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Southern California Workforce Housing: Finding Asymmetrical Returns in Uncertain Times

Updated: Sep 18, 2023

By: Fred Gortner, Co-Founder, COO & Head of U.S. Strategy, Paladin Realty Partners, LLC


Introduction

Rental apartments have historically been one of the most desirable investments for investors seeking passive income, wealth creation and inflation protection. This article describes five distinct characteristics of the SoCal workforce rental apartment market, which offer an asymmetrical risk-reward proposition (attractive upside potential with unparalleled downside protection) that is truly unique compared to other U.S. markets.

1. Cycle-Resilient Demand

Southern California is one of the largest and most supply-constrained housing markets in the U.S. Less than half of Angelenos can afford to buy a home. As a result, Class B/C apartments provide an essential need – affordable workforce housing – to a large permanent renter class of “renters by necessity.” Because of this and their superior rent advantage compared to newer product, Class B/C apartments in Southern California historically maintain high occupancies during good times and bad, averaging 97% during the past 20 years.

2. High Barriers to Entry Limiting New Supply

Despite best intentions, building new affordable housing in Southern California has proven to be an insurmountable challenge for decades due to the region’s lack of developable land, high cost of construction and other barriers. It will take Los Angeles 20 years to meet its existing housing deficit based on the current pace of development. Government-subsidized new affordable housing costs over $750,000 per unit, more than 2x the typical cost to renovate and reposition an existing Class B/C apartment building.


3. Irreplaceable Assets with Huge Cost and Rent Advantage

Most of the rental housing in greater Los Angeles was built after World War II when land was relatively cheap and plentiful. As a result, the existing infill rental housing stock is largely comprised of older, smaller Class B/C apartment buildings (typically 50 units or less). Such low-density apartments would not be economically feasible to develop today, and yet they can be acquired at prices based upon their under-utilized current income. As a result, Class B/C apartments enjoy a sizable cost advantage (50% discount or more) and rent advantage (36% discount or more) compared to newer Class A product.

4. Lack of Institutional Competition

The region’s smaller asset sizes also make it challenging for most large institutional investors to achieve desired portfolio scale, as they’d need to acquire 5-10x as many assets in Los Angeles to achieve the same scale as one 200 to 300-unit property in markets like Phoenix, Dallas or Atlanta where institutional ownership is more widespread. As a result, the SoCal market is largely dominated by smaller, less sophisticated “mom and pop” investors.

5. Abundance of Value-Added Opportunities

The typical “mom and pop” investor that dominates the SoCal apartment market has very different motivations than institutional investors. Most lack the experience, resources or desire to optimize the full market potential of these older assets. As a result, the SoCal urban landscape is filled with thousands of rundown Class B/C apartment buildings that are significantly under-performing their potential, with current rents 20-30% or more below market. This “loss to lease” is further amplified by the region’s complex rent control regulations, which artificially restrict the supply of residential units available for lease. Sophisticated investors who know how to capture that “loss to lease” through value-added business plans can be richly rewarded.

Conclusion: Asymmetrical Risk-Reward Opportunity

The five unique and beneficial characteristics of the SoCal apartment market described above offer a compelling market opportunity to acquire, renovate and reposition older Class B/C apartments. For experienced institutional investors like Paladin, who know how to navigate the region’s complex rent control regulations and capture higher market rents through value-added business plans, the upside potential can be very attractive. Indeed, every $1 of NOI growth in a ±5% cap rate market like Southern California generates $20 of incremental value. Further, by focusing on properties regulated under California’s statewide rent control (AB1482), such investments have strong inflation protection and a clear pathway to generate desired unit turnover to capture higher market rents.


Most importantly, the favorable supply-demand fundamentals described above are structurally imbedded in, and unique to, the Southern California apartment market. As a result, a value-added strategy focused on workforce rental housing here is much less reliant on market timing and, therefore, is relatively well-insulated from economic downturns that can have a much greater impact on other U.S. markets.


Paladin believes this combination of (1) strong downside protection and (2) attractive upside potential in a relatively lower cap rate market results in an asymmetrical risk-reward proposition that is difficult to replicate in most other property types and U.S. markets, a welcome investment outcome in these uncertain times.


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