Crunch Time: How a Real Estate Credit Crunch Could Benefit Investors

After decades of benign inflation, easy monetary policy, and low rates, we are being reminded what a rate shock means for real estate. The increase in interest rates over the last year has increased the cost of capital for all asset classes, which has meaningful, direct implications for the investment landscape. However, second-order effects of rate increases on real estate values and capital markets are arguably just as important, particularly the sharp decline in availability of debt capital for commercial real estate. In our view, the pullback in real estate debt markets will dictate both outcomes and opportunities for investors in the coming months and quarters.

As we continue to navigate all of the new dynamics of the current environment, we frequently hear a few key questions from our investors. In this letter, we will address these questions based on what our real estate team and KKR colleagues across the firm are observing.

• What are the root causes of the current commercial real estate (CRE) debt pullback?
• What are the second-order effects investors should watch?
• Is the focus on CRE loans on bank balance sheets justified? Are the real estate capital markets as dire as headlines suggest?
• How long could it be until liquidity returns to the market and capital markets resume more normalized functioning?
• What are the best investment opportunities today, and what opportunities will emerge over the course of the next year?

Ultimately, we believe the current market dynamics will create a once-in-a-decade real estate investing opportunity. The environment remains dynamic and complex, and the degree to which commercial real estate lenders are intertwined with one another is likely to complicate and prolong a return to normal liquidity conditions over the next year. We expect banks to remain on the sidelines for some time, in part because regional banks likely face tighter regulations that will curtail their lending activity. We do expect to see an uptick in defaults that will be concentrated in the office sector; however, we do not see office real estate loans or exposures as a systemic risk to banks.

For investors, the opportunity in real estate credit is here. Today’s commercial real estate loans have lower loan-to-value ratios (LTVs), better interest coverage on higher interest rates, and more lender-friendly covenants and structures. Non-bank lenders with the strongest relationships are at a particular advantage. In real estate equity, well-capitalized buyers are entering an attractive environment, as forced selling will likely bring high-quality assets to a market where many traditional buyers sit on the sidelines. We expect that many borrowers will need to recapitalize, seek equity infusions, or sell attractive assets as $1 trillion of commercial real estate loans mature in 2023 and 2024.

As we look across today’s market, we will cover the following themes: