By KKR Real Estate Feb 21, 2023
In 2022, the majority of global central banks took action to combat soaring inflation, ending the decades-long period of lower inflation and lower interest rates and giving way to a new era of higher inflation and higher interest rates. The historic increases in short-term interest rates led to market-wide volatility and a repricing of risk assets, real estate included.
We begin 2023 with a more constructive tilt, even though uncertainty and volatility are still with us. We believe now is the time to start shifting our pace of investment from a “walk” to a “jog,” as our colleague and CIO of the KKR Balance Sheet Henry McVey says. Why?
- Real estate fundamentals remain strong. Rental rate growth is healthy, though moderating in certain asset classes, occupancies are high, and forward supply is generally limited, with the economics of new construction becoming trickier as the cost of financing, labor, and raw materials increase.
- We believe that inflation is peaking in most markets and foresee a slowdown in global central bank tightening, settling into a “higher resting heart rate” for both inflation and rates.
- As interest rates stabilize, we think transaction activity will pick up in line with increasing capital markets activity. And we are beginning to see this occur. Though still wide, bid-ask spreads are narrowing and transactions are increasing as visibility on terminal interest rates improve.
- We have ruled out our most bearish macro scenarios for the year ahead. The tail risk of extreme energy shortages in Europe is receding, the tight U.S. labor market supports consumer demand, and China’s reopening could buoy growth across Asia and the world.
While we expect further asset volatility in 2023, we don’t think it’s necessary or prudent to wait for a bottom, especially since history shows us it’s only possible to identify one once it has passed. On the equity side, we have started cost-averaging into high-quality, well-located assets that fit within the thematic sectors where we focus. Given the prospect for lower entry valuations, we think 2023 and 2024 are poised to be strong vintages for real estate equity funds.
On the credit side, we believe it remains a very attractive time to be a lender. Major lenders, including banks and many debt funds, are still effectively on the sidelines and capital markets remain stalled, although we are seeing signs of thawing. Those who have access to capital are able to lend on high-quality properties at higher all-in yields, lower leverage levels, and with more protective covenants than a year ago.
The current period of dislocation will likely generate attractive opportunities as property owners look to raise liquidity and delever capital structures. We continue to see sharp differences in performance both by geography and by sector, and we expect the gap between winners and losers to widen. Sector, asset, and market selection are paramount today.
Below, we dive further into our views by region:
Inflation seems to be peaking, and we expect the pace of Federal Reserve hikes to slow this year; though based on the strength of the labor market, we believe a dovish Fed call is off the table.
Our base-case scenario calls for a mild recession in the second half of the year, more akin to the shallow recession of 2001 than the harsh economic pullback of 2008. That said, we do expect a continued shakeout in real estate markets. Market participants are grappling with negative leverage and need lower prices to meet their required yields. Sellers have been slow to lower their pricing expectations, but transaction activity is starting to pick up as bid-ask spreads have compressed.
Within real estate equity, we’re looking to buy core-quality assets from motivated sellers at value-add pricing. If forward curves are correct, there will be significant refinancing optionality as both inflation and interest rates plateau or decline in outer years. We are seeing opportunities across the size spectrum (both small and large) and expect that the opportunity set will continue to evolve over the coming months and quarters.
From a financing perspective, debt capital is still in short supply, which, in turn, creates an environment in which lenders can be selective. Banks are still largely out of the market, and CMBS remains expensive (though credit spreads have been grinding tighter on stronger demand and lighter issuance). Further, many private debt funds are having a hard time sourcing senior financing, pushing them to the sidelines. Until the money center banks start lending and the capital markets start functioning more normally, we believe only those with the strongest lending relationships will able to finance high-quality properties on attractive terms. While we view real estate lending as an attractive evergreen opportunity, we think this period of outsized opportunity will persist until the banks come back into the market, which will likely take time. In the meantime, we see the most attractive opportunities in large loans, where the absence of banks and a slower CMBS market hit most acutely, and transitional loans, where the pullback from debt funds is creating a vacuum.
We are selectively investing behind our highest-conviction themes within our real estate equity and credit businesses, focusing on our favored sectors: all things housing (multifamily, student housing, self-storage, senior housing), industrial, and life sciences. Here is a brief rundown of our sub-asset class views:
- Residential: While rent growth is moderating, the asset class is still performing well and occupancy rates are high. Many would-be buyers are forming families later than in the past and opting to rent rather than own. This is a secular trend that should support the asset class for some time to come. Moreover, mortgages are expensive, reinforcing potential homebuyers’ propensity to rent versus own.
- Industrial: The market remains undersupplied, though additional supply is coming. The rise of e-commerce and onshoring continue to benefit the sector, but we will need to monitor consumer demand closely if and when economic growth slows. For the time being, rental growth remains strong.
- Office: While we remain constructive on well-located, amenitized, class A office assets with strong ESG credentials over the long-term, we have deep concerns about class B/suburban office and expect continued repricing and stress in the asset class.
2022 was a year defined by volatility and uncertainty across Europe. The war in Ukraine led to an energy crisis, resulting in record-high inflation to which central banks responded by embarking on the fastest hiking cycle in history. This caused risk to reprice across the region, though some markets adjusted more dramatically than others, with the U.K. at the forefront in terms of both the speed and magnitude of the correction.
Coming into 2023, Europe appears to be more resilient than expected. Our macro team recently revised its euro area real GDP forecast from contraction (-0.2%) to positive growth (+0.4%) this year. Industrial production, which was expected to be impacted by a decrease in the supply of gas, has not faltered. In fact, factories have cut gas consumption by a quarter with no impact on output. Thanks to a milder winter, combined with increased imports of liquefied natural gas, the prospect of forced rationing this winter and next has receded. Prices of natural gas have declined recently, though they are still two-to-three times above what would have been considered normal pre-war. Europe will likely come out of the winter heating season with 30 percentage points more gas in storage compared to the same time last year. With better gas storage levels, our macro team cut inflation forecasts, but headline inflation remains much too high for our taste (and that of the European Central Bank). Looking forward, we expect 2024 real GDP growth to improve to +1.4%, with the lagged effect of tighter monetary policy slightly dampening the potential upside.
Consumers are also in relatively good health, having saved nearly €1 trillion during the pandemic. They are also benefiting from a tight labor market and nominal wage growth that helps to partially offset the higher costs of food and energy. Meanwhile, fiscal discipline gives European governments the tools to support economic stabilization and recovery. Since the start of the energy crisis in September 2021, governments have earmarked €786 billion (with €265 billion by Germany alone) across European countries to protect consumers from rising energy prices. We also expect China’s reopening to provide a positive boost to sentiment and business prospects.
Interest rate hikes are likely to continue this year, but we think that the European Central Bank and the Bank of England have done most of the heavy lifting already. Rising rates and uncertainty due to the war in Ukraine will continue to put real estate valuations under pressure in the near term. However, the pipeline for new supply is very tight, which should support the long-term prospects of the asset class. It’s also important to note that rental growth has been healthy, albeit slower than in the United States, and should continue if consumer demand remains strong.
Several trends in Europe should also support long-term property demand. The war in Ukraine has encouraged near-shoring and reshoring, which should increase demand for logistics and industrial property. Further, given supply of high-quality space is constrained by inflation in construction costs and by strict planning systems, vacancy rates for prime industrial are at historic lows.
Europe was already a world leader in efforts to decarbonize and transition to renewable fuel sources, and the Russian energy embargo underscored the urgency of these efforts. The European Union has ambitious plans for decarbonization, including measures to support energy-efficient construction and rehabilitation of existing real estate. And the greening of real estate isn’t just a top-down push: occupier demand is skewed toward high-quality properties with strong sustainability credentials. We expect sustainability concerns to continue to be a core driver of value across new developments and the rehabilitation and renovation of older and noncompliant buildings.
On the credit side, liquidity in Europe is tight and more suited to smaller projects. A key theme is that size is not your friend – while liquidity is still available for deal sizes of c. €50-150 million, it’s constrained for larger assets. This is largely because some of the more active buyers are family offices, smaller funds, and unlevered buyers, which puts a natural cap on the size of equity tickets. Small amounts of bank capital is available, creating an opportunity for lenders with ready capital to step into the gap.
In the end, Europe is experiencing ongoing asset re-pricing, but we remain confident in the strong fundamentals of favored asset classes, mindful of the clear bifurcation between high-quality, well-located, sustainable properties over the alternatives, and optimistic about our ability to identify new opportunities and execute transactions.ASIA-PACIFIC
The Asia-Pacific “market” consists of many markets, at different points in the economic cycle and with different supply-and-demand dynamics. Keeping that in mind, we think it’s safe to say that the economic realities in Asia are generally different than they are in the United States and Europe. Growth is relatively strong, and inflation is relatively moderate. In fact, neither of the region’s two largest markets, China or Japan, is experiencing high inflation or rising rates on the order of what has happened in the U.S. and Europe.
The long-term growth profile for real estate is also different in Asia. Strong growth in domestic consumption and productivity have powered the region’s strong economic expansion to date, and the growth drivers of the future ― urbanization, Millennials forming households and consolidating their purchasing power, and the enormous, growing middle class ― all seem poised to increase both consumption and demand for real estate. In light of all these trends, we think that commercial real estate will likely be significantly undersupplied, particularly in some markets, in the long term.
In the near term, of course, supply-and-demand trends vary by country and sector. For example, the work-from-home trend that gained traction during the pandemic and still threatens office occupancy rates in Europe and the United States is generally not a factor in Asia. However, digging deeper, a brief tour of the region’s office markets shows:
- South Korea: We expect that the class A office sector will continue to experience low vacancy rates and strong rental growth. Logistics, on the other hand, is one area that is less attractive in South Korea than in other Asian economies due to supply concerns and a relative lack of debt funding.
- Hong Kong: The outlook for the office sector remains negative due to a record amount of supply and backfill space. A peg to the U.S. dollar has also driven up the cost of debt and will likely continue to do so.
- Australia: The commercial office sector remains healthy. While the return to office has been slower than in the rest of APAC, we do not expect a supply/demand imbalance as Australia has added 5% more jobs compared to pre-pandemic levels. This is primarily due to immigration, which is back above pre-pandemic levels and expected to approach an all-time high in 2023.
- Japan: Our focus in the commercial space is class B office buildings where we see the potential to upgrade and sell. In this sector, vacancy rates are stable, workers have returned to the office, and supply remains limited. On the other hand, class S office (above class A) is oversupplied.
The big story of the last quarter has been the end of China’s zero-COVID policy and what it means both for domestic demand as well as regional and global growth. China is still the region’s main growth engine, with an enormous, fast-urbanizing middle class. We expect that the first wave of infections post-opening has likely already peaked and that consumption should start to slowly return to pre-pandemic levels. Indeed, some early data shows that people have taken full advantage of relaxed rules, riding public transit and taking more domestic flights. We think that unleashing the pent-up demand of Chinese consumers will reverberate from Australia to Japan, and we are particularly bullish on hotels and other parts of the travel economy.
Longer-term, we favor logistics in China, which is vital to building out the country’s infrastructure, including the spread of e-commerce. As the costs of home ownership have risen in China, we also see strong opportunities in multifamily housing.
We also continue to find the Japanese market attractive, and our acquisition last year of KJR Management (“KJRM”), a leading Japanese real estate manager, provides us with unique access to this important real estate market. Japan is still benefitting from structural reforms designed to bolster return on equity, while inflation remains modest, and the 10-year Japanese government bond is yielding approximately 50 basis points. Lending is robust and spreads are attractive relative to unlevered cap rates. These conditions are creating meaningful new institutional demand for Japanese real estate, which we believe will continue to support cap rates. The Japanese market should also enjoy the cyclical tailwinds of a weaker currency and an increase in both domestic and international tourism.
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