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Today, I want to talk about one of the most important valuation metrics in real estate, and that's the capitalization rate (or often called "cap rate" for short). And basically it's the inverse of the price earnings or PE ratio that is used commonly to value stocks. So cap rate is simple - it's the net operating income of a property divided by its value. So for example, if a property is generating, say, $1,000,000 of NOI or net operating income in a 5% cap rate market, that would be valued, that asset would be valued at about $20 million. In a 4% cap rate market, that same asset, generating that same cash flow would generate $25 million of value. So there are a lot of factors that influence cap rates, but they generally fall into three categories: One, and perhaps the most important is the capital market. And more specifically, I mean, where are interest rates, and where are returns offered by other asset classes like stocks or bonds, because ultimately any investment is competing with other alternatives out there. So that's perhaps the most important factor influencing cap rates. Second would be growth expectations for the underlying cash flow of the asset. And a lot of things can influence that. The supply demand fundamentals in a market, the supply demand fundamentals for a particular product type, the particular competitive attributes of a specific asset and so forth. And then the third category, which is related to growth expectations are risk factors, and that would include the competitive weaknesses of a particular asset or larger structural forces.
So for example, the Amazon effect on Main Street retail, and the effect of remote work on the office sector, those are two big structural forces that have affected cap rates because it has affected the risk factors and the growth outlook for those particular product types. So now, some commercial real estate investors are spooked by low cap rates, and they believe that it limits the cash flow potential of an asset and thereby puts the upside potential for holding that asset at risk. And for some markets and strategies, that's a legitimate fear. So, for example, if you buy an asset in a low cap rate market that has significant supply-side risk, such as a lot of developable land that's in the city, few barriers to new construction, existing assets aren't priced at large discounts to replacement costs, and so forth then the introduction of new supply can significantly limit the growth potential and even reduce the operating cash flow of that asset and thus the appreciation potential. And that in turn will cause the perceived risk of that asset to rise, the growth expectations to come down, and cap rates to rise in response to that. And similarly, if you buy a stabilized asset, in a low cap rate market, virtually everything has to go right. The capital markets and interest rates have to work in your favor, the growth prospects for that asset have to remain the way you underwrote it, and so do the risk factors. And if the economic outlook for that product type or that market becomes less certain, cap rates will rise and values will adjust.
And that's actually what's happening across almost all real estate markets and product types in the US today in response to tighter capital markets, more economic uncertainty and higher interest rates. Now, for value-added investors like Paladin, not all, but certain low cap rate markets can actually offer an exceptional investment opportunity, even during times of economic uncertainty with an asymmetrical relationship between risk and reward. What do I mean by that? What I mean is you have a combination of attractive upside potential valuation, value appreciation, but strong downside protection in the event of a market downturn. So let's take a look at one example of this, which is the value-added strategy that we've been pursuing for 30 years that's focused on Class B, C apartments in Southern California. Now, for many decades, SoCal has had among the lowest cap rates of any US market across a range of product types. Why is that? First of all, it's a major gateway city - it's a huge population, 10 million people in LA County alone, a large dynamic economy. It's also one of the most supply constrained markets in the country. And there are huge barriers to new development here, and as we've discussed in other videos, Class B, C apartments provide a unique, essential need in this marketplace. And what I mean by that is affordable workforce housing, near jobs. And this attribute gives Class B, C apartments here in SoCal some competitive advantages that you cannot replicate in other US markets. One is a huge cost advantage compared to new construction. Class B,C apartments in LA typically trade at 50% discounts or more to replacement cost, even after you factor in the renovation costs that you plan to make the asset.
Secondly, these types of assets, these Class B, C workforce housing apartment buildings have strong pricing power on rents even during downturns, and this is because of a huge loss to lease that we typically target. And we've talked about this in other videos, but loss to lease is basically the difference between market rents and where current rents are, and we target a 30% discount. So that gives us pricing power. Even if market rents come down, they're still going to be above where our current rents are, and that's a unique attribute in this market. And lastly, these assets cater to a permanent renter class in LA that's been priced out of home ownership because of the cost of housing here. It's a renter by necessity, not by choice, and they have very few other housing options available. And so these advantages of Class B, C apartments are really unique to the SoCal market. You cannot replicate the kinds of discount to replacement costs and pricing power of a large loss to lease to the same scale in other US markets, which are far more competitive and far more active with institutional investors like Paladin. We've talked in other videos about why that's the case. So in turn, these attributes are what provide, what in our view is unparalleled downside protection, especially during economic downturns.
And so in other words, what does all this have to do with cap rates? From both a long term growth perspective, as well as a risk mitigation perspective offered by these attributes, SoCal apartments historically trade at low cap rates and the prospect for continued low cap rates in this asset class relative to other US markets remains high. And that that's an important distinction. I'm not saying that cap rates aren't rising here in LA due to higher interest rates - they are rising, we've seen that already transpire this year, and expect it to be a trend that continues well into 2023. But what I'm saying is that relative to other US markets and other product types, SoCal apartments are likely to exhibit cap rates that are on the low side of the spectrum. And so why is that beneficial? So as I mentioned earlier in this video, low cap rate markets like Southern California place a high value on cash flow. So if you know how to increase cash flow as we do, and we've been doing this for 30 years in this market, pursuing the same value-added strategy, the upside potential can be quite rewarding. Here's an example - for every $1.00 of cash flow increase that you're able to generate through a value-added business plan, that produces $20 to $25 of incremental value in a 4% to 5% cap rate market, like we have here in Southern California. And with conservative leverage, the returns to the equity investors in this strategy can be hugely attractive. So let me summarize here.
What's unique about the Southern California market is the asymmetrical risk/reward proposition that is offered. You have the upside potential that's offered by increasing cash flow in a low cap rate market. You get that 20 to 25 times multiple in a 4% to 5% cap rate market. But you have unparalleled downside protection due to the unique attributes of Class B. You have unparalleled downside protection due to the unique attributes of Class B, C workforce housing in Los Angeles. And that's why of the 90 + apartment investments that we've made across the US to date, half of them were located here in Southern California. That's why our returns in this particular strategy have been among the best performing across $7 billion of real estate in eight countries since we started the firm 30 years ago. Of all the factors that influence cap rates, interest rates are the strongest because almost virtually every investment is tied ultimately to a risk premium over a risk free rate. And the risk free rate standard is US treasuries. So if the cost to US treasuries goes up, if the risk free alternative of investing goes up, money is going to flow there, unless the returns offered by other investments rise as well. So that risk premium is maintained. And so in cap rates, there's a lot of discussion about the spread between where cap rates are and US treasuries, and that spread can contract and it can expand at different stages of a cycle. And what you're seeing right now with interest rates going up, and sellers still remembering last year's prices, and a lot of buyers sitting on the sidelines, you're actually seeing some compression.
You're not seeing a 1 to 1 correlation increase in cap rates for what's already happened in interest rates. Interest rates have gone, depending on the measure, has gone up by over 200 basis points. But you haven't seen cap rates, at least in LA and many other markets go up by 200 basis points...yet. Ultimately, the markets do a wonderful job of reaching equilibrium, and arbitrage investors, and money flows to where the best risk adjusted opportunities are. And ultimately, the pricing of real estate assets - it has been adjusted. We've already seen at least a 50 basis point increase in cap rates here in Los Angeles. You wouldn't expect to see a 1 to 1 correlation because of the growth prospects and the perceived risk mitigation of workforce housing in a supply constrained gateway city like Los Angeles. But we are definitely seeing it and there will be continued pressure, I think, on cap rates. And right now we're being quite patient. There's a lot of interesting opportunities, but we're being patient because we think the market has some room to move. We think the next two years are going to be exceptional buying opportunities. This particular strategy we're pursuing isn't really market cycle dependent, but when a market cycle hands you some low hanging fruit, which I think it will in the next 1 to 2 years, we want to be ready to pounce on it.