[00:00:00] There's an old adage in real estate investing that it's all about location. The saying is, "location, location, location". In other videos, I've talked at length about how cap rates, which is the way that investors value income producing real estate assets, and how investor psychology often follow predictable cycles. And it can range from pessimism, and translated into higher cap rates of lower values during recessions and recovery periods, to optimism and ultimately what I would describe as just unsustainable. Greenspan might call it irrational-exuberance - those are periods where there's greater access to capital that drives cap rates down and elevates values. And that tends to happen during periods of economic expansion, and when development starts to enter the real estate markets. In low barrier to entry markets (and I would describe Phoenix, Dallas, Atlanta as examples of that), the hangover from the top of a market cycle where there's been easy access to debt and equity capital, and resulting in a lot of new development and significant additions to new supply - that can have a dramatic impact on cash flow, cap rates, and real estate values when the market conditions shift and sources of debt and equity capital dry up and investors sit on the sidelines, whether by their own choosing or just because they don't have access to the capital. And so for most markets in the US, successful real estate investing is really dependent on market timing, and getting the market timing right.
[00:01:52] So, in some respects, yes, location is important - but "timing, timing, timing" is everything in most US markets. One exception that we've seen to that, having invested in apartments all across the US (almost $1 billion in this strategy over 30 years), is that there's unique aspects about the Southern California market, particularly if you're focused on workforce rental housing, which is what we do in all of the markets that we invest in. It's a market sector where timing is less critical to success. Timing opportunities do materialize, but it's not as critical as location and product type as we've seen in other markets. And I've talked about why this is the case in other videos: there are unique attributes to the Class B/Class C rental apartments in SoCal that make them less dependent (on market timing), really more of a function of asset selection, conservative capitalization and use of debt, and skill in executing value-added business plans. Those are the three factors really that drive success. So, why is this the case? The Class B/Class C apartments in LA that we target provide an essential need: it's affordable workforce housing in one of the most chronically supply constrained markets in the US. And we provide it to what is really a large permanent renter class that doesn't have any other affordable housing choices nearby. Our rents in fully upgraded properties, once we're done with our renovations, represent great value. They're about half of what apartments in Class A properties rent out for.
[00:03:44] So, our buildings, historically, have stayed filled no matter what the economic environment is. And especially during recessions, we have had historically high occupancies in the 95% to 98% range in some properties, 100% during recessions. So, that's an important attribute. Secondly, we target properties where current rents are about 20% to 30% below where market rents are. And we've talked about this before - this is the loss to lease. What gives that I think is the great benefit of that loss to lease, not just being able to capture that value, raise cash flow and thus increase value, but it gives you a cushion during a market downturn, because if rents come down 10% (market rents come down 10%), which they've done in the last two major recessions that LA has gone through in the last 20 years, we still have a 20% loss to lease that we can capture even if market rents come down. And so even if we get a turnover during a recession, which tends to be more difficult because again, we're the value proposition, and so people move out of Class A properties into our Class B and Class C properties because the rents are more affordable. But when a unit does turn over in one of our properties, even if market rents come down by 10%, that unit we're able to raise rents by 10% to 20%. So we can actually have rental income at our properties increase during recessions,
[00:05:19] if we get turnover of those large loss to lease/below market rent units, to turn. So, for both of these reasons, our properties tend to have durable cash flow and net operating income during market downturns, and that's not always the case in other markets where there is greater supply side risk, and where there's just more abundance of developable land. So, we use debt conservatively, that's the other key factor that provides some downside protection for us. It's typically about 50% of the total cost. And we typically, and in our most recent acquisitions, are funding the renovations with equity, not with debt. To the extent we do get debt, we always fix the rate during our expected holding period. So, we really try to take as much risk off the right side of the balance sheet as we can off the table. So, all of these factors mean that if cap rates rise - and nobody's bigger than the market, we're already seeing here in late 2022, cap rates have risen by 25 basis points to 50 basis points already. We think it's going to go even higher. But even when cap rates rise, we typically have the pricing power and the durability of cash flow to weather the storm, and that's what's important to us.
[00:06:48] We don't want to have any of our assets from a capitalization standpoint or a cash flow standpoint, and not be able to service debt during a market downturn. So, it means that when a market downturn does hit the Southern California apartment market - and that's already starting to happen in our view, it's going to be characterized by less capital chasing deals. And you're going to see overleveraged investments that have been made over the last 1 to 3 years. They're going to have difficult refinancing next year in a higher interest rate environment. We're already seeing some opportunities like that. I don't think it's going to be widespread distress, but there's going to be some interesting recapitalization opportunities as properties aren't able to refinance. And so we're pretty optimistic that this is going to create some attractive buying opportunities over the next few years for our strategy, particularly for a well-capitalized investor like Paladin, who's got a track record of being contrarian during uncertain times and knowing how to create value and targeting assets where there's a durability of cash flow. So, the next few years will create, I think, a nice market timing opportunity for our strategy, but we've never really relied on that because even in good times and robust times, our strategy has been one that provides downside protection, the way we approach it.