possible.

Paladin’s Target Tenant Profile

Our renovated properties are designed to provide modern, safe workforce housing to a broad pool of working class and middle-class tenants. In the Los Angeles metro area, 63% of all households are renters and most are “renters by necessity” – a permanent renter class of dual-income families who have been priced out of homeownership given the staggering cost of housing. The median sales price of L.A. homes now exceeds $750,000.

Our workforce housing renter cohort tends to be teachers, nurses, police officers, construction workers, city clerks, and other blue-collar professionals. These tenants typically earn too little to afford newer Class A apartments and earn too much to qualify for subsidized housing.

Paladin: Creating Opportunity and Competitive Advantage in a Major Gateway City Market

Los Angeles is one of the largest and most dynamic markets in the U.S. Accordingly, the region’s real estate market is one of the largest and most competitive markets in the country.

However, the nature of competition in the L.A. rental apartment sector is very different from other U.S. markets – a crucial difference that provides institutional-quality firms like Paladin a competitive advantage over most buyers.

Here’s why -

Relatively little competition from institutional investors in Los Angeles compared to most other U.S. markets. Most institutional investors shy away from the smaller, value-added apartment properties in Los Angeles because it’s very management intensive to scale up and manage an institutional-sized portfolio comprised of small properties. The existing infill rental housing stock in Los Angeles was largely built out 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 assets. Indeed, 85% of the existing rental housing in Los Angeles comprises buildings that are 50 units or less. As a result, an institutional buyer would need to acquire and manage 10x as many assets in Los Angeles to achieve the same scale they could achieve by buying a small handful of larger apartment complexes in Atlanta, Phoenix, Dallas, or any other major U.S. market where the typical multifamily asset is 300 units or more. So, most large institutional investors simply find the greater Los Angeles market to be too management intensive.
We buy from a pool of fragmented, unsophisticated owners. The lack of institutional players in L.A.’s apartment market means that it is dominated by a large, fragmented pool of smaller “mom and pop” owners. As described above, most do not realize that their properties are underperforming their market potential. Most don’t have the knowledge, financial resources, or desire to invest in their properties to optimize value. They would rather keep capital expenses low and minimize turnover. This creates a tremendous opportunity for sophisticated value-added operators like Paladin with proven experience in growing operating cash flow.

Sellers often place greater value on certainty of closing rather than pricing. Paladin has a reputation in the brokerage community as being a well-capitalized buyer that closes deals with reliability and without re-trading (unless 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. 1031 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 whole exchange and will have massive tax implications to the sellers. Certainty of closing is often more important than price to these sellers. We utilize this to our advantage.

We can avoid costly auctions when buying assets. Apartment property sales in most U.S. markets dominated by institutional investors 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. 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 our and first-look opportunities because of our reputation as a strong, reliable buyer who protects broker relationships. This frequently gives us a two- to three-week head start against other local buyers. That advantage often allows us to preempt the marketing process when buying.

Asymmetrical Risk-Reward Profile: Attractive Upside Potential + Strong Downside Protection

The thesis for Class B/C value-added apartment investments in Greater Los Angeles offers an asymmetric risk-reward proposition that you simply cannot find in most other U.S. markets or property types.

- Tremendous Untapped Upside Potential. As noted above, our target property profile is an older Class B/C apartment building with current rents 20% to 30% below market. Capturing that loss-to-lease through strategic value-added investments that increase cash flow is the primary objective of our value-added business plans. Simultaneously, we bring best-in-class third-party property management and while keeping asset management in-house. The combination of higher cash flow and lower operational costs boosts Net Operating Income, which is the key metric when calculating a property’s value.
  
  The Los Angeles multifamily market has historically been a low cap rate environment due to its supply constraints and resulting growth potential. Our value-add business plans do exceptionally well in such low cap rate markets. In a 4% to 5% cap rate environment, every $1 increase in cash flow translates into a $20 to $25 increase in value. This is how we are able to achieve such attractive returns for our investors.

Unparalleled Downside Protection. For decades, Los Angeles has been one of the most chronically supply-constrained housing markets in the U.S. Even the most herculean efforts will likely do little to change this shortage in the foreseeable future. Land is scarce, entitling new development can take years, and the high cost of new construction results in luxury properties that are out of reach for most renters or homebuyers.

By contrast, our strategy provides essential workforce housing to a large permanent renter class at a substantial discount to new construction – 50% or more. Rents at our renovated Class B/C apartment buildings are also at a similar discount to newer Class A apartments, so we have a sizable competitive cost advantage that largely insulates our properties from any threat of new supply. It is rare to find that degree of cost advantage in any other major U.S. market where ownership is dominated by more sophisticated institutional investors.

Further, because people need to live somewhere, and because Class B/C apartments represent the bulk of affordable infill housing available to Angelenos, occupancy rates at these assets have historically remained resilient (95% to 98%) even during major recessions. When units do turnover, the large loss-to-lease described above often allows us to increase rental income even if overall market rents decline. This resilience of occupancy, combined with Paladin’s conservative approach towards debt, helps ensure a durability of cash flow that can withstand the natural ebbs and flows of any real estate cycle or broader economic cycle.

Our investment offerings tend to oversubscribe quickly. So, we encourage you to join our waitlist for new offerings. There is no obligation to invest.

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Why Paladin?

There are thousands of value-add apartment operators across the U.S. and many are indeed first-class and institutional-quality.

Why, then, choose Paladin?

Here are three reasons Paladin stands out from most other sponsors.

We have been an institutional fiduciary for three decades. Paladin is unique in that we are a U.S. SEC-Registered Investment Advisor and have been executing our strategy for nearly thirty years. Our clients include some of the largest pensions and institutional investors in the world. We bring this institutional-quality precision to even our smallest deals. Our due diligence, underwriting, and reporting is the same caliber regardless of whether we are working on behalf of a $300 billion pension fund or a high net worth individual investor.
In the U.S., we are uniquely focused on workforce rental housing in Southern California. Many sponsors try to be everything to everyone. We believe in staying focused. And to that end, in the U.S. we are acutely focused on Class B/C apartments in and around Los Angeles. With its asymmetrical combination of attractive upside with strong downside protection, our Southern California focus can provide valuable diversification to any U.S. real estate portfolio, and be a complement to similar apartment strategies in other U.S. markets that may be more vulnerable to market cycles.
Our track record speaks for itself. Since 1995 we have invested in more than 90 value-added apartment properties across the U.S comprising over 15,000 units and nearly $1 billion of total capitalization. Half of these investments were in Southern California. While our national track record is impressive (26% IRR net to investors on 83 realizations to date), our Southern California investments have been among the best performing to date for all the reasons described above. Over the past three decades, we have built robust, institutional-quality asset management systems tailored to achieve efficiencies and economies of scale across portfolios of smaller workforce housing assets in multiple markets across the Americas.

Conclusion

Identifying, buying, renovating and managing value-added apartments in Southern California is not for the faint of heart. It requires a seasoned operator with a proven track record of scaling up and managing portfolios of small-scale assets, with institutional-quality management personnel and systems. For experienced institutional-quality investors like Paladin, the rewards can be quite compelling.

We invite you to learn more about Paladin and our investment thesis. If you are considering investing in real estate – particularly if you’re drawn to Los Angeles, one of the most dynamic markets in the world – please contact us today. Our team would be happy to discuss our investment thesis with you in more detail.

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