Real Estate: is now a good time to invest?

By Nick Bullick, Portfolio Manager, Qualitas

There is no shortage of news flow around the property sector at the moment, often leaving investors confused. However, that doesn’t mean investors should shun it entirely. There are many potential opportunities to make money from real estate, regardless of price movements.

This is true of any asset class, not just equities. While there are some headwinds for the real estate sector, it does not follow that there are no investment opportunities.

Real estate investment firms have long recognised that in an environment of high asset prices, ownership is not always the most effective investment strategy. Instead, financing the purchase or construction of assets by third parties may provide strong and predictable returns while avoiding the scramble to buy properties at high prices and low yields.

Qualitas has been a key player in the commercial real estate (CRE) debt space for the past decade, forging a strong track record of predictable returns for investors by responding to the opportunities that the market cycle presents.

A changing debt landscape

Commercial real estate debt has traditionally been the province of the large banks, who are attracted to the security provided by first-ranking mortgages on the underlying assets. If the borrower defaults, the bank is first in line to claim the assets provided as security.

However, in recent years, alternative lenders such as Qualitas have increased their share of senior debt in the CRE market. This is a result of the banks reducing their appetite for such debt, as they grapple with the regulator’s demand for higher capital buffers and to rebalance their loan portfolio exposure to certain sectors.

Some standard CRE loans that the banks would previously have approved, are no longer meeting their requirements. This has increased opportunities for alternative lenders and has adjusted the pricing of such loans, making it a more attractive option for private and institutional investors.

Rethinking mezzanine debt

Mezzanine debt is an important source of capital for real estate developers, who use the funding alongside senior debt. Mezzanine loans are often used earlier in the development process to finance construction activities. They have a fixed term, typically around two years, to match the lifecycle of a project.

This type of loan is usually subject to a second-ranking mortgage. It is still secured, but any senior debt claims would take priority in the case of a default. The risk is therefore higher, as are the rates charged to borrowers, and the returns to investors.

Mezzanine debt garnered something of a bad reputation in the wake of the Global Financial Crisis (GFC), and to some investors, it retains an air of risk. However, it’s important to put this into perspective.

When the share market in Australia dropped by over 40% following the GFC, investors did not abandon the entire asset class. They looked at the companies that collapsed, or came close, and identified the issues that had placed them at risk.

If we apply the same lens to mezzanine debt providers, several issues affected failed lenders before the GFC. First, there was a mismatch between their funding and loan terms. They were obtaining short-term capital (e.g. a two-year corporate debt facility) and then providing longer term loans (such as a three-year construction loan) and this ‘double leverage’ created structural weaknesses.

Another factor was that many of the parties providing mezzanine loans were not experienced in this type of specialist lending. Banks traditionally have an arm’s-length approach to monitoring assets in their loan book. They may receive a third-party construction report on a monthly basis and be satisfied with this. By contrast, specialist construction financiers closely monitor development risks – meeting regularly with the developers, whereas a report by a bank-appointed quantity surveyor is backwards-looking.

When markets were destabilised in the GFC, inexperienced lenders had a tendency to overreact to issues. Rather than manage through the construction or valuation issues, many banks called in loans and booked losses.

As a result, mezzanine debt came to be seen as risky. It is further up the risk curve than traditional senior debt – but it attracts a price premium as a result. Specialists with a stable source of funding (private and institutional capital), have proved that when managed skilfully, this can be a high-performing asset class.

Risk management and capital protection

There are several factors to consider that aim to protect investors.

The first is the nature of secured debt investments – there is a buffer created by only lending up to a certain percentage of the property value.

For example, a loan made at 70% LVR means the asset value would need to fall more than 30% before the lender stands to make a loss.

In addition, there is an underlying ‘security package’ that can be claimed by the lender, including, for example, the mortgage over the development site, personal guarantees and corporate guarantees.

From this perspective, real estate debt is often seen as less sensitive to asset price fluctuations than real estate equity investments. Moreover, the ongoing interest payments mean that income is generally more predictable than asset classes such as shares with discretionary dividends.

CRE Debt as a source of income

One of the attractive aspects of debt-based investments is the income stream they provide. While property ownership can provide rental income, there are ongoing interest costs if the asset is leveraged, plus the risk of vacant periods pushing down yields.

By comparison, debt-based exposure to property aims to provide a predictable source of returns without significant ongoing costs.

For income-focused investors, real estate debt can also be a valuable source of diversification for those with high equities exposure. Real estate generally follows a different cycle to the share market, and this lower correlation can help to smooth out market fluctuations across a portfolio.

With all these facts in mind, investors who take a more nuanced view of the property market have the potential to achieve strong, risk-adjusted returns by working with the right investment manager. 

This article is general information and does not consider the circumstances of any investor or constitute advice. Material published in SAFAA Newsroom is copyright and may not be reproduced without permission. Any requests for reproduction will be referred to the contributor for permission.

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