Debt always becomes a big topic of conversation when the winds of economic fortunes start to shift and we're seeing that right now. And there's really two areas where debt influences real estate market cycles. One is at the macro economic level and how the level of debt in an economy affects an economic cycle and it influences the start of a cycle. It influences the severity of an uptick in both a downturn and then it will also influence the pace of future GDP growth. So that's one level. It's just sort of the macroeconomic influence that debt in the economy has. The second is, debt within the real estate sector, and it's both the amount of leverage and the type of leverage, whether it's fixed or floating, whether it's amortizing or interest and so forth, that affects the relationship between debt service and NOI. That impacts the likelihood of loan defaults, the likelihood of foreclosures and distress buying opportunities. So, disruption in the capital markets affects financing alternatives, particularly non bank type of lenders, debt funds and so forth, which have been very active over the last two or three years in the multifamily space. Those markets completely imploded and dried up in the first half of this year when war broke out and when the Fed started raising interest rates. The lines of credit that provided the supply of capital to those non-bank lenders, those debt funds dried up and the capital completely dried up. That has impacted the IRR to equity investors.

You can't get 70%, 75% financing at three and one half interest rates anymore. That kind of financing is now in the 6% to 7% range. That affects the IRR to equity investors and without an adjustment in your return expectations as an equity investor, it has to influence asset pricing. And we've already seen that in the transactions that we've been involved in over the last six months. We've been able to negotiate price discounts and that's been across the board as we've been comparing notes with other sponsors in this space. So, let's look at where we are debt wise in those two different levels, both real estate and macroeconomic level. And how does it compare, say, to where we were 14 years ago going into the global financial crisis. So, here's the good news compared to where we were in the years leading up to the global financial crisis. If you look at the banking sector, incredibly important. You look at mortgages, you look at consumer credit card debt, you look at state and local governments. The current debt, as a percentage of GDP, is actually below where we were leading up to the global financial crisis. So, I think that the risk, barring some black swan event, the systemic risk of excess leverage in the financial sector is low right now, which should mean that the economy and the financial sector, the banking sector should weather the storm relatively well. Where we are seeing record levels of debt right now and some of it should be troubling is federal government, most of that in response to two major economic disruptions, the global financial crisis and then the lockdowns and the shutting down of our economy as a result of the COVID pandemic.

I won't get into the debate on, is there too much or too little. Does federal government debt matter? But, suffice to say, we're at record levels of debt, and it certainly is influencing politics, and policy. The business sector, corporations have record levels of debt compared to where we were going into the global financial crisis. That's more alarming to us because an overleveraged corporate sector could make it more challenging to hire people coming out of a recession. It could amplify job losses in the event of a recession. Where you're seeing debt on the consumer side right now is auto loans and student loans. Been some recent relief. We'll see if it actually gets enacted by Biden on the student loans. But what worries us, I think, of all the leverage that's in the economy right now is really the leverage that's on the business sector, but also the effect of rising interest rates on the consumer and high levels of debt at the federal government level and at the consumer level. Those are the two things that could impede the pace of economic growth coming out of a recession. It's one of the reasons that you saw a very sluggish recovery coming out of the global financial crisis.

So, where does this all take us? You've got, in terms of the banking sector and just real estate debt, relatively low compared to where we were going into the global financial crisis. So that's good news for sure. I don't think we're likely to have a debt bubble burst leading to a potential systemic breakdown of the banking sector like we had in the middle of the global financial crisis. It was truly close to meltdown status. As I said, corporate America is highly leveraged today. Highest debt to GDP in its history. Asset prices in the housing sector have soared during the pandemic. Unsustainable growth, in our view on that. Against the backdrop of rising interest rates, with five hikes this year already to tame inflation, it's at a 40 year high. The economy is already showing some signs of cooling off and the jobs market report has slowed down. It's still a growing economy. There's still companies hiring. So it's difficult to imagine that we're actually in a recession now with the level of hiring that is still going on right now. But, it is slowing and maybe the Fed will be able to pull off a soft landing. The track record, historically, is not that good on that front. And, given the pace of the rate hikes that we've seen, we think the risk of recession is very high over the next 12 to 18 months. And there very well could be a hard landing, particularly with how leveraged the corporate sector is right now.

So, what does that mean for Paladin? We have always taken a defensive approach in terms of the sectors that we target, the strategies that we target and the way that we capitalize investments, and that's even more important today. So, the sectors that we target, which is workforce housing, renters or occupants of necessity. They don't have any other affordable housing option, in our markets, whether it's for sale housing in Latin America or it's rental Class B and C rental workforce housing here in Southern California. Those sectors have proven to have resilient demand during market cycles. They're immune, frankly, to whatever politician might be in office at a given period of time. I think that the hallmark of our defensive approach is conservative debt capitalization. In Latin America, our average loan to cost is about 30%. And what we have been capitalizing on our last four transactions, here in Southern California, it's been about 50% of cost, all with fixed rate financing. That's how it's affected our strategy. We haven't changed our course other than to be even more conservative with our capitalization. So it's not just the economic and the priority of repayments and so forth and how debt compounds good news and bad news to equity holders considerably. A 50% levered asset, it doubles, in terms of magnitude, the effect. A 10% decline in the asset value creates a 20% decline in equity value, and it's an exponential kind of relationship that exists.

But the power that you talk about is key, which is why you need to match your loan durations and any kind of extensions. So you're not having a conversation with your lender in the middle of a recession. The fundamental rule for us is to make sure that we've accomplished our business plan and we've increased NOI before we have to have any conversation. There's a lot of factors that go into cap rates, and it's not just interest rates. If you look historically just in our market, Southern California apartments, which has been traditionally a Southern California large, dense, built out infill markets like SoCal tend to have lower cap rates because there is a higher expectation of income growth in those kinds of markets. And I think that thesis still exists. A lot of investor psychology goes into the supply side risk. There's just so many different factors, asset quality, that impact the cap rate. But in general, go cap rates are cyclical. I think that, we've seen in our market here, probably a 50 basis point swing, this year to date, in cap rates. It depends on a variety of factors. The loss to lease that still exists, the value add potential. But there's a whole universe of buyers that were dependent on 70% - 75% bridge financing. That financing is no longer available. That money is sitting on the sidelines. They have no other choice.

If you look at nationally, compare notes with a lot of friends of mine who run real estate private equity funds. For the most part, when you're in a transitionary stage of the market, like we are now, sellers have last year's prices in their heads. Buyers have today's yield return requirements that need to be met and they don't reconcile. And so, the stuff that's on the market right now is on the market for a reason. I would not be a seller unless I had to be, in today's market because you're just relying on funny money that just isn't there to take you out. And so it takes time. There's a lot of friction in real estate markets, which can be a good thing that you can take advantage of. Those frictions create inefficiencies that sophisticated investors can exploit. But right now, it's not quite like trying to catch a falling knife, although certain sectors like office and some of the Amazon effect on retail, you might feel as if it is a falling knife. It's not. You can't have a blanket statement like that on the sector as a whole. But I think that we certainly have taken a much more cautious view in terms of future exit cap rates that we're projecting in our underwriting. What interest rates are going to be over the life of our investment if we're going to do a refinancing scenario and so forth. And that translates into asset prices. Most recent deal that we were looking at, the broker kept encouraging us to put an offer in and we were 20% below what the guidance was, the whisper price to us.

And we ultimately decided not to put it in, not because we didn't think we would get it. I think we actually would have gotten it, judging by the brokers - how strongly he was encouraging us to put the offer in. But there were some flaws to that particular property that were not easily correctable. Most of what we buy has deferred maintenance or other weaknesses that are correctable, and we go in and renovate to make those corrections. This property was under par and there just wasn't a way to solve that problem efficiently and easily without having some offsite solution to it. And at this stage of the market, why take any kind of risk like that? There's plenty of opportunities where you don't have to. So, we're in a fortunate spot where we're one of the well heeled value-added buyers that's still active in this market, that still has access to financing and investors who don't rely on 70%, 75% leverage in order to want to invest with us. They like the downside protection. They actually like more conservative leverage. They like the fact that we can get to a cash flow driven investment profile sooner because of lower leverage. So all of those things are playing to our advantage. But we're, I think, an anomaly in the current market here in Southern California.