ESR Group’s chairman Jeffrey Perlman believes strong rental growth and inflation will offset the potential impact of interest rate hikes on his company’s portfolio.
“Rent growth is a very powerful thing. Let’s not forget the impact of inflation as it relates to real estate. Having just been in Australia recently and seeing the impact, the market is ripping from a rent growth perspective. And you know, to put it in perspective, every 7 percent growth in rent offsets about 25 basis points of cap rate expansion,” Perlman said during a webcast on the firm’s H1 2022 results announcement last week. In Australia, the firm saw average rent growth of 13 percent for leases signed in the first half of 2022.
South Korea is another market witnessing a spike in interest rates after the Bank of Korea raised the short term rate by 200bps over a short period of time, according to Perlman. “But again, there’s strong rent growth. We’re seeing upwards of, in South Korea and certain of our assets, over 15 percent rent growth in some of these submarkets,” he added.
Overall, the firm saw a positive weighted average portfolio rental reversion of 5.8 percent across its new economy portfolio. In addition, 40 percent of ESR’s leases are due to expire within the next 30 months, which allows the group to capture the rental growth in its major markets, according to the announcement.
Perlman also pointed out that different countries have different interest rate outlooks. While South Korea and Australia are seeing rising interest rates, China is gradually cutting rates and Japan has remained stable.
“If you talk to many market participants, you could probably see a world where, especially based on where the C-REITs are trading, where cap rates could end up a bit lower than where they are right now. In Japan, rates have remained constant, but you’re seeing a lot of capital want to go to Japan for a number of reasons, including where the currency is at the minute,” he explained. Given these factors, he does not expect any valuation changes for the assets in ESR’s portfolio.
While Perlman remained optimistic about the future of the new economy real estate sectors, the firm is building more cost contingencies into its underwriting to reflect the uncertain macroeconomic environment. The group has been able to lower its cost of financing by refinancing its historically higher cost debts with $2.5 billion in new sustainability-linked loans. The firm consequently has reduced its weighted average interest cost to 3.8 percent from more than 7 percent at the time of its IPO, reflecting its growing scale and access to lower cost of capital sources.
“Given how much we do on the development side, it’s very important that we can underwrite construction costs for projects with a high degree of certainty in order to preserve our development spread. Markets where we’re seeing the highest spikes in construction costs are in Korea, Australia and select markets in Southeast Asia,” he said.
ESR has a new economy development portfolio of $12 billion, including development starts of $3.5 billion and $2 billion of completions during H1 2022.
Despite the market headwinds, Perlman expects the firm’s capital partners to allocate more to real assets over the next 12 to 18 months, especially in Asia where they are “meaningfully underallocated.” The group raised $3.9 billion through 15 new or upsized funds and mandates. This included the firm’s newly launched pan-Asia discretionary development vehicle and its inaugural $1 billion APAC data center fund.