What Makes the SoCal Apartment Investment Market Unique?
We have long touted the benefits of investing in apartment buildings located in and around Los Angeles County. In turn, people ask us whether there is something truly unique about the SoCal market.
In short, the answer is yes. Yes, we believe the SoCal market is unique compared to other U.S. markets.
We have been investing in apartments across the U.S. for nearly 30 years. In total, we have purchased and renovated more than 15,000 units. Half of these investments have been located in Southern California. Our breadth of experience gives us a perspective in which we can say, SoCal is unequivocally unique. Moreover, we can confirm that our SoCal workforce housing rental portfolio has proven to be among both the most profitable and the most cycle-resilient of our strategies to date.
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What to Know About the SoCal Apartment Market
There are three primary reasons why SoCal market is especially unique relative to other U.S. markets. Together, these attributes make SoCal very attractive to value-add apartment investors like Paladin.
- Less competition from institutional investors. Most of SoCal’s value-add apartment opportunities are smaller, low-rise, garden-style buildings that were constructed 50+ years ago. These assets are too small and management intensive to be of interest to most large institutional investors. This means we can avoid costly auctions when buying assets, which would otherwise drive down profit margins and returns.
- Fragmented local ownership. The lack of institutional ownership results in an abundance of value-add opportunities around Los Angeles characterized by smaller “mom and pop” owners. There are literally thousands of older, tired looking, under-performing apartment buildings across L.A. that are rented for 20-30% below market. This “loss to lease” is critical, as it creates an ability to increase rents even during a market downturn.
- Asymmetric risk-reward. Typically, risk and reward go hand in hand. The higher the risk, the higher the potential reward and vice versa. However, the SoCal apartment market has an asymmetrical risk-reward proposition in that these relatively low-risk existing apartment investments have tremendous upside potential.
Now let’s look at each of these attributes in more detail.
Less Competition from Institutional Investors
The lack of institutional ownership may come as a surprise to some. After all, multifamily properties are among the most desirable product types for real estate investors nationwide. They have strong cash flow characteristics, are a good hedge against inflation, tax benefits, and have strong long-term appreciation potential. There are literally hundreds of institutional investors that solely focus on multifamily assets.
Yet, most are not active in Los Angeles—one of the largest, most dynamic markets in the U.S. - home to more than 10 million people.
Why is that? There are a few reasons.
First, most of L.A.’s rental housing was constructed just after World War II when land, labor, and construction costs were cheap. This made it easy to build new apartments and, in turn, the housing stock was plentiful. And, due to plentiful available land at reasonable prices, construction consisted almost entirely of smaller, very low density apartments, mostly two-story walkups surrounding a courtyard or pool. There are typically few, if any, other amenities.
The apartment stock is comprised of very small buildings. Roughly 85% of the rental housing stock in SoCal consists of properties that have 50 units or less. Moreover, they are older properties. More than 90% of the rental housing is 20+ years old. Due to age alone, these are considered by apartment investors to be “Class B” or “Class C” properties due to the issues that come with age.
The preponderance of smaller assets means that L.A.’s apartment market is too management-intensive for most institutions. Scaling is also a challenge as large institutional investors find it very inefficient to invest small amounts of capital. Institutional buyers would need to acquire 5 to 10 times as many buildings in L.A. to achieve the same portfolio scale in L.A. as could easily be achieved in Atlanta, Phoenix, or Dallas, where the typical apartment building has an average of 300 units. As a result, these other markets are where institutional capital tends to be focused.
In comparison, the SoCal apartment market is dominated by a large, fragmented pool of smaller, unsophisticated “mom and pop” owners. These landlords may not even realize their properties are underperforming the market. They may not have the knowledge, financial resources, or desire to invest additional capital in their properties to optimize value. Instead, they’d rather keep maintenance and capital expenditures low and minimize unit turnover—a rational objective for many individual investors, particularly long-time owners who have an exceptionally low cost basis and simply don’t want their consistent monthly cash flow interrupted.
These owners are also typically afraid of rent control, a complex system that that can be difficult to contend with by a mom and pop owner in the SoCal market. They tend to see rent control as a burden rather than an opportunity and would prefer not have to deal with the municipality and any regulatory agencies in order to change things.
On the other hand, savvy, experience investors like Paladin look forward to taking advantage of these opportunities.
Fragmented Local Ownership
SoCal’s fragmented local ownership creates an abundance of value-add opportunities for investors like Paladin. Absent much institutional competition, there are very few sophisticated investors in the market with the experience and know-how to renovate these older units, take advantage of any rent control regulations, increase rents and maximize a property’s potential value.
Upon driving around greater Los Angeles, you will see there are literally thousands of opportunities that can meet Paladin’s investment criteria - tired, rundown properties where existing rents are as much as 30% below market rental rates. Clearly, many of these properties are being mismanaged and may be ripe for acquisition as an older mom and pop cohort looks to exit.
These are all opportunities for an investor like Paladin. We focus on older, Class B/C assets that have a similar profile: low-density, two-story walk-ups with between 20 and 50 units each. These opportunities simply don’t exist at scale in other marketplaces.
In short, these factors create a unique combination of upside potential and downside protection that is unique to Los Angeles. It creates an asymmetrical risk-reward proposition that is difficult to find elsewhere.
The upside potential is multi-faceted.
As discussed above, the fragmented pool of mom-and-pop sellers creates abundant buying opportunities. We do not compete with large institutional buyers which generally means we don’t participate in auctions that would bid up the purchase of a potential acquisition. Rather, each proposed acquisition can be negotiated individually with an owner, which we have found leads to a more attractive purchase price.
The “loss to lease” created by rents being 20-30% below market also offers tremendous potential for those who know how to capture it—something we’ve been doing for nearly 30 years.
In a supply-constrained gateway city like Los Angeles, cap rates will generally be lower than most other U.S. markets. While this may at first blush sound like a negative, it is actually quite positive for value added investors. For example, in a 4-5% cap rate market, this means that every $1 in additional cash flow created by our renovation and repositioning business plans produces an additional $20-25 in value. This is a huge opportunity for value-add investors like Paladin.
However, there are other relatively low cap rate markets in major markets in the U.S.—which is why it’s the downside protection that really sets SoCal apart.
Consider, for example, that Class B/C properties are virtually irreplaceable. Land, labor, and material costs are too high and regulatory barriers too steep to build these smaller, low-density properties today. And larger, mid-rise and high-rise apartments are so expensive to develop, that they are developed as luxury rentals that command rents well above rents for our workforce housing apartments.
This gives investors like Paladin who can acquire and improve smaller, older Class B/C properties a huge cost advantage relative to newly constructed apartment buildings.
We typically acquire existing buildings at a 50% or more discount to replacement cost, including factoring in substantialgg improvements. You cannot find that in other U.S. markets where ownership is dominated by more sophisticated institutional investors.
Because L.A. is one of the most chronically supply-constrained housing markets in the U.S., there is a “permanent renter class.” As the region’s housing costs have skyrocketed, these renters have been locked out of homeownership and therefore, are “renters by necessity.” Our target Class B/C properties can provide the workforce housing these renters so badly need, given its relative affordability and proximity to employment clusters.
This translates into resilient demand for workforce housing, demand that continuously exceeds supply. These properties tend to have below-average turnover and even during recessions, tend to remain leased. Our average occupancy hovers around 98%, even during market downturns.
Finally, because we focus on acquiring buildings with significant loss to lease and rent to a “renters by necessity”, we have substantial pricing power. We are typically able to raise our rents even during a downturn. For example, if we buy a property that is leased for 30% below market rate and then, during a downturn, rents drop 10%, we are still providing a 20% discount to tenants. This also gives us flexibility to raise rents as units turn over. In other words, even during a downturn, we can increase cash flow.
We believe it unlikely that real estate investors will not find an asymmetrical risk-reward proposition of this magnitude anywhere else in the country. SoCal is truly a unique market.
As we’ve described, the SoCal Class B/C apartment market offers exceptional value-add upside potential with excellent downside protection. Even during recessions, this translates into stable occupancy and durable, growing cash flow.
For investors seeking attractive defensive strategies with sound upside potential, we believe our SoCal apartment strategy provides a compelling opportunity worth considering.
Interested in learning more? Contact us today to explore our current investment opportunities.