Understanding Workforce Housing as a Real Estate Investment Class
Over the past several decades, much of the multifamily property investment made by pension funds and other institutional investors has focused on the high end of the market, namely Class A apartments. Fueled by decades of wealth creation among the Baby Boomer generation, demand for these highly-amenitized luxury apartments has been robust. Many of these tenants could afford to buy a home but choose instead to rent. We refer to these tenants who can afford expensive Class A apartments as “renters by choice.” Nonetheless, even these tenants can become quite price sensitive when economic conditions shift and the outlook for continued employment and personal income becomes more uncertain, causing increased vacancy and likely rent reductions for Class A apartment landlords.
In sharp contrast, Class B and Class C apartments generally cater to “renters by necessity.” Such tenants are typically low- to middle-income households seeking relatively affordable housing alternatives located near jobs, schools, neighborhood retail and public transportation. In supply-constrained urban markets like greater Los Angeles, these tenants comprise a permanent renter class who cannot afford to buy homes of their own or rent Class A apartments.. As a result, Class B/C apartment buildings comprise the bulk of “workforce housing” available to low- and middle-income households in Southern California.
Importantly, because Class B/C apartment buildings provide badly needed workforce housing to a permanent renter class in Southern California, such investments have historically shown resilient occupancy during economic downturns and steady long-term rent growth through multiple market cycles. As a result, many savvy institutional investors are increasingly focusing on these types of workforce housing investments as a reliable source of durable cash flow and long term appreciation with strong defensive attributes.
In this article, we provide a detailed look at workforce housing.
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What is Workforce Housing?
While there is no universal definition of “workforce housing,” the most widely accepted definition comes from the Urban Land Institute, which classifies workforce housing as housing affordable to households earning between 60 and 120 percent of area median household income (AMI).
When it comes to rental properties, most workforce housing comprises “Class B” or “Class C” assets, which are typically older and have fewer amenities than newer “Class A” properties. In Southern California, these types of assets are also relatively small in size; approximately 90% of the existing rental housing stock in Los Angeles County is comprised of 50 units or less and is more than 20 years old.
The predominance of smaller apartment buildings is a unique and important attribute of the Southern California market, especially when compared to other U.S. markets. As such, it presents a compelling market opportunity as described further below.
What is Driving Demand for Workforce Housing?
Supply Shortages and Increasing Mortgage Interest Rates
The nation is currently facing a housing shortage caused largely by a prolonged supply and demand imbalance in the aftermath of the 2008-09 Global Financial Crisis. This shortage is particularly acute for low- and middle-income households who have been boxed out of homeownership in many markets due to soaring home prices during the pandemic and, more recently, a sharp rise in mortgage interest rates. The need for workforce housing has never been greater and relatively few affordable options exist.
Continued Population and Economic Growth
The U.S. population continues to grow, in some areas more so than others. For example, despite the negative press about people leaving California, the population of Los Angeles continues to grow by about 0.3% annually. Today, Los Angeles is the second largest city in the U.S. In recent years, household formation in L.A. County has outpaced new housing supply by a rate of 4 to 1. Meanwhile, job growth in L.A. County has exceeded permits for new multifamily construction by about 5 to 1.
New Housing Construction Falls Well Short of Ever-increasing Demand
The nation’s affordable housing supply/demand imbalance continues to grow as land and construction costs rise. The lion’s share of new residential development has been confined to single family home production concentrated in suburban markets. And yet, the aggregate supply of new housing has lagged well behind population growth since the 2008-09 Global Financial Crisis. There is a huge need for new multifamily housing, particularly in and around major cities where most jobs are located. While deliveries of new apartments in 2022 are expected to be near historic highs, reaching 400,000 units for the first since 1972, that new construction won’t make much of a dent in the nation’s housing deficit which is estimated to be nearly 4 million homes. The problem is especially acute in land-constrained urban markets like Los Angeles, where high land and building costs, lengthy and uncertain approval processes, material and labor shortages, and other barriers to development have constrained new supply for several decades.
Renters by Necessity are on the Rise, Especially in Southern California
Nationally, the median sales price for homes reached an all-time high of $440,300 in Q2 2022. Home prices in some markets are dramatically higher (even double). For example, data provided by Zillow indicates that the average Los Angeles home is now valued at more than $970,000. In order to buy a home in L.A., families need to earn at least $150,000, more than twice the region’s median household income. Based on Moody’s household income projections, the national home price-to-income ratio is on the rise across the country (4.37 nationally) and is especially pronounced in Los Angeles (9.4).
Given Southern California’s chronic shortage of affordable housing and limited new supply, it’s no surprise that the homeownership rate in Los Angeles is only 37%, well below the U.S. average of 65%. Those who are priced out of homeownership, an increasingly larger share of the regional population, have no other housing option than to rent. This has created a permanent renter class in Southern California – a “renter by necessity” demographic that relies heavily on workforce housing.
To that end: a recent study from Harvard University finds that 46% of the nation’s renters are now spending more than 30% of their income on housing. An estimated 24% are spending more than half of their income on housing. Workforce housing, particularly Class B/C rental apartments, help fill a critical void among those looking for reasonably priced housing.
Large Discounts to Replacement Cost Provides Opportunity for Investors and Value to Renters
A prime reason there is such high demand for Class B/C apartments in Southern California is their relative affordability and value compared to newer Class A apartments. Rents for Class A apartments are typically about 50% higher than Class B/C space. This huge difference creates a competitive advantage for renovated Class B/C apartments and reflects the steep discount such assets have to “replacement cost” (i.e., the cost of new construction).
Much of the existing stock of Class B/C apartments in greater Los Angeles was built after World War II, when land was more plentiful and new construction was encouraged. As a result, the typical Class B/C asset is a smaller (under 50 units), low-rise (usually two stories), garden style building around a courtyard or pool. These low-density properties were affordable to develop 30, 40 and 50 years ago, but would never be feasible to build today given the region’s high cost of new development (land and construction costs).
Indeed, the development cost for new apartments in Los Angeles is estimated to be $750,000 or more per unit and necessitates more dense, mid-rise construction (four to ten stories or more). This is nearly twice the cost basis of our typical Class B/C apartment investment after renovations are complete. The low-rise, low-density Class B/C apartments we invest in are truly irreplaceable assets given the high cost of new development.
The steep discounts to replacement cost are another unique attribute of the Southern California Class B/C apartment market; the discount to replacement cost in most other U.S. markets is typically much less or non-existent, due primarily to cheaper, more abundant land, and cheaper labor. Importantly, this steep discount to replacement cost in Southern California provides value to our tenants by renovating existing properties to provide badly needed affordable workforce housing to a permanent renter class. And, as an investment, this discount helps insulate our investments from the potential impacts of new supply.
The Workforce Housing Renter Profile
Those who rent workforce housing tend to be working class and middle-income households, earning somewhere between 60 and 120 percent of AMI. In most cases, they earn too much to qualify for housing subsidies or income-restricted low-income housing units (e.g., Section 8).
The typical workforce housing renter would look very familiar to all of us. They are often police officers, firefighters, teachers, healthcare workers, janitors, construction workers, retail service providers, government employees, social workers, clerks, and people with similar occupations. Often, these are two-income households.
In areas with high housing costs, like greater Los Angeles, these workforce households typically cannot afford to buy their own homes. The only affordable homeownership opportunities tend to be on the outskirts of the city and in some cases, would result in a 2+ hour commute each way. Most middle-income families cannot sustain that type of commute given already high pressure on their time, and increasing gas prices. Instead, they opt to live closer to the urban core and employment centers and in turn, become permanent “renters by necessity”.
Is Workforce Housing Recession Resilient?
In supply constrained markets like Southern California, workforce rental housing has historically proven to be quite cycle resilient. Data shows that Class B/C apartments in Southern California tend to perform relatively well during all parts of the market cycle, especially compared to other U.S. markets and Class A assets. For example, during the past two recessions (2020-21 Covid pandemic and the 2008-09 Global Financial Crisis), Class B/C rents dropped by less than 5% according to REIS, only to rebound quickly to pre-crisis levels within 1-2 years.
As described above, the reason for this comparative advantage is the nature of the workforce housing tenant that Class B/C apartments serve: a permanent renter class that has few other affordable housing options available. As a result, there is an inherent cycle resiliency to workforce housing demand, especially in the supply-constrained Southern California market, that is unparalleled compared to other income generating property types.
Moreover, occupancy rates at Class B/C properties tend to remain stable or even increase during periods of economic uncertainty. Those who are renting more expensive Class A apartments (which historically rent for twice the rents of Class B/C properties) frequently retreat to more affordable Class B and C assets during recessions. In turn, occupancy rates at Class B/C properties tend to remain high. Indeed, occupancy at Class B/C apartments in Los Angeles exceeded 95% during the 2008-09 Global Financial Crisis and 97% during the Covid pandemic.
Working class and middle-class households that make up the permanent renter class in Los Angeles simply have nowhere else to go, regardless of economic conditions.
What’s the Difference Between Affordable Housing and Workforce Housing?
People often use the terms “Affordable housing” and “workforce housing” synonymously—but they are actually two decidedly different housing types.
Affordable housing (with a capital “A”) is typically built with some form of government subsidy and is targeted to very low-income families who may also receive certain subsidies. For example, housing vouchers are the largest rental subsidy program. These “Section 8” rent vouchers are funded by the U.S. Department of Urban Development (HUD) and target families earning up to 50% of AMI. Those who earn up to 80% of the AMI may be eligible to live in Low Income Housing Tax Credit (LIHTC) properties.
Workforce housing, while “affordable” (lower-case “a”) compared to newer market-rate housing, tends to target those working class and middle-income households who do not qualify for Section 8 vouchers or LIHTC housing. Such households tend to have incomes closer to 60-120% of AMI.
The easiest way to distinguish between the two is to think of Affordable housing as government-subsidized low-income housing, whereas workforce housing is affordable market rate housing targeted to working class and middle-income households.
Why Workforce Housing in Southern California is a Compelling Investment Opportunity
For many real estate investors, workforce housing is a new concept, a property type that is unlikely to be on their radar screen. Yet, as a number of institutional investors have recently discovered, there are many reasons to consider adding workforce housing to a real estate investment portfolio.
Little Competition from Institutional Investors
When pursuing new apartment investments, it has always been difficult to compete with large numbers of institutional investors with huge amounts of capital that needs to be invested (e.g., pension funds, hedge funds, insurance companies, etc.). Such investors are often willing to pay a premium for well-located, Class A assets that will generate modest but steady returns that are perceived to be low risk.
Until recently, few institutional investors invested in workforce housing. There are a few reasons why;
First, and especially in our target market of greater Los Angeles, workforce housing rental properties (i.e., Class B/C apartments) are much smaller in size compared to most other U.S. markets, typically 20 to 50 units each. Creating a meaningful portfolio of workforce housing is therefore quite challenging, as it could require in the range of 10 acquisitions to result in a portfolio of 300 workforce housing units. Because most such large institutional investors would prefer to invest in a single 300-unit apartment building in Dallas, Phoenix, or other less dense markets, Southern California presents an excellent opportunity for smaller institutional investors like ourselves that prefer our less competitive market.
Second, workforce housing in Southern California tends to be more management intensive than other U.S. markets. Part of this is related to the fact that the properties are smaller as noted above; an operator might have to manage 10x the number of properties in Los Angeles to accumulate the same number of rental units in one property in Dallas, Phoenix or Atlanta. Further, the market is fragmented as these smaller properties are spread out over the highly dense areas of Southern California.
The typical owner of these smaller properties is not an institutional investor, but, rather, a “mom and pop” owner (i.e., individual or family owner). Many such owners do not have the management acumen, capital resources nor the desire to invest in their properties to maximize value. They tend to manage their investments with minimal capital improvements and tend to raise rents infrequently with the aim of minimizing unit turnover.
As a result, much of the rental housing stock in greater Los Angeles suffers from considerable deferred maintenance and operational inefficiencies, with current rents that are well below their market potential – in other words, a high “loss to lease”. The process of correcting these physical and operational deficiencies to capture the higher revenues inherent in its loss to lease requires considerable capital, expertise, time and effort. It can be simply overwhelming to the relatively unsophisticated, smaller “mom and pop” owners of these assets.
Additionally, this process is similarly unattractive to large institutional investors who prefer less management-intensive “turn-key” investments where they can put a much greater amount of capital to work, albeit at lower returns.
These unique attributes of the Southern California workforce housing market create a compelling opportunity for experienced value-added investors like Paladin Realty, namely:
- Buying tired Class B/C assets from a fragmented pool of unsophisticated owners,
- Buying at deep discounts to replacement cost (resulting in a strong competitive advantage),
- Offering attractive value-added potential (capturing a large “loss to lease”) to increase cash flow and residual value,
- Competing with few large institutional investors in a demand-driven market, and,
- Providing unparalleled downside protection of our investors’ capital.
These distinct attributes of the South California market offer a unique value proposition to valued-added investors – asymmetrical upside potential with unparalleled downside protection.
Ability to Make Value-Add Improvements – An Abundance of Opportunity
As described above, the smaller size of workforce rental apartment buildings in greater Los Angeles (90% are under 50 units), mean that these assets tend to be owned by smaller unsophisticated “mom and pop” investors. Many have been held by families for decades if not generations, and during that time many of these owners have invested very little in capital improvements as they don’t want to spend the money or lose rent while improvements are going on. Basically, they are satisfied with collecting their current below market rents without interuption. For most long-time owners, maintaining the status quo (e.g., low unit turnover and vacancy) is their top priority, even at the expense of sacrificing higher potential rents and net operating income.
This mentality creates an abundance of value-added opportunities for investors like Paladin at multiple stages of the investment process.
For example, in a market with few institutional competitors that is dominated by less sophisticated and oftentimes inefficient “mom and pop” owners, Paladin’s size, track record and reputation mean we can usually avoid auctions when buying assets, as these owners trust that Paladin will give them a fair proposal and close the transaction. Off-market transactions provide us with a pricing advantage compared to heavily brokered transactions in most other U.S. markets where institutional competition for apartments frequently results in multiple-round auctions.
Second, because we’re buying assets from unsophisticated “mom and pop” owners, the typical asset we acquire offers very attractive value-added potential: (1) a large loss to lease representing a 25-30% discount to market; (2) correctible physical and operational deficiencies; and (3) an all-in cost basis upon completion of our renovation plan that is a typically a 50%+ discount to replacement cost.
Our typical renovation plan is comprehensive and flexible, depending on the target renter profile, and replicable across the entire portfolio resulting in scale efficiencies. Typical unit upgrades include modern cabinets, quartz countertops, stainless appliances, new bathrooms, contemporary wood laminate and decorative tile flooring, and modern lighting, fixtures and paint schemes.
To the extent feasible, the addition of in-unit washers and dryers can also result in a very attractive incremental return on investment. Taken together, the incremental value generated from loss to lease captured (i.e., higher market rents earned) on upgraded units is a 2-3x return on investment. We also refresh the common areas and add selective modern amenities to the extent advisable, depending on land and building constraints as well as market demand. Festival lighting, BBQ and seating areas, and children’s play areas are all low-cost improvements that add value and can be attractive on a case-by-case basis.
Making these value-add improvements allows us to target the upper-quartile of the workforce housing demographic (e.g., those earning closer to 100-120% AMI). In doing so, our targeted rent increases for renovated units are well within the financial capability of our tenants.
We will simultaneously look at operational improvements, such as implementing a “RUBS” (Ratio Utility Billing System) program to pass through utilities costs to tenants individually as units turnover. Based on our experience to date, very few longtime “mom and pop” owners have implemented RUBS, which is an effective way of passing the utility costs through to the tenants. This cost saving bolsters the property’s net operating income which in turn, improves the property’s value and boosts investor returns.
For investors who have a proven track record of increasing cash flow through value-added business plans, the rewards can be quite attractive in perennially low cap rate markets like Southern California. For example, every $1 of incremental net operating income generates $25 of incremental value in a 4% cap rate market.
Strong Downside Protection
We believe there to be strong downside protection in the way we approach value-added workforce housing investments in Southern California, particularly compared to similar strategies in other U.S. markets.
First and foremost, we tend to be relatively conservative when capitalizing our investments, we have a strong preference for conservatively leveraged fixed-rate financing with durations that match our business plans. The typical debt will total in the range of 50-70% of our total cost basis in the property post renovation. Conservative use of fixed rate leverage is one of the pillars of protecting our invested equity.
Second, the high loss to lease in our typical asset, with current rents 25-30% below market, coupled with the type of rent control we target (AB1482), gives our properties considerable pricing power. For example, during a recession, if market rents drop by 10%, our current rents would still be 15-20% below market. For every unit that turns over during that recession, we can still achieve a 15-20% increase in revenue. Further, for existing tenants that do not move out, AB1482 rent control allows landlords to raise rents by 5%+CPI up to a maximum of 10% annually.
Lastly, as described above, during economic downturns, the permanent nature of the “renter by necessity” that comprise the bulk of the Class B/C tenant profile, the sizable discounts to replacement cost, and the rents charged by such workforce housing assets compared to Class A space, all combine to support retaining high occupancy levels and durable cash flow during such times. Additionally, during a recession, many tenants who are paying much higher rents for Class A assets often downgrade to more affordable Class B and C properties, which helps keep occupancy rates high. Moreover, workforce housing tends to have a “sticky” tenant base. Once again, these are renters by necessity. They have few options to move elsewhere and most do not want to incur the costs associated with a move if they can avoid doing so.
Additionally, when we are in an inflationary environment, using fixed-rate debt, implementing a RUBS pass-thru of utilities cost, and benefitting from the limits on property taxes provided by California’s Prop 13 all help to mitigate the potential inflation impact on all three of these expense categories, the largest expenses in our operating budget. As other variable costs go up with inflation, we are able to pass those increases through to renters due to the nature of short-term leases typical for apartments and the fact that we are likely still the low cost provider for housing in the area in which we operate. natural turnover and incentives to move into upgraded units.
It is no secret that the nation is plagued by a shortage of affordable workforce housing, particularly in supply-constrained major cities like Los Angeles. The lack of institutional ownership in Southern California compared to other U.S. markets has created a considerable competitive advantage, at all stages of the investment process, for experienced smaller, institutional managers like Paladin Realty. We believe the asymmetrical risk-reward proposition offered by investments in Southern California workforce rental housing – namely, attractive value-added upside potential with solid downside protection for invested equity – is truly unique compared to other U.S. markets. Importantly, the defensive attributes of this strategy provide a compelling investment thesis especially during times of economic uncertainty, such as what we are experiencing today.
Are you interested in learning more about Southern California workforce housing? Contact us today.