The #1 Rule for Investors: Protect Your Downside

All investments carry some degree of risk—some more so than others. Investors with a higher risk tolerance might be willing to make big bets on risky deals that may (or may not) pay dividends. However, most investors are usually willing to trade some upside potential if it means their capital investment is well protected. This is called “protecting your downside.”

In real estate, that might mean investing in a value-add apartment deal with a target 12% IRR instead of a ground-up development deal with 20%+ projected IRR, especially when it appears we are near the height of a market cycle with a relatively high chance of missing projected returns due to a downcycle.

The problem is we seem to be living in this new era of FOMO (fear of missing out) investing. The younger generation of investors may be more tempted into making snap decisions based on market momentum (i.e., FOMO) rather than underlying fundamentals (e.g., Bitcoin, GameStop). FOMO investing can cause investors to forget the cardinal rule of investing: Above all else, protect your downside!

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Protecting Your Downside – What’s the Big Deal?

Consider this: if you lose 20 percent of your equity on an investment, you’ll need to earn back 25 percent just to break even. If you invest in a deal and lose 30, 40, or 50 percent of your equity, then you need to earn back 43, 67, and 100 percent, respectively, just to get back to where you started. In some cases, that can take years. In other cases, it may never happen at all.

Recovering lost principal is especially difficult when investing in leveraged assets, like real estate.

For example, on a deal financed with 80 percent debt, a 10 percent loss in value equates to a 50 percent loss in equity. On that same deal, if the property value decreases by 20 percent, then all of the investors’ equity is wiped out.

Defensive Strategies – Three Ways Paladin Protects Investors’ Downside

Even the smartest and most experienced investors will inevitably encounter market turmoil. How their investments perform during periods of economic uncertainty depends on what steps they have taken to protect their portfolios.

Over the past 30 years, Paladin has invested more than $6 billion in real estate. We have seen plenty of ebbs and flows of the market. This has taught us the importance of downside protection and given us some useful defensive strategies to preserve our invested equity.

Here are three ways we insulate our investors’ capital from market turmoil.

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.

Many real estate investors will focus on one, maybe two of the defensive strategies outlined above. However, our three-pronged approach is unique. And more importantly, we know that it works.

Since 1995, we have made 90 value-add apartment investments across the U.S. totaling over 15,000 units. More than half of these deals were in Southern California, our primary target market as described above. To date, we have never lost a dime of investors’ capital in Southern California, in large part due to the defensive strategies described above. While past performance is no guarantee of future results, we do believe our defensive focus helps to better insulate our invested capital from the effects of recessions and market downturns.



The defensive attributes of Paladin’s Southern California investment strategy, designed specifically to weather challenging economic times, is critically important toward our objective of delivering attractive risk-adjusted returns to our investors. We do this by maintaining a keen focus on protecting investors’ downside. This is particularly critical during uncertain times like today, when many investors have seemingly lost sight of the many risks facing various types of investments.

Contact us today to learn more about Paladin’s approach towards capital preservation.

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