The #1 Rule for Investors: Protect Your Downside

1. We maintain a conservative approach to debt.

One of the reasons people are drawn to real estate is for the ability to use leverage. You can potentially buy up to $1 million worth of real estate for a meager $200,000 (or less) of equity. Leverage is a popular way for sponsors to boost cash-on-cash returns. It can also inflate the IRR, especially when a property is only held for a couple of years.

Yet, just as leverage can enhance returns, it also amplifies losses.

Let’s say an asset loses 20 percent of its value during a downturn. Someone who owns the property outright (i.e., with no debt) only loses 20 percent of invested equity. However, someone with 70 percent leverage would lose two-thirds of their invested equity – a staggering number, especially for otherwise conservative investors.

This is why we are very strategic about the use of debt at Paladin. We typically utilize debt with durations that match our business plans.  Oftentimes we acquire assets with no more than 50 percent leverage. We always prefer to lock in a fixed interest rate before we make an investment.  Lastly, we aim to create positive leverage (i.e., the free and clear yield generated by the property exceeds the cost of debt) by making strategic value-add improvements and capturing the upside potential of market rents.

2. We target assets with strong pricing power.

When the rental income generated from existing leases is less than market rents, that difference is known as the “loss to lease”.

At Paladin, we look to capitalize on this arbitrage. We target properties where the going-in rents are roughly 25-30 percent lower than market rents. This way, even if market rents decline during an economic downturn, our pricing power remains high in the event of any vacancies.

We also invest in Southern California communities subject to rent control. Whereas less experienced “mom and pop” owners often view rent control as a confusing burden, we see it as an opportunity.  While rent control is generally well intentioned in seeking to make rents more affordable, such regulations often have the opposite effect of fueling higher rents – and thus the pricing power of Class B/C assets – by reducing the supply of market rate units available to renters.  This also discourages capital investments to maintain older properties resulting in significant deferred maintenance.

Further, individual cities in California can be subject to widely varying rent control regulations; annual rent increases in one municipality might be set by an appointed rent control board, while rent increases in an adjacent city might be tied to the Consumer Price Index.  Indeed, the allowable annual rent increases on existing leases in Southern California typically varies between zero and ten percent depending on the municipality.

Understanding these differences and the nuances of local rent control regulations in each market is paramount to any successful investment.  In short, our focus on rent-controlled assets with a relatively high loss to lease ensures that—even during a recession—our revenues remain stable and in some cases can even grow.

3. Our target market and product focus are inherently resilient.

The third way we protect investors’ downside is by targeting workforce rental housing  in Southern California, a region plagued by a chronic shortage of such affordable housing.

Older Class B/C apartment buildings provide the bulk of the “workforce housing” in greater Los Angeles, namely low- and middle-income households. Families who live in these properties generally earn 60 to 120 percent of the area median household income which, in Los Angeles County, is about $71,000. They are the teachers, nurses, firefighters, law enforcement, retail workers and other middle-class workers and retirees who can no longer afford to own their own homes given the region’s astronomically high cost of housing. They are “renters by necessity” with few other affordable housing options, effectively, a permanent renter class.

Now, let’s consider the fact that the bulk of Los Angeles’ existing rental housing stock was built shortly after WWII when land and construction prices were both low. This led to a low-density, sprawl pattern of development that, in turn, is insufficient to meet the higher demand of today’s much larger population. Add to that huge barriers to new development (e.g., little developable land, high construction costs, municipal bureaucracies, legal and environmental challenges) and it’s no surprise that Southern California has faced a chronic shortage of affordable housing for more than a half a century.

Due to the resiliency of demand for workforce housing in Southern California, Class B/C apartment properties have been among the most recession resilient investments we’ve seen across $6 billion of real estate spanning three decades. Class A apartments in greater Los Angeles typically rent for about twice as much as Class B/C properties.

During a downturn, Class A tenants often trade down to Class B/C properties to save money. This supports occupancy at Class B/C properties and makes rents at such properties generally less volatile than more expensive Class A space.  Indeed, during the past two recessions, Class B/C apartments in Southern California maintained occupancy levels between 95 and 98 percent. Rents dipped between 5 and 10 percent but rebounded quickly – within 12-18 months.