Today we're going to talk about the effects of inflation and rising interest rates on real estate. And no real estate strategy is immune to these effects. Why is all of this important to be thinking about, especially today? Rising interest rates and inflation usually means that a recession is looming around the corner - a market downturn coming into play in the months or years. And what that means is job losses. It means income declines. It means that demand for all kinds of real estate can be affected by those trends, and thus the rents that real estate earns from tenants can be affected. Inflation impacts operating expenses. Higher interest rates makes debt service more costly. All of that can impact cash flows. So we're going to talk about this within the context of what we are focusing on, here in Southern California and we believe our product focus and our market selection, which is specifically Class B, Class C apartments in Southern California, offers some unique advantages compared to other property types and markets in the US. Some of these are really important concepts, by the way, that we're going to take deeper dives into in other videos so I'd encourage you to go to our website, view those videos too.

So let's get into it. Let's talk about the top ten reasons why we think our strategy is relatively well insulated from rising interest rates. It's not immune but it's all about how our investments will weather a market downturn, will weather an inflationary environment, will weather a rising interest rate environment relative to other investments in real estate or any other investment for that matter. So first and foremost is the way that we approach debt in capitalizing on an investment. We have always favored relatively conservative amounts of debt. Look at the last four transactions that we've done. The amount of debt financing on those acquisitions was 50% or less. That's pretty low for real estate investments, number one.

Number two. We always lock in our interest rates at the time that we acquire a property and we make sure that our loan durations match the length of our business plans. We don't want to have an interest rate become a floating interest rate or a loan mature in the middle of a value-added business plan. That could prove disaster. Secondly, many buyers, value-added buyers of real estate, especially apartments where debt financing has been readily available rely on much higher leverage than what I just described. There's been a very popular form of financing called bridge financing - 2 to 3 year, in some cases, four year debt, that will lend up to 70% - 75% of the total cost of investment and fund the capital improvements, the value that investors put into a project. We've used that on occasion. Really, a minority of the type of debt that we use, as I said, favor much more conservative levels of debt. Many value-add investors relied heavily on that bridge financing and that market completely dried up in early 2022 with rising interest rates and economic uncertainty and a war breaking out in Europe. And so that's forced many investors, value-added investors in our marketplace in Southern California to sit on the sidelines. It's happening on a national level but it's happened especially here in Southern California. With those buyers sitting on the sidelines, more well capitalized investors like Paladin can take advantage of opportunities.

Third, while the higher interest rates killed that bridge lender that I just described. There's still plentiful financing options available for apartment assets, especially in Southern California among banks and other conventional sources. Banks and the agencies get scored based upon their loan footprint in different markets. It's been very challenging for these institutions to have a meaningful footprint and scale up their businesses in Southern California, because the type of the rental housing stock in Southern California is unique compared to other multifamily markets. We've talked about that in another video, how the build out of the rental housing stock here happened shortly after World War II, and it's mostly smaller assets, 50 units or less and much older assets, 20 years or older. So, it's been challenging for lenders to be active in Southern California. And so, there are plenty of lenders still available, even in uncertain capital markets for value-added apartment investments in Southern California.

Let's talk about the fourth factor. Inflation, which is the reason behind rising interest rates. For the type of assets that we target, all of which are subject to California's rent control, which is Assembly Bill 1482 or AB 1482 for short. Those are the type of assets we target. Inflation, for those kinds of assets, actually provides a tailwind particularly if you take into account the loss to lease that we target. So what's lost to lease? We talk about that in another video but it's basically the difference between the current rents that existing leases are generating on a property and what market rents are. We typically target 25% to 30%. Current rents are here. Market rents are here. That gap is 25% to 30%. That provides a tailwind for us because we are able, under AB 1482 rent control, to raise rents on existing leases by inflation plus 5%, up to a maximum of 10%. So, because of the loss to lease that we target, we have the pricing power to actually raise rents. If our rents were closer to market, which is really more of the phenomenon for multifamily investment across the US. Loss to lease is more in the 10% to 20% range, not the 25% to 30% range. You may not have the pricing power in an inflationary environment to raise rents that we have here in Southern California. So, the combination of AB 1482 rent control and a 25% to 30% loss to lease gives us pricing power to actually raise rents in times of economic uncertainty.

Let's talk also about the resulting impact on NOI and what that means. So, we're able to raise rents and we're able to keep the inflationary effects on our operating expenses under control, and there are some unique ways in Southern California and in California, in general, that you're able to do that. That helps offset the possible rise in exit cap rates (capitalization rates), which tend to lag interest rates. So, there's many factors that go into a cap rate. Interest rates is important but not the only factor, but the effect tends to lag. Sellers tend to have last year's prices in their minds when they bring a property to market. Buyers, brokers and lenders know what the real cost of debt is today. They know what the real inflationary impact is and they have return requirements for their investors and those two things, they tend to diverge when rates start to rise and we're seeing that right now. There's a fairly wide spread, bid ask spread between buyer and sellers in the current market. But eventually, if a seller has to sell an asset, there's going to be a market price and that market price is determined by, among other things, the required rate of return that equity investors have. And the risk has gone up in the current environment with inflation, rising interest rates and the threat of a possible economic recession.

So, sixth factor here, which is a really important one. Class B, C apartments in Southern California, which is our primary focus here in the United States. That's what we call workforce housing. And we've got another video that speaks in length about this particular topic. In short, workforce housing is what most low and middle income households live in. They are renters by necessity who, especially in a high cost housing market like Southern California, have very few other housing options available other than the Class B, C apartments that they're living in today. And as a result, demand for Class B and C units has historically been very resilient during economic downturns that often follow interest rate hikes. During the last two major downturns, the 2008-2009 global financial crisis and the most recent COVID pandemic lockdowns, occupancies in Class B and C properties in Los Angeles averaged between 95% and 98%. That's a huge benefit when you know you can rely on the cash flow that your properties are generating to remain intact, the occupancies to remain intact, especially during market downturns, is a huge advantage for Southern California apartments compared to almost any other real estate product, whether it's retail, hotels, office buildings and so forth.

Let's talk a little bit more about the home ownership in Southern California. Southern California has always been a supply constrained market when it comes to affordable housing. It's been a 50 year problem that Southern California and California as a whole has been trying to deal with. Higher interest rates make homeownership even less affordable in a market like Southern California and it was already low. Across the US, about 65% of households own their homes in Los Angeles. It's inversed. Only about 45%-46% of Angelenos own their home. So what does that create? What is that lack of affordable homeownership create for Southern California? It creates a permanent renter class that is looking for affordable workforce housing - exactly the assets that Paladin targets.

Another factor. Construction cost inflation and higher cost of capital could even further constraints on new supply in Southern California. It's already one of the most challenging markets to do new construction and assembling land, dealing with high land costs, dealing with onerous development approval requirements, environmental reviews. You are assured that there will be lawsuits along the way before you put a shovel in the ground. You'll be lucky if you can accomplish all of that pre-development work in a 3 to 5 year period in Los Angeles. And now, with inflation impacting construction costs and the cost of capital debt, interest rates approaching 20 year highs, that's put new supply even more out of reach in our market. All that does is widen the competitive cost advantage that our SoCal apartments have relative to new construction. That discount has been - it averages about 50% to replacement cost. Replacement cost is the cost to build a new apartment building. That's close to over $750,000 in some cases. In more urban areas of Los Angeles, close to $1,000,000 per unit. Our average cost basis is typically between $300,000 and $400,000 a unit. So a huge competitive advantage for the type of assets that we target.

Higher interest rates are going to put increased pressure on those buyers who used that 70%-75% bridge financing, over the last several years. Those loans are going to start coming due in the next year or two, and they're not going to be able to refinance if interest rates are as high as they are right now. And so that's going to create the potential for some motivated sellers in the next few years. And it's especially going to be the case here for those value-add investors who are now sitting on the sidelines. When their loans come due, there's going to be few options that are available to them to refinance, and those are going to be opportunities for us to take advantage of some of motivated sellers and some attractive pricing.

It's never really been a market timing play, our strategy here in Southern California, but I think the next few years are going to create some interesting buying opportunities from the market cycles standpoint. And then lastly, any assets that are acquired over the next few years, in a high interest rate, higher cap rate environment, should benefit when the markets start to normalize. Eventually, interest rates will come back down. Whether they come back down to where they were over the last 20 years is a topic of debate for a different video. My personal view is they won't. The interest rates are going to stabilize at a new level that will be higher and a little bit more normal with a longer term view on history.

I think it was an unusual environment of zero interest rates that we've had over the last 20 years. But at any rate, regardless of where interest rates end up landing, when interest rates do come down in the future and cap rates do normalize back to long term historical levels, existing owners who have bought at a higher cap rate, higher interest rate environment will benefit from lower cost of capital and possible cap rate compression. All of that can have a powerful effect on returns. So, hope you found this video interesting. A lot of these topics, we go into deeper dives on our website through articles and other videos. I'd encourage you to go there to take a look.