Real Estate: Focus on Growth, Yield and Infl ation-Hedging - insiGHts GLOBAL MACRO TRENDS - KKR
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insiGHts GLOBAL MACRO TRENDS VOLUME 2.8 • SEPTEMBER 2012 Real Estate: Focus on Growth, Yield and Inflation-Hedging
Real Estate:
Focus on Growth, Yield
and Inflation-Hedging
In general, we are attracted to many parts of
the real estate market because we view the
asset class as a compelling play on our macro
view that growth, yield, and inflation hedging
KKR Global Macro & Asset
Allocation Team
powers are prerequisites for success in a Phase III
environment. We also like that real estate is global
Henry H. McVey in nature. Given these views, we think now is an
Head of Global Macro & appropriate time for investors to reconsider the
Asset Allocation
+1 (212) 519.1628
role of real estate in their overall asset allocations.
henry.mcvey@kkr.com
David R. McNellis
+1 (212) 519.1629
david.mcnellis@kkr.com
Frances B. Lim
+1 (212) 519.1630
frances.lim@kkr.com
Rebecca J. Ramsey
+1 (212) 519.1631
rebecca.ramsey@kkr.com
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Kohlberg Kravis Roberts & Co. L.P.
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All Rights Reserved.
2 KKR Insights: Global Macro TrendsOver the past few months we have used our monthly Global Insights real estate sector, since traditional lenders are being forced
pieces to delve deeper into both real assets and the U.S. housing to shrink their books and contract—rather than expand—their
market. Not surprisingly, quite a few clients have come back and businesses. All told, the refinancing needs by the U.S. commer-
asked whether traditional real estate fits into our overall construc- cial real estate industry are estimated to total $1.7 trillion over
tive view of real assets. The short answer is yes—we do favor real the next five years3. Further enhancing this opportunity for new
estate as an asset class for two simple reasons. First, we view entrants, in our view, is the disappearance of the shadow bank-
real estate as an elegant way to own an income producing inflation ing system, as well as tighter standards administered by the
hedge. We do not see inflation as a threat today, but as we describe credit-rating agencies.
below, the current policy of artificially holding nominal rates below
nominal GDP is almost always inflationary over time. Second, we 4.
4 On the international front, we also see a significant opportunity
think that real estate is a pure-play on financial disintermediation. in Europe to generate compelling returns through real estate
Specifically, as Wall Street shrinks its balance sheet commitments investments, particularly in distress-related situations. So far,
to the real estate industry, there is a significant opportunity for new Europe has deleveraged less than the United States, but we be-
entrants, particularly those with patient capital, to fill this void and lieve that tougher oversight, including the introduction of a new
earn attractive rates of return. cohesive bank regulator, will now force it to deleverage more.
That said, our “on the ground” visits to the Continent in recent
Given these favorable macro tailwinds, we are increasing our target months lead us to believe that real estate opportunities are more
allocation to real estate to 5% from 3%. To “pay” for this additional idiosyncratic than broad-based, and as a result, require both
exposure, we are reducing to zero our 2% allocation to gold, corn discipline and patience.
and other commodities—particularly in the wake of corn’s valuation
increase of 50% over the last seven weeks.1 Overall, though, our 5.
5 Investors may use REITs4 to gain exposure to real estate, but
10% overweight allocation to real assets remains unchanged. Our we believe they should heed their many shortcomings, such as
key conclusions and investment allocations are detailed in Exhibit 2. high correlation to other financial stocks, which in 2011 stood
at a sizeable 86%.5 In addition, publicly traded REITs constitute
So, what are our key conclusions and investment themes that we a relatively small part of the real estate investment universe,6
think investors should consider when allocating to the real estate so institutional investors face a significant hurdle when trying
sector? We would note the following: to deploy large sums of capital through this segment of the real
estate market.
11. In our view, real estate is most effective as an inflation hedge in
an extremely low-interest-rate environment, which is generally 6.
6 Similar to investments like venture capital, manager selection in
what we expect for the next few years. Our research shows that the real estate market can make all the difference. Moreover, as
if we are wrong and rates do rise more than our current expecta- we show below, the disparity of returns tends to widen in a low
tions in the near term, cap rates might be less vulnerable to this rate environment. In addition to disparities in property types and
sort of “shock” than some investors currently believe .2 Key to our locations, we also link at least some of the differential to the dif-
thinking is that there is now a substantial “buffer” between cap ferent degrees of leverage employed7. Our advice for the future:
rates and the yield on the 10-year Treasury. All told, as we detail Given the diversity of opportunity sets we see ahead, we think
in Exhibit 11, the spread currently stands at 332 basis points, or having as much flexibility as possible to deploy capital, includ-
one full standard deviation above its historical average since 1978. ing the ability to provide equity, mezzanine, or even traditional
loans, across a variety of industries and locations is likely to be
22. Although real-estate investments provide yield, growth, and a critical input to driving strong returns in the asset class.
inflation hedging (all key underpinnings to our long-term macro
view), we do think selectivity is warranted at this stage in the From an asset allocation perspective, we feel confident realizing
cycle. Specifically, today we feel that a decent chunk of the our gains on corn and other commodities and increasing our expo-
prime, or core, global real estate asset class is fairly valued and, sure to the non-core and opportunistic segments of the real estate
in some cases, outright expensive. By comparison, we believe market. This move is consistent with our desire to own — in size
there are compelling investments in the non-core and opportu- — real assets that can provide yield, growth, and inflation hedges
nistic segments of the real estate market that can provide inves- in today’s low, government-induced rate environment. Besides this
tors with a more attractive risk-adjusted return profile. The key, shift, there is no change to our asset allocation framework as our
we believe, is to understand which locations will benefit from preference for ‘spicy’ credit and other alternatives at the expense of
secular growth drivers in employment, including manufacturing government bonds, cash, and European equities remains unchanged
re-shoring, oil and gas exploration, education, and technologi- (Exhibit 2).
cal/healthcare advances.
3 See Exhibit 18.
33. Given the magnitude and severity of the financial and govern- 4 REITs are real estate investment trusts which can be either public or
ment deleveraging that still needs to occur, we think there is privately held. Public REITs are listed on public stock exchanges. Further
a large and growing opportunity in providing solutions to the information can be found at http://sec.gov/answers/reits.htm.
5 See Exhibit 29.
1 See Exhibit 3.
6 See Exhibit 30.
2 Cap (or capitalization) rates are used in real estate and denote the ratio of net
operating income to purchase price. 7 See Exhibit 31.
KKR Insights: Global Macro Trends 3Exhibit 1 Exhibit 3
Real Estate: Overall Real Estate Allocations are Low, Reducing Exposure on the Recent Surge in Corn Prices
Though Some Investors Are More Enamored
Corn No. 2 Yellow $ per bushel
850 Gold Spot $ per ounce 825 2,000
Private Real Estate Equity Allocations (% Total Assets)
8.4% 800 1,900
Corn up 50% since
2004 June 1, 2012
2010 5.9% 750 1,800
3.7% 700 1,700
3.3%
650 1,600
600 1,500
For All 1050 U.S. Public & Private For Members of the Pension Real
Plan Sponsors Estate Association
550 6/1/2012, 552 1,400
Source: Pension Real Estate Association Investor Report July 2011.
500 1,300
Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12
Exhibit 2
Data as at July 20, 2012. Source: Bloomberg.
Fine-tuning Our Target Allocation: We are Raising Real
Estate and Lowering Gold/Corn/Other
Exhibit 4
KKR GMAA
Target As- Strategy The Money Multiplier Doesn’t Work While Financials are
set Alloca- Bench- Differ-
Asset Class tion (%) mark (%) ence (%) Deleveraging
Public Equities 50 53 -3 Wall Street Assets-to-Equity Ratio (Left Axis)
U.S. 20 20 0 U.S. Money Multiplier (Right Axis)
Europe 12 15 -3 20 10
All Asia 12 12 0 1Q08, 9.3
9
18 4Q08, 17.9
Latin America 6 6 0
8
Total Fixed Income 25 30 -5
16 Period of
Global Government 5 20 -15 7
deleveraging
Mezzanine 5 0 5
14 6
High Yield 5 5 0
High Grade 5 5 0 11.3 5
12
EMD 5 0 5
4
Real Assets 10 5 5 3.7
10
3
Real Estate 5 2 3
?
Energy/Infrastruc- 5 2 3 8 2
ture 2005 2006 2007 2008 2009 2010 2011 2012 2013
Gold/Corn/Other 0 1 -1
Money multiplier = M2/Monetary Base. Wall Street Assets to Equity
Other Alternatives 15 10 5 Ratio is an aggregate of GS, MS, BAC, C, JPM and WFC balance sheets.
Traditional PE 5 5 0 Data as at 1Q2012. Source: Factset.
Distressed & Spe- 5 0 5
cial Situation
Other 5 5 0 Real Estate as an Inflation Hedge
Cash 0 2 -2
If an investor is worried about inflation today, we think his or her
Data as at August 31, 2012. Source: Strategy benchmark is the typical angst is probably misguided. As one can see in Exhibit 4 delever-
allocation of a large US pension plan. Source: KKR Global Macro and aging is usually disinflationary as it almost always pressures the
Asset Allocation as at August 31, 2012.
money multiplier. Importantly, though, we are investing today for
tomorrow, and as we peer around the corner and look ahead, we do
4 KKR Insights: Global Macro Trendsnot see how massive debt loads around the world contract without Exhibit 6
some form of inflation over time. All told, the U.S. government has
increased its massive debt overhang by $6.6 trillion to $15.5 trillion Many Central Banks Are Holding Interest Rates Below
in 2011 from $8.9 trillion in 2006.8 GDP Growth, Which Could Ignite Inflation Over Time
History suggests that governments have several options for at- Fed Funds - Nominal GDP Growth 3yr Moving Avg.
tacking excessive debt loads. One option is to significantly raise 8.0%
government revenues through higher taxes; the other is to cut 6.0% 1982
social benefits. However, neither seems particularly popular in a 5.7%
slow-growing economy and a demographic environment in which a 4.0%
End of End of
new baby-boomer turns 65 every 8 seconds.9 2.0% Stagflation Disinflation?
0.9%
Exhibit 5 0.0%
Cutting Expenses or Raising Revenues Via Higher Taxes -2.0%
Has Not Been Attractive Options -4.0%
1978 2014e
U.S. Federal Revenues and Primary (Noninterest) Spending -6.0% -5.7% 2005 -4.0%
-4.0%
-8.0%
Revenues % GDP Primary Spending % GDP 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014e
26%
e = KKR Global Macro & Asset Allocation estimates as of April 5, 2012.
1960 to current. Source: KKR Global Macro & Asset Allocation analysis
24% Current trends are of Federal Reserve and Bureau of Economic Analysis data.
unsustainable
22%
20%
A third alternative, which the government is currently pursuing
and is almost always inflationary in nature, is to hold interest rates
down and do whatever it can to get nominal GDP growth above
18%
nominal interest rates in order to reduce the debt burden over time.
As Exhibit 7 shows, after about a three-year period of this strategy,
16%
inflation typically starts to increase — and typically at a pretty good
clip.
14%
1975
1978
1981
1987
1993
1996
1999
2011
2014e
2002
1990
2005
2008
2017e
2020e
1984
2032e
2026e
2023e
2029e
2035e
1972
e = estimate. Revenue estimates assume federal revenues as a % of
GDP revert to historical average of 18%. Primary (noninterest) spending
estimates are as per CBO long-term forecasts published June 5, 2011.
Source: Congressional Budget Office, KKR Global Macro & Asset
Allocation analysis.
“
Real estate appears to serve as
an effective inflation hedge in
very high or low interest-rate
environments.
“
8 Total liabilities of U.S. federal, state and local governments as of June 7,
2012. Source: Federal Reserve Board.
9 Spiegelman, Randy, “Spending Confidently in Retirement,” Schwab Center for
Investment Research, March 2004.
KKR Insights: Global Macro Trends 5exHibit 7 exHibit 9
Historically, There Is A Strong Relationship Between Fed Inflation Hedging Power of Real Estate is Strong,
Policy and the Direction of Inflation Two Years Later… Particularly in a Low Rate Environment
y = -19.0%x - 0.3% Correlation of Real Estate Indexes and
Y/Y CHANGE IN INFLATION RATE 2YRS LATER (3YR CAGR)
R = 43.4% Inflation in Various Yield Environments
2.0%
1.5% Fed funds 4% below
GDP today correlates NCREIF Total Rate of Return on Real Estate
1.0% with inflation rising FTSE NAREIT Equity REITs Total Return Index
~0.5%/year by 2014
0.5%
59%
Correlation against Inflation
57%
0.0% 51%
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
-1% -3%
-8% -6% -4% -2% 0% 2% 4% 6% 8%
-11%
FED FUNDS - NOMINAL GDP (3YR MOVING AVG.)
e = KKr global Macro & asset allocation estimates as of april 5, 2012. 0-4% 4-8% >8%
1957 to current. source: KKr global Macro & asset allocation analysis
US 10 Year Yield (%)
of Federal reserve and bureau of economic analysis data.
chart data from 1Q1978 to 3Q2011. correlation of Us consumer Price
Index quarter-over-quarter change against ncreIF total rate of return
on real estate10 and nareIt equity reIts quarterly total returns.
exHibit 8
source: bureau of labor statistics, national council of real estate
Investment Fiduciaries, Federal reserve board, bloomberg.
…Which Means We Should Finally Start to See Some
Inflation by 2015
US Inflation Forecast (Left Axis) exHibit 10
3.5% 6%
US Fed Funds Forecast (Right Axis)
Traditional Inflation Hedges Have Gotten
3.0% 5% Quite Expensive
We should start to see
some inflation in 2015
2.5% 5.00 U.S. 10 Year TIPS Yield %
4% U.S. 5 Year TIPS Yield %
2.0% 4.00
3%
1.5% 3.00
2%
1.0% 2.00
0.5% 1%
1.00
0.0% 0% 0.00
2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 2016e
source: KKr global Macro & asset allocation analysis. Negative yields make TIPs less -0.70
-1.00
attractive as an inflation hedge -1.17
-2.00
as we show in Exhibit 9, real estate actually performs best as an 1997 2000 2003 2006 2009 2012
inflation hedge in a low rate environment, particularly if economic data as at July 24, 2012. source: bloomberg.
growth is moderate to solid. so, it appears that real estate should do
well as an asset class in today’s low rate, muddle through environ-
ment. We also think real estate looks quite compelling relative to the
alternatives. In particular, given that treasury Inflation Protected
securities (tIPs) have a negative yield (Exhibit 10), anything with a 10 ncreIF total rate of return on real estate, where quarterly rates of
positive carry and some growth and inflation protection seems like return on real estate investments are calculated with net operating income,
a compelling arbitrage these days. appreciation in market value and improvements made to the property. For
more details, visit ncreIF.org.
6 KKR InsIghts: global Macro trendsHowever, if we are wrong and interest rates climb into the 4–8% Exhibit 12
range, real estate may prove less effective as a hedge, as history
shows (Exhibit 9). This is a risk, albeit one that we don’t believe Cap Rates Have Not Dropped As Quickly
will materialize. Key to our thinking is that from almost any vantage As Treasury Yields
point, we believe the U.S. government’s debt load is just too big for NCREIF Value Weighted Cap Rate %
the Federal Reserve to allow rates to increase that much before 10 Yr Treasury Yield %
employment levels regain their footing and progress is made toward 16
fiscal rebalancing. Indeed, if the cost of the government’s debt had
risen to 6% unchecked, the 2011 fiscal budget deficit would have 14
inflated by 300 basis points to a sizeable 11.3% of annual GDP11.
12
Separately, we would also just highlight that any material increase 2Q95 2Q01
in interest rates would be wholly inconsistent with current quanti- 10 8.9 8.5
tative easing initiatives and the Fed’s intention of holding nominal
interest rates below nominal GDP for an extended period of time. 8
3Q08
6 4.9
Probably more important, though, is that we believe if rates none- 5.5
theless begin to climb in the near term, the current spread between 4Q89
4 5.9
cap rates and the risk free rate should act as an initial cushion. All
told, the current spread between cap rates and the 10-year U.S. 2 1.6
Treasury yield stands at 332 basis points, or one standard deviation
0
above its average since 1978 (Exhibit 11). At today’s 10-year Trea-
1978 1984 1990 1996 2002 2008
sury yield, this excess spread equates to 315 basis points of “buf-
fer” that the cap rate has in excess of the risk free rate. So, similar Cap rate as of 1Q2012, 10-year treasury yield as of June 30, 2012. Note:
to the previous argument we made about corporate bond yields NCREIF Value weighted cap rates excludes hotels, hence the cap rate is
lower than those of other data sources. Source: NCREIF, Bloomberg.
relative to Treasuries a few months back, our belief is that any
initial back-up in the interest rate is likely to be muted, for the most
part, by the spread of the cap rate over the risk-free rate “normal-
izing” before heading higher in tandem12. So what’s our bottom line? As we think about real estate’s role in
asset allocation on a short- to medium-term basis, we are quite
Exhibit 11 optimistic about real estate’s attractive performance in a low rate en-
vironment because cap rates are likely to remain low in the near-term
Cap Rate Spread is One Standard Deviation
as Europe deleverages and the United States attempts to address its
Above Average fiscal woes. Moreover, as inflationary pressures begin to gain mo-
Spread Between Cap Rate and 10 Yr Treasury Yield (Bps) mentum as a result of the current policy of holding nominal interest
rates below nominal GDP for an extended time, our research leads
600 us to expect that any increase in nominal rates to account for higher
1Q12, 332 inflation should be offset initially by a normalization of the spread be-
400 +1 tween cap rates and the risk-free rate for at least the next 4–6 years.
200 315bp
buffer Core is Expensive, and We See Better Value in Non-Traditional
Avg, 17
0 Areas
-200 Core properties are typically high-quality assets in prime loca-
-1
tions—with high occupancy rates by high quality tenants—and their
-400 ownership stakes are characterized by relatively low leverage.
Think Midtown Manhattan or London West End.
-600
-800 Within core, there are broadly four categories of assets: office, re-
tail, industrial, and multifamily. Theoretically, core real estate, which
-1,000 tends to reward investors in the form of basic cash-flowing assets,
1978 1982 1986 1990 1994 1998 2002 2006 2010 should be a strong play on our demographic thesis that favors yield
Data as at 1Q2012. Source: NCREIF Value Weighted Cap Rate. and growth.13
However, despite Andrew Carnegie’s famous decree that “90% of
11 The 2011 U.S. budget deficit was 8.3% (federal deficit of $1,250B divided by all millionaires become so through owning real estate14,” we are
nominal GDP was $15,094B). Total public securities was $15,223B, so an
additional 300bp in interest rates would have brought the deficit up to 11.3%. 13 See our paper entitled “Brave New World: The Yearning for Yield Across Asset
Data as at July 12, 2012. Source: U.S. Treasury, Bureau of Economic Analysis. Classes,” December 2011, available at www.kkrinsights.com.
12 See our paper entitled “Portfolio Construction at the Dawn of 2012: Challenging 14 From “Autobiography of Andrew Carnegie”, Andrew Carnegie, Published by
Conventional Wisdom,” February 2012, available at www.kkrinsights.com. The Echo Library, Middlesex, England TW11, 1920.
KKR Insights: Global Macro Trends 7somewhat leery of the core market these days. Many investors, Exhibit 14
scathed by opportunistic real-estate investments that turned sour
following the 2008–2009 financial crisis, have flooded the core
Core Seems Fully Priced In Many Locations
market with capital. And as financial crises batter the likes of Spain, Cap Rates (%)
Greece, and other peripheral countries, we believe foreigners are
redirecting large sums of personal net worth toward high-end real
Sydney Industrial 8.9
estate in prime locations in such cities as London.
U.S. Industrial 7.7
Toronto Industrial 7.3
Our research shows that, in aggregate, much of the core market has
become expensive, with cap rates falling in some instances more Sydney Retail 7.1
than 200 basis points from their 2009 peak (Exhibit 13). In highly U.S. Hotel 7.0
coveted areas like Manhattan, cap rates have fallen even lower, U.S. Retail 6.9
towards an average of just 4.6%, while Hong Kong and Singapore Stockholm Industrial 6.9
have cap rates of just 2.9% and 4.2%, respectively (Exhibit 14). London Industrial 6.5
That level of yield may appeal to some, particularly against treasury U.S. Apartment 6.0
yields of just 1.4%.15 But we think that for investments that tie up Paris Retail 5.7
capital for several years (such as real estate), the “net” return to London Office 5.7
investors should embody an illiquidity premium that would bring the Stockholm Office 5.4
yield into the mid-to-high single-digit range, or even higher. We be-
Tokyo Office 5.4
lieve this premium, in many instances, is not reflected in investors’
London Retail 5.0
total-return analysis.
Manhattan 4.9
Exhibit 13 Manhattan Apartment 4.6
Core seems
Singapore Office 4.2
The Core Pool is Getting Crowded fully priced
Hong Kong Retail 2.9
Change in Core Cap Rates Between 2009 to Current (Bp)
Data as at May 31, 2012. Source: Real Capital Analytics, Bloomberg.
Sydney Retail -210
Kowloon Retail -200
U.S. Office -200 On the other hand, we believe there are a lot of interesting invest-
Hong Kong Retail -180 ment opportunities in non-core properties, despite their typically
Hong Kong Office -160 less desirable locations, lower occupancy rates, and/or greater need
London Retail -160 of renovation relative to core assets.16 In particular, we see several
London Office -160 non-core locations outside major metropolitan areas that are now
Manhattan Apartment -150 experiencing equal or stronger growth rates than core locations
U.S. Industrial -150 in New York and London—and that are more attractively valued
U.S. Apartment -130 (Exhibit 15). While non-core properties do carry their share of risks,
U.S. Retail -130
we believe their current valuations and potential returns can more
London Industrial -110
than compensate investors—especially compared to many prime
properties on offer.
Paris Office -100
Melbourne Industrial -90
Sydney Industrial -80 “
Data as at May 31, 2012. Source: Real Capital Analytics, Bloomberg. Investors may use REITs to gain
exposure to real estate, but we
believe they should heed their
many shortcomings, such as high
correlation to other financial stocks.
“
16 Core real estate assets are generally high quality assets, in prime urban
locations, with high occupancy rates, high quality tenants, relatively low
leverage and relatively high barrier to entry, generally made up of office,
retail, industrial, and multifamily properties. Non-core properties include
hotel, healthcare/senior housing, self-storage, and other niche sectors.
15 Data as at July 24, 2012. Source: Bloomberg. Source: KKR Global Macro & Asset Allocation analysis.
8 KKR Insights: Global Macro TrendsexHibit 15 Opportunistic Part of the Market Is a Direct Play on our Macro
Worldview
Example of Return Progression
We also find the opportunistic segment of the private real-estate
Real Estate Return Progression (%)
market compelling as a play on our Phase III thesis of heightened
Core Non-Core volatility and deleveraging (Exhibit 17). We believe as economic
5.0-6.0 15.0-18.0
cycles become shorter and more volatile, financing needs tend
to rise—and with them, opportunity. after all, traditional financial
intermediaries are less levered and have a smaller appetite for il-
4.0-5.0 liquid investments in today’s environment. In our view, this back-
drop opens the door for private, non-traditional lenders with flexible
financing capabilities to step in and provide the necessary capital
5.5-7.0 to complete transactions—whether in bridge equity, restructuring,
reorganization or spin-offs—especially with predictions calling for
refinancing needs of $1.7 trillion by the U.s. commercial real estate
industry over the next five years (Exhibit 18).
exHibit 17
Unleveraged Assuming 60% Market Value / Opportunistic
Core Leverage Growth Return De-Leveraging Often Leads to Shorter Economic Cycles
data as at May 31, 2012. source: KKr global Macro & asset allocation and More Volatility, Which Makes Opportunistic Lending
analysis. More Necessary
140
exHibit 16
DURATION OF ECONOMIC EXPANSION (MONTHS)
R² = 52.5%
120
Cap Rates Vary by Type and Location
100
ClAss A offiCe CBD
80
neW YorK cItY 4.50% - 5.00% core
60
WashIngton, dc 4.75% - 5.25% 1949-1953
1954-1957
dallas 8.00% - 9.00% 40 1945-1948
detroIt 8.50% - 10.00% non-core 2009-Current
20
1958-1960
ClAss A RetAil PoWeR CenteRs 0
20 40 60 80 100 120 140
seattle 5.50% - 6.50% core
US GOVERNMENT DEBT % GDP
WashIngton, dc 6.00% - 6.50% economic expansions from 1900 to 2012. sources: nber, bea, U.s.
treasury, and KKr global Macro & asset allocation analysis. data as at
PhIladelPhIa 7.25% - 7.75% July 31, 2012.
nashvIlle 8.00% - 8.50% non-core
ClAss A inDustRiAl
“
los angeles 5.00% - 5.50% core
We believe there are more
MIaMI 5.25% - 6.25%
compelling opportunities in
colUMbUs 7.75% - 8.25% the non-core and opportunistic
el Paso 8.25% - 9.00% non-core segments of the real estate market
source: cb richard ellis cap rate survey Published February 2012 for that can provide investors a more
2h2011.
attractive risk-adjusted return.
“
KKR InsIghts: global Macro trends 9Exhibit 18 Exhibit 20
In the U.S. There’s About $1.7 Trillion of CRE Maturing Mortgage REIT Yields Reflect a Changing Financial
Over the Next 5 Years Services System
U.S. Commercial Real Estate Debt Maturing Mortgage REIT Dividend Yields (%)
11.9%
$1.7 trillion in US CRE US$ Billion
to mature over the next 5 years
372
349 Other
329 335 331 Life Cos.
298 CMBS
Banks
4.3%
141
100
77
2012 2013 2014 2015 2016 2017 2018 2019 2020
January 2007 June 2012
Data as at April 30, 2012. Sources: Trepp, Morgan Stanley.
Average equity dividend yield of NLY, MFA, CMO, RWT, NCT, ANH. Data
as at June 30, 2012. Source: Bloomberg.
Besides Wall Street’s downsizing, the shadow banking system has
contracted, too. Nowhere is this truer than in the mortgage market:
Issuance of non-agency residential mortgage-backed securities But it’s not just mortgages. As the shadow banking system has con-
(RMBS) and commercial mortgage-backed securities (CMBS) has tracted, we believe real-estate investors have a compelling oppor-
shrunk 95% to $37 billion in 2011, down from $766 billion in 2007 tunity in such areas as mezzanine to earn similar returns with more
(Exhibit 19). As a result, the cost of capital for financing the shadow rewarding risk/return profiles in today’s market. This opportunity is
banking system has skyrocketed; mortgage REIT yields, which are apparent not only in valuations but also in the levels of seniority and
a good proxy for cost of equity, are now at 11.9%, up from 4.3% in leverage in the capital structure (Exhibit 22), particularly after the
January 2007 (Exhibit 20). 34–39% correction in commercial real estate prices.17
Exhibit 19 Exhibit 21
The Shadow Banking Market Has Collapsed Real Estate Mezzanine is Typically Higher Risk Credit…
U.S. Mortgage Related Issuance Commercial Real Estate Loans:
US$B Internal Rate of Return (IRR)
Agency MBS 7.5-11%
3500 3180 Agency Agency CMO
Agency Other
3000 Non-agency is now Non-Agency CMBS 5.0-7.5%
virtually non-existent Non-Agency RMBS
2500 3.5-5.0%
2231 -26%
2000
1660
1500
951 Senior Loan Junior Loan Mezzanine
1000
Source: RREEF Real Estate, “U.S. Real Estate Strategic Outlook,” March
500 2012.
0
2011
YTD
2001
2010
2002
2004
2008
2006
2009
2003
2007
2005
Year-to-date through June 30, 2012. Sources: SIFMA, Dealogic, FDIC,
GSEs, NCUA, Thomson Reuters, Bloomberg.
17 From 2007 peak to 2009 trough, commercial real estate prices fell 34% per
NCREIF transaction based price index, 37% per Green Street Price index, and
39% per Real Capital Analytics. Data as at 1Q2012. Source: NCREIF, Green
Street, Real Capital Analytics.
10 KKR Insights: Global Macro TrendsExhibit 22 Exhibit 23
…But Real Estate Mezzanine is Starting from a Lower Risk Deleveraging Cycles Take Roughly Six Years
Base These Days
Real Lending Growth Rate (% Change From Year Earlier)
Real Estate Capital Stack Evolution 35 35
Finland (1990 = 0)
$100 Norway (1988 = 0)
30 30
10
$90 Mezz LTV of Spain Sweden (1990 = 0)
10 80% or above 25 25
United Kingdom (2008 = 0)
$80
Mezz LTV of 20 Spain (2009 = 0) 20
15 Equity
$70 60% or above US (2008 = 0)
15
15 Japan (1992 = 0) 15
$60 Mezzanine
16 8
10 Norway 10
$50 Junior Loan Finland
11
10 (B-Note) UK
$40 5 5
65 10 Senior Loan
$30 (A-Note) 0 0
$20 41 -5 -5
29 Japan
$10
-10 -10
US Sweden
$0
2007 2009 2012 -15 -15
-3 -2 -1 0 1 2 3 4 5 6 7 8 9 10
Source: CB Richard Ellis presentation, “Capital Stack for 2012,” YEARS FROM START OF CRISIS
February 2012, Mortgage Bankers Association.
Source: Bank of England, Financial Stability Report, Thompson
Datastream, Bank Calculations, and Morgan Stanley Research. Finland
and Japan represent bank lending and all other series represent lending
by financial institutions, report dated December 6, 2011: European
International Opportunities
Banks 2012 Outlook – Deleveraging remains the key theme.
“Any fool can make things bigger, more complex,
and more violent.”
Exhibit 24
-Albert Einstein
One Percentage Point of Fiscal Contraction Has Equated
These days it takes a touch of genius—and a lot of courage—to to 1.6% Slower GDP Growth
move in the opposite direction of convention, which is precisely why
Europe’s predicament requires both genius and courage to solve. 3% Germany
Our base case is that, as European banks slowly deleverage over the
ANNUALIZED REAL GDP GROWTH ('09-'12E)
2%
next few years, history will probably repeat itself, and lending will France
1%
remain muted for some time (Exhibit 23). There are also likely to be
Spain Ireland
a lot of adjustments in the European corporate sector as companies 0%
Italy
are forced to deal with the fallout from the efforts of member states -1% Portugal
to reduce their fiscal deficits to 3% in coming years (Exhibit 24).
-2%
-3% y = -1.6x + 3.5%
R² = 80.6%
-4%
“ -5% Greece
We find the opportunistic segment -6%
0% 1% 2% 3% 4%
of the private real-estate market PRIMARY DEFICIT REDUCTION, % GDP PER YEAR ('09-'12E)
compelling as a play on our Phase e = IMF estimates updated as of April 2012. Source: KKR Global Macro
III thesis of heightened volatility & Asset Allocation analysis of IMF data.
and deleveraging, which tend to
increase financing needs. No doubt, we believe the potential deleveraging of Europe’s finan-
cial-services industry appears to qualify as a large and compelling
“ opportunity for anyone with capital and involved in real estate. One
can see this in Exhibits 23 and 25. According to the investment
bank Morgan Stanley, European commercial real estate faces a
KKR Insights: Global Macro Trends 11€400–700 billion financing gap, mainly from bank deleveraging.18 Exhibit 26
In all, banks are set to reduce their exposure by €300–600 billion,
or 12–25% of the total. Further, run-offs on CMBS and open-ended Composition is Shifting Towards Asia
fund liquidations could generate an additional outflow of €100 bil-
Regional Composition of Global CRE
lion. This potentially opens a total financing gap of €400 –700 bil-
100%
lion for non-bank lenders to plug. Such alternative lenders will most
90%
probably be “niche players” and thus cherry-pick their opportuni-
80% GCC
ties, offsetting this gap by perhaps only €100–200 billion, according
70% North America
to our estimate. This then could leave a €300–600 billion gap in
60% Latin America
need of funding.
50% 27% Asia-Pacific
39% 49%
40% Europe
Importantly, though, we expect the process of asset-shedding by
30%
European banks to be more evolutionary than revolutionary. Why?
20%
Because we think the banks will face challenges in jettisoning those
10%
assets off their balance sheets without significantly impacting their
0%
equity. So, our research shows that while we clearly expect asset 2011 2021 2031
sales to accelerate, our base case is that European deleveraging
could be more incremental than many anticipate as many banks Data as at December 31, 2011. Sources: Economist Intelligence Unit,
International Monetary Fund, Prudential Real Estate Investors Research.
will be forced to ‘extend and pretend.’ Thus, we expect the banks to
abstain from renewing lines of credit or terminate non-core lending
relationships—rather than engage in massive loan sales across the
board in a hurried fashion. Meanwhile, we believe there should be Separately, having traveled extensively to the emerging markets, we
compelling demand for refinancing in the market (Exhibit 25). believe that rising consumption and urbanization trends are creating
attractive investment opportunities. As GDP per capita improves,
So, our bottom line is that opportunity to invest in European real es- we expect the usage of office, hotels, and apartments to increase—
tate is still appealing from a return perspective, but we think it will but as with any investment in emerging markets, finding the right
require patient, flexible capital, and the ability to operate in multiple local partner, understanding the pricing model, and assembling the
countries across the region. appropriate transaction is more art than science. We’ve witnessed
multiple instances in which input costs, project delays, and cost
Exhibit 25 overruns have all diminished opportunities that were theoretically
attractive—and even resulted in losses.
In Europe 55% of CRE or €530B is Due Within the Next
Three Years Exhibit 27
€ Billion
Europe Commercial Real Estate Debt Maturing Driven by the Emerging Middle Class
250
€960B of debt maturing over the next Global Middle Class (mm of people)
10 years of which 55% or €530 billion
is due within the next 3 years 338 2009
200 North America 333
2020
322
The middle class 2030
CMBS Other 664 population in Asia
150 Europe 703 will grow 515% from
680 525m strong in 2009
to 3.3 billion
Central and South 181
100 251
America 313
525
50 Asia Pacific 1,740
3,228
32
0 Sub-Saharan Africa 57
2011 2012 2013 2014 2015 2016 2017 2018+ 107
Data as at December 31, 2010. Sources: CB Richard Ellis, Bloomberg, Middle East and 105
North Africa 165
Trepp, Morgan Stanley. 234
Data as at January 31, 2010. Source: OECD.
18 Source: “Implications of a €400–700 Billion Financing Gap,” Morgan Stanley
Research, March 2012.
12 KKR Insights: Global Macro TrendsExhibit 28 Exhibit 29
Asia Middle Class to Grow Six Fold to 3.2 Trillion REITs are Highly Correlated to Financials…
From 0.5 Trillion
52-week Correlation Between REITs
and S&P 500 Financials Index
Middle Class Population 100%
2030 vs 86%
90%
In Millions 2009 2020 2030 2009
80%
North America 338 333 322 -5% 70%
60%
Europe 664 703 680 2%
50%
Central and 181 251 313 73% 40%
South America 30% 25%
20%
Asia Pacific 525 1,740 3,228 515%
10%
Sub-Saharan 32 57 107 234% 0%
Africa 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Middle East and 105 165 234 123% Using Dow Jones Equity REIT Total Return Index and S&P 500
North Africa Financials Total Return Index. Data as at December 31, 2011. Source:
Bloomberg, S&P, Dow Jones.
World 1,845 3,249 4,884 165%
Data as at January 31, 2010. Source: OECD. Exhibit 30
…and a Very Small Pool of Assets
REITs: A Tough Way for Institutional Investors to Play Real
Total Value of Various Real Estate Markets
Estate
10 9.4
US$ Trillions
In recent years, we have seen an increasing number of individuals 9
7.5
and institutions seeking exposure to real estate via REITs. While 8 7.2
we favor the liquidity of REITs, investors—particularly the sophisti- 7
6
cated individual and institutional variety—should be aware of their REITs are a Very
5
shortcomings too. These include their high correlation to financial- Small Universe
4
services equities, which reduces their diversification benefit (Ex-
3 1.8
hibit 29). For one, consider the 86% correlation between REITs and 2
the S&P 500 Financials index over the past year compared to the 0.4 0.7
1
-7.5% correlation between the NCREIF Transaction Based Return 0
index and the S&P 500 Financials over the last 20 quarters ended U.S. REITs GCC CRE Latin Asia- North Europe
1Q2012.19 America Pacific CRE America CRE
CRE CRE
The sector’s relatively small size is also a factor institutional inves- GCC = Gulf Cooperation Council; CRE = Commercial Real Estate. Data
tors should consider: REITs make up just 2.7% of the S&P 1500 as at December 31, 2011. Source: NAREIT, Economist Intelligence Unit.
Super Composite index20. That’s a quite small representation in a International Monetary Fund, Prudential Real Estate Investors Research;
data for 2011.
diversified portfolio. In absolute dollars, the total public equity REIT
market capitalization is a mere $0.4 trillion, according to National
Association of Real Estate Investment Trusts, compared to the $7.5
trillion U.S. Commercial Real Estate market (and that excludes U.S. The bottom line is that although we perceive public REITs as poten-
household real estate, worth an additional $18.1 trillion21). So we tial destinations for tactical investments at the margins of a core al-
believe the REIT market really isn’t a viable mainstream option for location to real estate, we do not think that they are well-positioned
large institutions looking to invest sizeable sums of money to work to serve as a core allocation per se. This could change over time if
on behalf of their pensioners or retirees (Exhibit 30). the public REIT universe market capitalization increases substan-
tially and its correlation to equities decreases significantly, but we
19 Past 20 quarters of returns from 2Q2007 to 1Q2012 of NCREIF Commercial
Real Estate Transaction-Based Total Return Index against the S&P 500 do not see this happening in the near term.
Financials Total Return Index. Source: KKR Global Macro & Asset Allocation
analysis.
20 The S&P 500 Super Composite Index is approximately 90% of the U.S. equity
market capitalization. Source: http://www.standardandpoors.com/indices/sp-
composite-1500/en/us/?indexId=spusa-15--usduf--p-us---.
21 Data as at 4Q2011. Source: Federal Reserve Flow of Funds.
KKR Insights: Global Macro Trends 13Summary exHibit 31
In our view, today’s environment presents attractive investment Manager Selection Matters: Dispersion of Real Estate
opportunities in certain parts of the real estate market that can Returns Vary Significantly…
provide yield, growth and an inflation hedge. We favor opportunistic
150 Internal Rates of Return (%) Net to Limited Partners
investments that capitalize on Wall street’s need to shrink its expo- of All Real Estate Fund by Quartiles Vintage
sure to real estate financing, and also view compelling opportuni- Years 1994-2008 as of September 30, 2011
ties in non-prime (or non-core) properties with defensible business
models and moderate-to-solid growth potential. the key, though, 100
we believe, is to find cap rates that allow room for growth and that
properly compensate investors for illiquidity and leverage.
INTERNAL RATE OF RETURN (%)
50
Yet manager selection is paramount, as in any global investment en-
tailing leverage that is affected by multiple economic factors. In the
words of english poet herbert read, “Progress is measured by the 0
degree of differentiation within a society.”22 he might as well have
referred to real-estate returns. In 2008, for example, the median re-
High
turn of real-estate funds was 3.3%, with a high of 44.6% and a low -50 Upper Quartile
of -96.2%—a spread of 140 percentage points, no less (Exhibit 31). Lower Quartile
return dispersion is often higher when cap rates are low, like they Low
are today (Exhibit 32). therefore, as we look ahead, our view is to -100 Median
favor managers with flexible capital that can step in and provide the
necessary financing to earn sound risk-adjusted returns in today’s
unstable macro environment.
data as at september 30, 2011. source: cambridge associates llc non-
Marketable alternative assets database. notes: based on data compiled
from 443 real estate funds, including fully liquidated partnerships,
formed between 1994 and 2008. Internal rates of return are net of
fees, expenses, and carried interest. as of september 30, 2011, there
were an insignificant number of funds in vintage year 2009 and 2010
that had called capital. vintage year funds formed since 2008 are too
young to have produced meaningful returns. analysis and comparison of
partnership returns to these benchmark statistics may be irrelevant.
exHibit 32
…Particularly When Cap Rates are Low
“ Return Spread vs Cap Rate
As the shadow banking system 9.0
R² = 38%
has contracted, we believe real- 8.5
estate investors have a compelling
NCREIF VALUE WEIGHTED CAP RATE
8.0
opportunity in such areas as 7.5
7.0
mezzanine to earn similar returns 6.5
with more rewarding risk/return 6.0
The lower cap
rates are...
profile in today’s market. 5.5
“ 5.0
...the wider is the divergence
4.5
in real estate returns
4.0
0 30 60 90 120 150 180
PERCENTAGE POINT SPREAD BETWEEN HIGH AND LOW RETURN*
* real estate return spread between high and low return in exhibit 31.
sources: cambridge associates llc non-Marketable alternative assets
database, ncreIF value Weighted cap rates.
22 “the Philosophy of anarchism” by herbert read, first published september
1940 by Freedom Press. 27, red lion street. london, Wc1.
14 KKR InsIghts: global Macro trendsImportant Information is only as current as of the date indicated, and may be current as of the date indicated. There is no assurance
superseded by subsequent market events or for other that such events or targets will be achieved, and may
The views expressed in this publication are the per- reasons. Charts and graphs provided herein are for be significantly different from that shown here. The
sonal views of Henry McVey of Kohlberg Kravis Roberts illustrative purposes only. The information in this docu- information in this document, including statements
& Co. L.P. (together with its affiliates, “KKR”) and do ment has been developed internally and/or obtained concerning financial market trends, is based on current
not necessarily reflect the views of KKR itself. This from sources believed to be reliable; however, neither market conditions, which will fluctuate and may be
document is not research and should not be treated as KKR nor Mr. McVey guarantees the accuracy, adequacy superseded by subsequent market events or for other
research. This document does not represent valuation or completeness of such information. Nothing contained reasons. Performance of all cited indices is calculated
judgments with respect to any financial instrument, herein constitutes investment, legal, tax or other advice on a total return basis with dividends reinvested. The
issuer, security or sector that may be described or nor is it to be relied on in making an investment or indices do not include any expenses, fees or charges
referenced herein and does not represent a formal other decision. and are unmanaged and should not be considered
or official view of KKR. It is being provided merely to investments.
provide a framework to assist in the implementation of There can be no assurance that an investment strat-
an investor’s own analysis and an investor’s own views egy will be successful. Historic market trends are not The investment strategy and themes discussed herein
on the topic discussed herein. reliable indicators of actual future market behavior may be unsuitable for investors depending on their
or future performance of any particular investment specific investment objectives and financial situation.
The views expressed reflect the current views of Mr. which may differ materially, and should not be relied Please note that changes in the rate of exchange of a
McVey as of the date hereof and neither Mr. McVey upon as such. Target allocations contained herein are currency may affect the value, price or income of an
nor KKR undertakes to advise you of any changes in subject to change. There is no assurance that the tar- investment adversely.
the views expressed herein. In addition, the views get allocations will be achieved, and actual allocations
expressed do not necessarily reflect the opinions of may be significantly different than that shown here. Neither KKR nor Mr. McVey assumes any duty to, nor
any investment professional at KKR, and may not be This publication should not be viewed as a current or undertakes to update forward looking statements. No
reflected in the strategies and products that KKR of- past recommendation or a solicitation of an offer to representation or warranty, express or implied, is made
fers. KKR and its affiliates may have positions (long or buy or sell any securities or to adopt any investment or given by or on behalf of KKR, Mr. McVey or any other
short) or engage in securities transactions that are not strategy. person as to the accuracy and completeness or fairness
consistent with the information and views expressed in of the information contained in this publication and
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tions or other forward-looking statements regard- information. By accepting this document, the recipient
This publication has been prepared solely for infor- ing future events, targets, forecasts or expectations acknowledges its understanding and acceptance of the
mational purposes. The information contained herein regarding the strategies described herein, and is only foregoing statement.
KKR Insights: Global Macro Trends 15www.kkr.com
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