After decades of mild inflation, easy monetary policy and low interest rates, we are once again witnessing how an interest rate shock can affect real estate. Rising interest rates over the past year have increased the cost of capital across all asset classes, creating a meaningful direct impact on the investment environment. However, the second-order impact of rising interest rates on real estate values and capital markets, particularly the sharp decline in commercial real estate debt capital, is arguably just as significant. In our view, the pullback in real estate debt markets will determine both investor outcomes and opportunities in the coming months and quarters.
As we navigate emerging trends in the current environment, investors frequently ask us several important questions: In this letter, we address those questions based on what our real estate team and KKR colleagues are observing internally.
What are the underlying causes of the current commercial real estate (CRE) debt write-off? What are the secondary effects that investors should be aware of? Is the focus on CRE loans on bank balance sheets justified? Are the real estate capital markets as dire as the headlines suggest? How long will it take for liquidity to return to the markets and for the capital markets to resume more normal functioning? What are the best investment opportunities today? And what opportunities will emerge over the next 12 months?
Ultimately, we believe current market trends create a once-in-a-decade real estate investment opportunity. The environment remains dynamic and complex, and the degree to which commercial real estate lenders are intertwined may complicate and prolong the return to normal liquidity conditions over the coming year. Regional banks will likely face tougher regulations that limit lending activity, so we expect banks to remain on the sidelines for some time. While we expect an increase in concentrated defaults in the office sector, we do not believe office real estate lending or exposures pose a systemic risk to banks.
For investors, real estate credit is an opportunity. Today's commercial real estate loans have low loan-to-asset ratios (LTVs), excellent interest coverage even at higher interest rates, and favorable covenants and structures for lenders. Non-bank lenders with the strongest relationships are particularly favored. In real estate equity, forced sales are likely to bring high-quality assets to a market where many traditional buyers are on the sidelines, creating an attractive environment for well-capitalized buyers. With $1 trillion in commercial real estate loans maturing in 2023 and 2024, we expect many borrowers to need to recapitalize, consider capital infusions, or sell unattractive assets.
Looking across the market today, we see the following themes:
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The origins of CRE's tough credit conditions
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Looking at the issues facing regional banks from an objective perspective
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Real Estate Opportunities