Traditionally, income plays an important role for Australian investors. With global interest rates at all-time lows, investors are having to search harder for alternative investments that will help them achieve a consistent and reliable income to fund their lifestyle and retirement.
And when low rates combine with increased fiscal stimulus to cause asset price inflation, investors’ effective yields are eroded further.
In this Money Management Toolbox, we will introduce commercial real estate (CRE) debt – an alternative investment that aims to achieve an attractive regular income while preserving capital.
We’ll explain where CRE debt sits within the income investment universe, how alternative lenders complement traditional bank lending for CRE borrowers, and the important role alternative lenders play within the global financial system.
From there, we’ll discuss some of the features of the asset class and how your clients can benefit, before delving into the investment opportunity as it stands in Australia in 2021 and some of the key structural tailwinds that have led to year-on-year growth of CRE debt over the past decade.
THE INCOME INVESTMENT UNIVERSE
For investors seeking income, there are many options available. But, most don’t offer any worthwhile yield unless you’re willing to take on sizeable risk.
Term deposits carry the lowest risk and usually offer the lowest return. Bonds issued by developed market governments such as Australia, the US and the UK are also very low risk and low (sometimes negative!) return, while emerging market government bonds can offer higher yields as you climb the risk curve.
Corporate bonds can offer higher yields too; but across the board, government and corporate bond yields have declined steadily since 2009 as central banks have kept interest rates very low in an attempt to keep their economies afloat. In other words: bonds are expensive and much less attractive as a source of income compared to years gone by.
Equities can provide a compelling source of dividend income for those investors willing to put their capital at risk, but may not be suitable if you want to preserve it.
Property in the ownership form, is also a major asset class for income but there are other debt investments that provide exposure to property such as residential mortgage-backed securities and commercial real estate debt.
COMMERCIAL REAL ESTATE DEBT
A CRE debt investment seeks to generate regular income by providing loans to commercial borrowers who require funding for real estate purposes. The income is derived from loan interest and fees and agreed up front. The loans can be provided by banks or by alternative lenders (known as private CRE debt).
The borrowers of CRE loans are distinctly commercial – typically property developers, private corporations, or high net worth groups or individuals. It’s important to note that these are not home loans to retail borrowers such as individual owner occupiers and investors.
In Australia, the CRE debt market is circa $380 billion, with banks providing around 93% of those loans and alterative lenders the remaining 7%.
With any investment, it’s important to understand where it sits in the capital structure.
CRE debt is always classified as secured debt – the highest priority in the capital structure – which means it’s repaid first if the borrower defaults on the loan. This is a key feature of the asset class as it means investors’ capital is much less at risk.
BANKS AND ALTERNATIVE LENDERS: WHAT’S THE DIFFERENCE?
Alternative lending is where any party other than a bank provides a loan to a borrower. This includes financing commercial real estate.
The biggest difference between banks and alternative lenders is how they fund their lending activities. Banks raise their capital from deposits and wholesale funding, whereas alternative lenders raise their capital primarily from investors. So for an investor seeking a regular income from CRE debt, the opportunity sits solely within the alternative lending sector.
The second difference is how these entities are governed. Alternative lenders in Australia are not regulated by the Australian Prudential Regulation Authority (APRA), the prudential regulator for Australian banks, which are categorised as Authorised deposit-taking institutions (ADIs). Depending on how an alternative lender funds its lending activities and the types of loans it provides, it may be regulated by the Australian Securities and Investments Commission (ASIC).
The loans offered by alternative lenders are commonly referred to as private debt, as they’re not traded in secondary markets in the same way that bonds or syndicated bank loans are.
But like banks, alternative lenders range in the size of their operations, their funds under management and their experience. They can also have many different ownership structures and can service both retail and wholesale borrowers.
THE ROLE OF ALTERNATIVE LENDERS IN GLOBAL FINANCE
Globally, 50% of all loans are provided by alternative lenders, and 50% by banks. Together, these loans comprise the global credit markets. Alternative lenders now provide US$200 trillion ($259 million) worth of debt, after decades of year-on-year credit market growth and increased market share taken from banks.
Alternative lenders play an important and significant role in the global financial system by providing borrowers with an alternative source of finance to banks. For investors, the deep alternative lending market represents an income-focused investment opportunity across a wide range of debt investments, including corporate loans, bonds and CRE debt.
Because alternative lenders are typically more flexible than banks, borrowers are willing to pay a premium for alternative financing. This flexibility extends to the terms of the loan, the availability of loan options and the speed of funding. Plus, alternative lenders can often form a closer relationship with borrowers, due to their smaller size and more flexible approach.
HOW YOUR CLIENTS CAN BENEFIT FROM INVESTING IN CRE DEBT
There are several key benefits from investing in CRE debt. The first is a regular and predictable income. With interest rates and cash and bond yields at historic lows – and forecast to remain low – CRE debt can provide attractive risk-adjusted returns over the current low cash rate.
The second benefit is portfolio diversification. CRE debt is unique in that it can be categorised as fixed income, property or alternatives. Fixed income, given it’s a credit instrument which generates a fixed level of income from pre-agreed interest and fees; property, given it provides exposure to the property market but without the equity risk of investing in property; and alternatives, since it doesn’t neatly fit into traditional asset classes.
Most investors want to lower their risk by diversifying across the capital structure. So an allocation to CRE debt may suit investors looking to avoid the capital volatility that can come from investing in property.
The third key benefit of the asset class is capital preservation. All CRE loans are secured by real property mortgages and carry the highest repayment priority in the capital structure. If the borrower cannot repay the loan, the lender has the right to sell the property to recoup repayment.
THE CRE DEBT OPPORTUNITY IN AUSTRALIA
For many decades in Australia, CRE debt was the domain of institutional and wholesale investors. That’s now changing, as the asset class opens up more to retail investors by way of the alternative lending sector.
It’s also underinvested, both compared to traditional asset classes and to the more established markets in the US and Europe. There, alternative lenders comprise 45%-50% of the CRE debt market, demonstrating not only the importance of alternative lending in the global financial system, but the potential for growth in the Australian CRE debt market.
The growth so far in the CRE debt space has been driven by a number of structural tailwinds. Our steady population growth drives urban expansion, creating demand for CRE development, while low interest rates support cheaper borrowing which fuels demand for loans to support CRE investment. Additionally, the Australian economy has been relatively sound compared to other countries, with uninterrupted gross dometsic product (GDP) growth.
Importantly, banks have pulled back from CRE lending, which has widened the gap for alternative lenders to fill. Not only do banks typically reduce their lending in times of uncertainty and market downturns, but since the Global Financial Crisis (GFC) there has been a structural and permanent decrease in banks’ CRE lending appetite as a result of increased APRA and government regulation.
There are now at least 50 recognised alternative lenders in Australian CRE debt. Some only lend while others are also equity investors in property, which requires a broader skill set. Just like on the global stage, alternative lenders play an important role in financing property loans.
They don’t compete with banks, but fill the funding gap created by banks that are not willing to lend in certain situations. They provide more lending options for borrowers and they create liquidity in the market to support third-party loan refinancing. This improves the efficiency and accuracy of market pricing and ultimately investment returns.
HOW TO ACCESS CRE DEBT
CRE debt is an accessible and easily-understood asset class for all investor types, whether institutional, wholesale or retail. And though small compared to global peers, it’s a well-established sector: alternative lenders have been operating for more than 30 years in the Australian CRE debt market.
Investors can access CRE debt by purchasing units in a fund structure like a managed investment scheme, which can be listed or unlisted. An investment manager with a specialised skillset in the asset class manages the fund and invests pooled equity capital into CRE loans on a discretionary basis.
The CRE loans generate loan interest and fee income for the fund, which is then paid as a regular cash distribution to investors, typically monthly in line with interest payments.
The role of the investment manager is an important one. They will source all lending opportunities and undertake loan assessments and due diligence to ensure all loans meet the investment objectives and mandate of the fund. They also actively manage the fund’s loans throughout their lifecycle to mitigate repayment risks and other risks.
Commercial real estate debt is an excellent diversifier which can complement your clients’ exposure to traditional asset classes. It’s compelling because it can deliver a stable and predictable income and healthy risk-adjusted returns compared to equities or traditional property, which are higher up the risk curve. And its focus on capital preservation means it’s an attractive investment for more risk-averse investors.
Yin-Peng Chiew is director, strategy at Qualitas Group.