Using property to supplement fixed income
Unquestionably, the last few years have been tough for advisers positioning portfolios for clients close to or in the retirement phase. Clients already in retirement have uncomfortably ridden the long, steady grind of lower interest on term deposits and cash, all the way to record-low levels.
For this group of investors, the fact that the rate cycle has finally turned, and rate rises are back on the agenda is cause for some celebration. But they should be wary of the fact that interest rates – and thus, returns on their old-favourite yield-generating investments – are not going to get back to what they might consider ‘normal’ anytime soon.
Further, depending on the level of their continued exposure to bonds, some are likely to return capital appreciation previously enjoyed whilst rates were declining over the last decade.
Chart 1: Average term deposit rates as of March 2022
Since the Global Financial Criss (GFC), private debt has grown in importance as an asset class. Though there are several sub-categories of private debt, direct lending continues to grow in scale in Australia. This growth, is largely attributed to the changes in banking regulation and subsequent deleveraging of banks that occurred globally post the GFC. From an investor standpoint, private debt offered returns that were not dissimilar to equities, whilst allowing institutional investors to diversify away from equity market volatility.
In Australia, there is an added dynamic. The Australian Prudential Regulation Authority (APRA) has publicly noted that “poorly underwritten, monitored, and controlled credit exposures to commercial real estate (CRE) borrowers have historically proven to be a key source of credit loss for banks.”
As a result, APRA initiated a thematic review of the banks in 2016, to better understand underwriting quality and rectify processes if it was required. Secondly, to put in place monitoring to identify future deterioration in CRE lending.
The outcome of this review was that banks tightened their lending standards and restricted the real estate development sector from debt capital. As can be observed in Chart 2, development finance dropped from ~9% of CRE exposure in 2016 to ~6% end of 2021; a 33% drop over this period.
Banks have reduced their exposure to real estate debt primarily by increasing conditions or ‘hoops’ that developers need to jump through to obtain finance. For example, the equity banks require from developers has doubled since the APRA-review in addition to requiring a materially higher pre-sale debt cover on projects.
Even when they will lend, the exhaustive and slow bank process can result in delays and uncertainty for developers, and hence they increasingly seek alternatives.
Chart 2: ADI Commercial Property Exposure ($m)
This funding vacuum has been filled by non-bank lenders, whose skill base lies in assessing, making, monitoring, and managing specialist loans. Key executives at the non-bank lenders have generally come from institutional firms with capital primarily sourced from institutions or family offices.
More recently, these strategies have been made available to advisers through platform friendly vehicles as well as Listed Investment Trusts (LITs). Even though the real estate private debt sector in Australia is still relatively small by global standards, circa $15 billion - $20 billion, where in many comparable jurisdictions the market share is between 20% – 30%; representing a $90 billion to $100 billion market opportunity.
Investors have sought out well-managed real estate private debt to supplement fixed income portfolios for the following key reasons:
- Lower risk relative to other alternative assets or yield options (e.g. core real estate);
- Higher yield compared to traditional bonds;
- Security of underlying real estate (CRE debt only);
- Diversification as counterparties are typically mid-market private entities;
- Very low correlation to equity markets; and
- Low volatility which can buffet portfolios in extreme events like COVID.
Alceon lends to mid-sized developers in Australia, with senior secured loans (typically first-mortgage) with a loan-to-value ratio of between 45% and 65%. Such loans go to development projects (typically residential real estate projects, but sometimes commercial property) of high-quality development businesses, across Australia and select locations in New Zealand.
Given the size of Sydney and Melbourne relative to other cities, they dominate the locations of our counterparties or sponsors.
For the calendar year 2021, the retail fund achieved an annual return of 8.03%. Alceon believes that in the current interest-rate environment, risk-adjusted returns of this level meet the requirements of many income-focused investors.
More importantly, these returns are uncorrelated to equity markets, and are generated in Australia, through lending to an industry with which most investors are familiar.
There are many lenders active in the marketplace, with an income-bearing investment product available, and this kind of investment offers advisers an attractive option for the portfolios of their income-oriented clients.
And, given that the non-bank lending sector is increasingly filling the void in development lending left by the banks’ retreat, this style of product has benefits for both its investors and its borrowers.
Omar Khan is director, real estate, at Alceon.
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