[00:00:03] I want to talk about cap rates in this video. We've talked in other videos about the benefits of investing in a low cap rate market with high barriers to entry like Los Angeles. But today, I want to expand on that topic a bit more, and I want to discuss the importance of comparing the fundamentals that underpin cap rates between different markets and different property types, and how cyclical trends in investor psychology and capital flows can really distort the relationship between these fundamentals and cap rates at different stages of a market cycle. And identifying these cyclical distortions and the resulting risks of buying a mispriced asset at a particular stage in the market cycle. That's ultimately what helps distinguish excellence among investment managers and strategies. And so, to simply believe that you're safe buying an identical apartment property, say, at a 4% cap rate in Phoenix or Los Angeles, or that buying in high cap rate markets and product types are always more attractive because you're getting a higher going in income return. That ignores the importance of all the supply demand fundamentals and other risk factors that go into determining cap rates and asset pricing. We've concluded there are - no two cap rates are alike. So, let's recap from another video, we talked about: there's three main factors that influence cap rate, or the capitalization rate, which is basically the net operating income of a property divided by its market value - it's the inverse of a PE ratio for stocks.
[00:01:54] And those three general categories are: capital markets, which is interest rates, expected returns that other asset classes provide, growth expectations, job and population trends, supply/demand fundamentals and so forth, and risk - the risk appetite at a given point in time, supply side risks in particular, the competitive weaknesses of a particular asset or a particular market. The common thread that binds these three general categories together (capital flows, growth expectations, and risk), is investor perceptions about that and what the investor psychology is at any given point in time. Investors' expectations about growth, and about risk, greatly influence capital flows, and they can bid up or down valuations of different asset classes. And in the case of real estate cap rates, depending upon the property type, depending upon the market and depending upon the time of a market cycle. So, for example, many secondary markets in the US, like Phoenix, and Nashville, and Austin, and Dallas, saw a lot of net gains of migration of jobs and people during the pandemic. People moved out of the gateway cities toward some of these more affordable markets for lifestyle and other reasons. And so demand soared for residential real estate in these markets, and the capital markets responded with significant inflows of debt and equity capital - and that drove housing prices up, and it drove cap rates for rental apartment properties in these markets down to all-time lows.
[00:03:41] Our view is, in the exuberance to chase growth opportunities in these secondary markets, many investors ignored some of the critical supply side risks that these markets face. There's generally a lot more developable land in Phoenix, and Dallas, and some of these other secondary growth markets compared to gateway cities like Los Angeles that have been largely fully built out in the decades after World War II. There's fewer regulatory barriers to new construction. And so, low cap rates, at such low cap rates, existing assets in these markets were not trading at the kinds of discounts to replacement costs, new construction, that you would ordinarily see. And in some cases, they weren't trading at any discount to replacement cost. And so, in general, we have found that in frothy times, investors often lose the insight, the ability, the discipline to differentiate relative value across different markets and different product sectors, and it's so important for a diversified portfolio, and it's so important for long run success in real estate investing. And so, over the last two years, in 2020 and 2021, there was not a meaningful pricing difference for comparable apartment assets in Phoenix or Dallas, which are secondary markets with considerable supply side risk because of the availability of developable land, and the ease with which you can do new construction - compared to Los Angeles, by contrast, one of the most chronically supply constrained markets in the US with huge barriers to new construction.
[00:05:37] So, the capital flows that were chasing low cap rates in Nashville, Atlanta, Phoenix, and Dallas - those investors forgot that most real estate markets go through very predictable cycles of economic expansion, followed by development, which is characterized by periods of relatively easy money, fueling new additions to supply - followed by unsustainable exuberance, crashing, demand falling, recession, low risk tolerance and repricing of assets during those periods, and then recovery where there tends to be good buying opportunities and visibility on economic improvements. And so, one of my favorite investors, Warren Buffett, famously said, "When the tide goes out, you see who's swimming naked". And we think that next year - 2023 and 2024, we're going to see this tide go out in many of these high growth secondary markets that were the darlings of institutional capital in 2020 and 2021. And we're already starting to see this happen in many of those markets. We're seeing changing investor expectations about growth and risk. We're seeing a pause or just an outright contraction in capital flows, both on the debt side and the equity side. And, you've seen cap rates in some of these markets rise already, just to date in 2022 by 50 basis points to 100 basis points or more and we think there's further room for cap rate expansion in these markets. So, you know, again, back to the theme: no two cap rates are alike. Historically, markets like Phoenix and most of the major cities in Texas, when a downturn hits, they get hit with a triple whammy - a triple.
[00:07:33] So you get a combination of lower tenant demand, excess supply - that causes rents to drop and vacancies to rise. And so that has a huge impact on NOI (operating cash flow), which tends to fall during the market downturn in these more supply side risk cyclical markets. That causes valuations to drop, not only because of lower cash flow but also higher cap rates as risk tolerance drops and people start to reprice these assets, and the impact on invested equity can be enormous. For example, 100 basis point rise in cap rates from 4% to 5% will result in a 20% decline in the asset value - just assuming that income stays flat, NOI stays flat during that period. If you have 70% leverage on that type of investment, you've just wiped out two thirds of the value of your equity investment, just by a 100 basis point rise in cap rates, which we're already starting to see in those markets. And then if you add to that, the possibility of a 10% decline in NOI (in operating income), which is not uncommon for secondary markets to see declines in NOI during major downturns, that wipes out nearly all of your invested equity. So, these are much more cyclical markets that I think have never really justified cap rates in the high 3% or 4% range.
[00:09:06] They should always be trading at a cap rate premium relative to a market like Southern California. Let me dive into a little bit more justification of that. We've talked about this in other videos. There are unique things about this particular asset class - workforce rental housing in this particular market, Southern California, that provides much greater downside protection for invested equity than you can find in other markets. I've talked about it at length in other videos, but in a nutshell, the Class B, Class C apartments that we target provide an essential need in this market - affordable workforce housing in one of the most chronically supply constrained markets in the US, and we provide it to a permanent renter class that has been priced out of home ownership. They have few, if any, other housing choices nearby the jobs. And, the rents in our fully upgraded Class B, Class C properties represent huge value, a great value proposition to renters because our rents are about half of what Class A apartment units tend to rent out for. And so as a result, our buildings stay filled during all times, but especially during recessions. With the last two major recessions that Los Angeles, Greater Los Angeles has gone through, Class B, Class C occupancies were in the 95% to 98% range. We've always experienced that in our assets here in Southern California as well. And second, because we target properties where current rents are 20% to 30% below market rents - this is the loss to lease that we've talked about in other videos, and capturing that loss to lease is where we make our money.
[00:10:57] But that loss to lease also provides pricing power during a recession and a cushion to our cash flow during market downturns. So, even if market rents come down by 10%, if we get turnover, any units turning over in our buildings during a downturn, we can still raise rents - we still have a 10% to 20% loss to lease, even if market rents come down. So, that gives B/C apartments, in Southern California, the unique advantage of durable cash flow. And actually, the ability to increase cash flow, if you get turnover of units that have a big loss to lease during market downturns, very difficult. The other major markets in the US where those kinds of discounts - that kind of loss to lease, the discount to replacement costs, the discount to new space, isn't as significant because there's much broader institutional ownership in those markets. We've talked about why that's the case in other videos. And I think the last factor that's very important here, is that we've always, across all of our strategies - $7 billion of real estate in eight countries across the Americas - the common thread that runs, there's a couple of common threads: one is, demographically driven workforce housing to renters and buyers of necessity. But the second is, we've always conservatively capitalized our investments.
[00:12:26] We take a very conservative stance on the use of debt. Typically it's about 50% of total cost, including renovations. We always fix the interest rates during our expected holding period. So, we really try to take as much risk on the right side of the balance sheet off the table as we can. So, nobody's bigger than the market and cap rates are already rising in our space in Southern California. But the factors I've just described mean that even if cap rates rise, which they will and they are, we typically have the pricing power and the durability of cash flow to weather the storm. We may have an impact on our returns. We may have an impact on the resulting IRR but we're not - the likelihood of getting into trouble with our lenders and not being able to service our debt is very low. The way that we approach this business - and it's one of the reasons why half of the 90 plus apartment investments that we've made to date, almost $1 billion of asset value across the US over the last 30 years - half of those were focused in Southern California, and it's also one of the reasons why the returns in this particular strategy have been among the best performing of any strategy or asset class that we've focused on across $7 billion of real estate, and over the past 30 years. So, I hope this was an informative video for you.