An Inside Look at Paladin’s Value-Added Process
Investor demand for multifamily real estate has been incredibly strong over the past few decades. Even in today’s market, amidst record high inflation and increasing interest rates, investors continue to look for apartment investments due to their ability to provide durable cash flow and an inflation hedge. The multifamily market continues strong.
Additionally, the lack of developable land, increasing cost of materials and labor, permitting delays, and other factors have significantly driven up the cost of new construction, effectively limiting ground-up infill apartment development in supply-constrained major cities like Los Angeles. Instead of pursuing new development, investors like Paladin are finding more attractive risk-adjusted returns by focusing on strategic, value-added investments in existing, poorly managed properties that can be renovated and repositioned to create value.
In this article, we provide an inside look at Paladin’s U.S. value-added apartment strategy and describe how this approach has generated attractive returns for investors in the past and should continue to do so in the future.
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What is Value-Added Real Estate?
Value-added real estate investing is a popular business strategy among institutional investors in which a new owner acquires an existing, poorly managed property that can be renovated and repositioned to increase cash flows and residual value.
Value-added improvements can be both physical and operational. Physical improvements correct deferred maintenance, modernize existing apartment interiors, improve security, and enhance the property’s exterior curb appeal. Operational improvements are typically aimed at increasing efficiencies and lowering costs by adding professional marketing and management and expanding potential revenue streams. All of these improvement serve to bring the property up to modern market standards and today’s tenants aspirations, thereby increasing rents, cash flow, and overall value.
The extent to which a new owner makes such value-added improvements can vary. Some investment managers will utilize a “light value-added” approach. This may include modest cosmetic improvements, such as new interior paint and carpet, or minor operational improvements such as hiring professional management. A “heavy value-added” approach is much more substantial and may include a complete renovation of each unit, including new appliances, plumbing fixtures, cabinets, flooring, windows and other improvements.
Paladin’s Target Property Profile
At Paladin, we are primarily focused on acquiring value-added rental apartment properties located in the Greater Los Angeles area. Most of the existing rental housing stock in this region was built in the decades just after WWII, when the area was less dense and land more reasonably priced. This led to a sea of low-density, garden style apartment developments built in the 1950’s, 1960’s and 1970’s, where the typical apartment building was comprised of two and sometimes three stories and less than 50 total units. The preponderance of smaller assets is a unique attribute that sets the Southern California apartment market apart from virtually every other major U.S. market – and which also creates a compelling market opportunity and competitive advantage for firms like Paladin.
These are the properties we look to acquire:
Our typical target property is an older, “Class B” or Class C” two-story walk-up apartment building with anywhere between 20 and 50 units. These buildings tend to have very few, if any, amenities. They might have a central courtyard or swimming pool, but even these few amenities are generally outdated and underutilized.
Because of the size and management-intensive nature of the assets that dominate the Southern California market, there are relatively few institutional buyers that are willing to spend the time and energy to target this market. Paladin, on the other hand, although itself an institutional investor, sees these market characteristics as a competitive advantage if one is willing to do the work. Paladin is able to source investment opportunities through its network of brokers, property managers, accountants, lawyers, title companies and others who have relationships with property owners within this large and fragmented marketplace. These small, older properties are typically held by relatively unsophisticated “mom and pop” owners who have owned their assets for many years, oftentimes many decades. These owners typically manage their properties to keep current cash flow intact, minimizing unit turnover costs, vacancies and new capital investments. Most of these owners do not fully understand the upside potential of their assets and even if they do, also typically lack the experience and resources needed to substantially renovate and reposition their assets to capture their market potential.
The predominance of “mom and pop” ownership of multifamily assets in the Southern California market has resulted in thousands of tired-looking, under-performing apartment buildings covering the urban landscape of Los Angeles. Paladin’s typical value-added acquisition is characterized by significant deferred maintenance with rundown and outdated apartments interiors and drab exteriors. Not surprisingly, current rents for such units are typically 20 to 30 percent below current rents for fully renovated and repositioned comparable properties (this discount to current rents is also called the “loss to lease” of a property).
Rarely do we acquire properties with professional, institutional-quality property or asset management in place. Once acquired, our aim is to transform these under-performing properties into well-run, more secure, modern apartments that attract today’s younger tenant profile, while at the same time increasing cash flow and residual value for our investors.
Paladin’s Value-Added Process: Buy, Fix and Harvest Returns
The value-added process that we employ when executing our business model includes:
Communicating our plans to tenants (i.e., no surprises).
We explain who we are, our vision for the property, and our anticipated timeline for execution, as well as the fact that they may be living in a construction zone for several years. In many cases, we encounter tenants who have lived at the property for years and have endured years of mismanagement and deferred maintenance. Our initial contact with our existing tenants is to explain that we are here to fix things and improve their lifestyle. A common misconception is that tenants living in older workforce housing want the cheapest apartment they can find. To the contrary, most of our tenants want the best apartment they can afford, and, as a result, often move from their unrenovated unit into our fully renovated apartments, even at a much higher rental rate.
Providing relocation incentives to encourage unit turnover.
One of our value-added strategies is to create as much voluntary unit turnover as we can in the first few years of ownership to capture the loss to lease (under market rents) by improving the units and bringing rents to market. We don’t believe in forcing people out of their homes. Instead, we set aside a pool of capital to provide relocation assistance to tenants willing to move elsewhere. Many tenants do not desire to live in a building under construction and readily welcome such relocation assistance. We also provide incentives for existing tenants to move into upgraded units at market rents as they are completed—thereby freeing up those current units for renovation.
Renovating and repositioning the property.
Our value-added business model includes investing $10,000 to $20,000 per unit in various exterior upgrades, which may include addressing deferred maintenance, updating the façade with contemporary paint and materials to enhance curb appeal, increasing security, and improving landscaping. To the extent feasible, we often invest in outdoor amenities such as pergolas, BBQ areas, festival lighting, dog runs, and children’s play areas.
Inside the buildings, we invest in the range of $30,000 per unit on interior improvements. We often fully renovate bathrooms and kitchens, installing new cabinets, quartz countertops, plumbing and lighting fixtures, and stainless-steel appliances. Whenever feasible, we add in-unit washers and dryers, further justifying increased rents as well as tenant satisfaction). We often replace dated aluminum windows with new, double-pane vinyl-clad windows. All flooring is replaced with modern, wood laminate and tile, and the entire unit is repainted with contemporary design schemes.
Improving management and lowering operating costs.
As noted above, rarely do we buy a property that has professional management in place. We hire best-in-class third-party property management firms that are supervised by our internal asset management team to improve operating efficiencies and reduce costs. Our property managers start with the basics - enforcing lease agreements and addressing any tenant’s nuisance behaviors. We look at new systems in order to pass certain costs through to tenants, such as implementing a RUBS (ratio utility billing system) program which allows us to charge tenants directly for their use of utility services. Typically, our property managers are equipped with app-based systems that we leverage for billing, maintenance requests, and other tenant communications, providing a better experience for our tenants.
In the Los Angeles market, where most properties are owned by mom-and-pop investors, very few buildings have the high- quality management that we provide to our tenants. As a result, our tenants welcome the change of ownership.
Harvesting equity via sale or refinancing.
The value-added process outlined above results in increased cash flows that increases the property’s value. In a low cap rate market like Southern California, the value appreciation can be quite rewarding. For example, in a 4% to 5% cap rate environment that we have experienced for many years in Los Angeles, every $1 in additional cash flow we generate can result in $20 to $25 of incremental value.
Our value-added process generally takes between three and five years to complete. Upon completion of our business plan for the property, we usually harvest the increased returns through a refinancing or sale.
Why Paladin’s Value-Added Strategy Works
There are several important reasons why Paladin pursues value-added investing and why the Southern California market offers a uniquely attractive environment for this strategy.
First, we invest in essential workforce housing targeting a large and growing “permanent” renter class in Southern California. Our tenants are working class and middle-income “renters by necessity”, namely persons who may want to buy a home but cannot afford to do so without having previously saved for a cash downpayment and enduring very long, daily commutes to and from work. In a rising interest rate environment, home ownership is put on hold for many of our tenants due to higher mortgage rates. In today’s market, renting is a more affordable option the buying. Additionally, our tenants cannot afford the rents in newly constructed Class A apartment building, but still desire to live in safe, modern, affordable and well-managed properties. Those are the ]properties we aim to deliver.
Second, despite the major investment in renovation and repositioning costs these properties require, our value-added strategy is substantially less capital intensive relative to new development. Unless subsidized by government at huge cost, land, labor, and material costs for new construction must target Class A renters, rents our workforce tenants cannot come close to affording. It is simply not economically feasible to build the types of low-rise, low-density properties we are renovating for the price we pay. Our all-in costs (acquisition, renovation, repositioning,, etc.) are typically about 50% or less than the cost of new development (i.e., “replacement cost”) . You’d be hard pressed to find this high of a discount to replacement cost in other major U.S. markets which are not supply constrained and have cheaper land and building costs. Combined with the cushion of the large “loss to lease” mentioned above, as well as Paladin’s conservative approach to leverage, Paladin’s strategy provides strong downside protection for our investors.
Our value-added strategy targeting existing properties also aims to provide our investors with similar returns as targeted by developers of new apartment construction, but with significantly less risk and greater downside protection. The permitting process in Los Angeles is both time and resource intensive. It could take up to two years or more just to design and secure the permitting for a new project. The project may then become tied up in litigation for another year or two given the region’s NIMBY (i.e. “not in my backyard”) and general anti-development environment. Actual construction may take another two years, and then it may take another year to lease up and stabilize the property. In other words, it can take up to five or six years (or more) for a new apartment building development to begin generating cash flow. In contrast, our value-added investments in existing assets generate cash flow at inception and we have typically exited our investments between the third and fifth years.
Paladin’s Value-Added Track Record
Founded in 1995, Paladin is a U.S. Registered Investment Advisor that has invested in billions of dollars of real estate across the Americas, with an emphasis on workforce housing (both rental and for-sale).To date, we have made over 90 value-added apartment investments across the U.S. totaling more than 15,000 rental units and nearly $800 million of total cost. About half of these deals were in Greater Los Angeles. The other half were located in select regions throughout the U.S., which has given us valuable perspective and point of comparison when we weigh investments in the Los Angeles area against those in other U.S. markets.
While our U.S. apartment portfolio has averaged IRRs in the mid-20% range, our value-added investments in Southern California have outperformed the portfolio average, achieving average IRRs in the 30% range. Our investments in Class B/C apartments in Southern California have clearly been the best performing properties in the Paladin portfolio.
In fact, it is our breadth of experience across three decades of value-added real estate investment in a broad variety of markets across the U.S. that convinced us that Class B/C apartments in Southern California will continue to generate the best risk-adjusted returns for our investors.
We believe our strategy of investing in and improving workforce housing will continue to provide attractive risk-adjusted returns, generating durable cash flow and appreciation, while limiting downside risk due to our focus on low-leveraged investment in properties well below replacement cost. In today’s uncertain economy, we believe it’s critical to invest with an investment manager such as Paladin that has successfully navigated numerous economic cycles through three decades of experience.
If you’re interested in learning more about Paladin’s value-added apartment strategy, contact us today!