November 18, 2013
Interviewed by: Privcap
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KKR’s Rosenberg: Core is ‘Toppy and Choppy’

Investors lose intellectual integrity thinking real estate is as risk-free as Treasuries, says the head of KKR’s real estate platform. Less than three years into the business, Ralph Rosenberg shares with PrivcapRE his aims and insights.

Investors lose intellectual integrity thinking real estate is as risk-free as Treasuries, says the head of KKR’s real estate platform. Less than three years into the business, Ralph Rosenberg shares with PrivcapRE his aims and insights.

Putting the Intellectual Integrity Back into Core

With Ralph Rosenberg of KKR

Zoe Hughes, PrivcapRE: I’m joined here today by Ralph Rosenberg, global head of real estate at KKR. Welcome and thank you for joining me.

Ralph Rosenberg, KKR: Thank you for having me.

Hughes: You lead real estate for one of the largest investment managers globally, yet by definition, you could even be called an emerging manager. When you joined KKR in 2011, you were charged with building an entire real estate platform. How is that going over the last three years?

Rosenberg: We’ve made quite a lot of progress in the last three years. Basically, the firm felt at the beginning of 2011, that there’s a huge market opportunity to come into the market with new, flexible capital to help deleverage the capital structures that were created during the bubble. And also to be able to do that with the breadth and depth of the KKR franchise on a global basis. So our last two and a half years, we have invested about $750 million of capital in 12 transactions. And we have a team of 13 people in New York, two colleagues in London, three colleagues in Asia, and another colleague in India.

Hughes: So building the real estate team at KKR, someone argued that as a private equity player entering real estate, you perhaps came a little bit too late to the party. Did you?

Rosenberg: Well, I can understand why somebody might have that perspective initially. But the real answer is that coming out of the financial crisis, there are lots of reasons why an important new entrance to the marketplace is merited. Number one, the capital structures that were created during the bubble need to be de-levered and the size of the market that needs to be de-levered, continues to be quite robust.

Secondly, a lot of the players in the space who were the major players in the world are either literally out of business today or are a fraction of their former size. And so when you’re looking at it from the perspective of KKR, when you can effectively flip a switch and leverage the ecosystem and the infrastructure of KKR globally to be a player right out of the box in the real estate space and you have capital, you should expect that there could be a lot of opportunities. And I think we’ve demonstrated that thesis or executed on that thesis over the last two and a half years.

Hughes: And I remember when you left Goldman in 2006, you said you were actually worried about how expensive the markets were. As you kind of look around you today and you look at the opportunities for commercial real estate, particularly here in the U.S., but also globally, are you actually worried the same thing is happening?

Rosenberg: I’m not anywhere close to as worried today as the market suggests in 2006. The reason for that is primarily that the financing markets are in check I think today, there’s a very efficient financing market up to call it 65% of our capital structure. You very rarely see very cheap financing going from 65 up to 90% of the capital structure.

And I think in the prior bubble, a lot of the capital appreciation was driven by a very cheap cost of capital from the shadow banking system and from the securitization system in the 65 to 90 slice of a capital structure. So I think from a financial perspective, the markets are much more in check today. I would also say that the markets for the most part are in supply/demand balance. You didn’t see a lot of overbuilding in this bubble. It’s really a bubble caused by a financial crisis, not an oversupply crisis.

And so for a real estate fundamental perspective, I don’t think that you’re seeing any aggressive speculative behavior on the development side. What I will say is the flight to quality trade, which is, I think, pervasive in all asset classes, not only commercial real estate, is starting to feel very toppy in the core asset group in primarily the gateway markets around the world.

When I talked to our major institutional partners on a global basis and ask them what their interest is from a real estate perspective, almost every one of them says that they’re interested in core defensive cash flowing assets in gateway cities like London or in New York. And when reciprocally you point out to them that the expense of actually getting that exposure, many players today are still interested in aggregating exposure as opposed to effectively selling that exposure.

So I am a little bit worried about the “toppiness” of those markets. But again, those are primarily unleveraged buyers. So to the extent that somebody pays a 4% cap rate for the city of London, if the city of London widens to a 5% cap rate, there might be a 20% diminution in value. But I don’t think that’s going to have any, knock out a derivative effect in terms of causing a financial crisis ‘cause those are unlevered players.

Hughes: But what about the growth? ‘Cause obviously we’re all underwriting rising rates and cap rate expansion, I would argue. But what about the growth? Is there enough NOI growth in these markets, the core markets, to actually offset the raising rates issue?

Rosenberg: I don’t believe so. You need a lot of NOI growth to offset a hundred basis point expansion in cap rates if your starting benchmark, let’s call it a 4% cap rate. So I think that values will by definition diminish over time, given your belief and my belief that cap rates will ultimately widen. But I don’t think that’s necessarily a bubble that’s going to burst problem.

I think the players that are getting that exposure today are primarily thinking about it as a fixed income substitute. And so they’re looking at the real estate core asset class as a better alternative than buying the risk-free rate. I think where they sort of lose a little bit of intellectual integrity is when they think that at the end of that holding period, that they’re going to get power par back for their asset the way that they would get par back for owning the risk-free rate.

Hughes: Do you think actually some investors may have to sell at discount then when they come to actually exit the investments?

Rosenberg: I think that most of the players who are playing the game that we’re talking about are investors that are not thinking about a holding period. That they are perpetual owners of assets. I think that as you’ve seen sovereign wealth funds migrate into alternatives, including commercial real estate, that they think of these holding periods as 20 plus years and so they don’t really, quite frankly, worry about what you and I are worried about which is cap rate expansion over the next two to five years.

Hughes: You’ve obviously argued that core is perhaps as risk or more risky than opportunistic. Now is the time to be more opportunistic in terms of investing. Some people will say well, of course, you’re more an opportunity player. So what do you advise in kind of advisors as they look at perhaps moving up the risk spectrum?

Rosenberg: I would say that our advice is quite simple, which is the “cap rate distribution curve”, is very steep right now. You can get paid a lot for taking value-add or opportunistic risks and you don’t get paid very much to take core risks. And I actually believe that ultimately that curve is going to flatten. I don’t know whether or not cap rates are going to compress in the value-add and opportunistic space or whether or not they’re going to widen in the core space.

But I do believe that curve will flatten. And so my advice to investors is to think about ways to effectively play for the curve flattening and you can do that in a couple ways. You can either serve core exposure or you can increase exposure to value-add and opportunistic investing. But I think you can do that without taking on too much financial risk. Most of the assets that we own aren’t levered more than 65%.

We think the asset level we’re creating 16 to 20% returns. And in an environment where the risk-free rate even today is called 3%, that’s pretty good risk-adjusted return on your capital, particularly when you create sort of an eight to 10% current cash yield at the asset level, given how efficient the financing markets are.

Hughes: Ralph, obviously KKR has been in the real estate space for a while in terms of investing. Why launch a dedicated real estate platform?

Rosenberg: Well, the firm historically invested in real estate related opportunities our of our private equity verticals, primarily in the hospitality space and the retail space where those are operationally intensive aspects of the commercial real estate world. But really, coming out of the financial crisis, Henry Kravis and George Roberts really took a step back and observed that there was a unique opportunity in their perspective to invest in the real estate space because a lot of the incumbent players had lost the confidence of their traditional institutional partners.

A lot of the former players no longer had capital to invest and in fact, went out of business. Or the incumbent players were effectively a fraction of their former size. So Henry and George really felt that we could take advantage of that observation and the need for the capital markets to continue to de-lever coming out of the crisis to use our own flexible capital to be a formidable player in the real estate space.

And that he could really sort of flip a switch of KKR and leverage all the aspects of the firm, our private equity firms, our capital markets teams, our special situations investing teams, and compliment those teams with the real estate core competency, that there should be lots of opportunities for the firm to capitalize with dedicated capital off of our own balance sheet. And that’s why we decided to enter the business.

Hughes: And what was attractive for you when you came into KKR? Why KKR and why now?

Rosenberg: Well, for me personally, there were a number of observations about KKR that resonated. Number one, it had an incredible brand and a global brand and I like the idea of running a building of global brands. Secondly, we had the benefit of no legacy assets. So all the successes that the firm had had in commercial real estate, it actually realized and liquidated prior to the crisis.

And so we are sitting with a clean slate to proactively invest in the markets. Thirdly, we had capital and the firm was committed from a strategic perspective to commit that capital to scaling real estate franchise. And so that capital was used not only to allow me to bring in 13 colleagues for me to transact in space, but also a balance sheet to allow us to immediately go and invest capital in the real estate space, to effectively prove that KKR could have a differentiated approach to the real estate asset class, relative to incumbent players in the space.

Hughes: And as you look for the growth of the real estate team particularly, obviously you’ve grown quite a bit over the last three years, 13 members now globally, how do you see the growth over the next two to three years for KKR?

Rosenberg: It’s a great question. I would say the next step is to continue to build out our European footprint. We have two colleagues full-time on the ground in London who are adjacent to our special situations team and our private equity team so we can cross staff. But in terms of dedicated professionals, we are continuing to add in Europe. And then you should also expect that in the next 12 to 18 months, we would add a couple of professionals in Asia.

Hughes: And do you think to be an effective commercial real estate fund manager today and investment manager, do you have to be a global player?

Rosenberg: I don’t think you necessarily have to by design. I think that real estate by definition is a nuanced local market game with a macro overlay. But I think when you have the infrastructure and the ecosystem of KKR being a dominant player in the private equity space primarily in Europe and Asia and the United States, that it’s sort of silly not to leverage that dominance to effectively create a sister adjacent real estate practice.

Because a lot of the deal flow comes through the same sourcing channels. A lot of the deal flow is nuanced and effectively results in collaboration across industry verticals like a retail vertical that we have KKR. Obviously the retail asset class is a big asset class. You can connect the dots in that respect on a global basis and you should be able to create differentiated access to opportunities and better underwriting than people who are siloed in those local markets.

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