An emerging asset class: what’s driving the rise of alternative lenders?

26 June 2018

Australia is witnessing a fundamental shift in the commercial real estate lending landscape in Australia, creating new opportunities for investors.

As banks retreat from the property sector, alternative capital providers are coming to the fore.

These financiers are sometimes called ‘shadow banks’, but this is a misnomer. Unlike banks, who take deposits from savers, alternative lenders source funds from investors for the express purpose of loaning them out.

The dynamics of the sector are therefore fundamentally different to the banks: it’s designed to match investors (not depositors) with borrowers.

Why alternative lending is growing

The retreat of the major trading banks from Commercial Real Estate (CRE) lending has coincided with the rise of alternative lenders, who fill the gap with flexible financing solutions.

This has been a positive development not just for borrowers, but also for the investors who provide the capital.

Private and institutional investors increasingly realise that they don’t need to own real estate to make money; they can finance it as well.

To better understand the market, it’s useful to look at the key sources of funding in this space:

  1. Authorised Deposit-taking institutions (ADIs), which are banks, credit unions and building societies;
  2. Financial Institutions that are not ADIs (e.g. foreign banks that do not take deposits in Australia);
  3. Private and public debt capital markets; and
  4. Non-ADI lenders, including companies such as Qualitas and other private specialist lenders, superannuation funds and international funds.

A key difference between ADI and non-ADI lenders is that ADIs accept and make loans with deposits from the general public. They are the custodians of people’s savings.

Accordingly, this attracts a level of regulatory oversight from the Australian Prudential Regulation Authority (APRA). By contrast, non-ADI lenders privately raise wholesale funds to provide to borrowers under their own criteria, and this is currently largely unregulated by APRA. Investors in this space take on a certain level of risk and are rewarded for it.

For example, non-ADI lenders can often accept lower levels of pre-sales for construction projects and allow a lower loan-to-value ratio. They also have the ability to require varying levels of security, from senior, first-ranking mortgages to mezzanine, second-ranking mortgages. Both are secured but have different levels of priority in the case of a default.

In recognition of this higher risk profile, lenders are able to demand a higher risk premium[1], which is one reason investors can benefit from investing in this asset class. The risks are tightly managed, however, with lenders taking security over assets to protect their investment. This is in contrast to asset classes such as shares or hybrids, where all of the invested capital is at risk and shareholders rank last in the list creditors.

Banks pull back from CRE lending

While the alternative lending industry has existed for many years, the dynamics have shifted in the past two years, leading to a rise in demand for this type of funding.

 The total size of Australian ADIs’ exposure to (secured and unsecured) commercial real estate finance was estimated to be $270 billion[2].  In the years before the Global Financial Crisis (GFC), CRE finance was provided by a mix of local and international banks, with Australian ADIs accounting for less than 70% of market share. However, following the GFC, several international banks exited the Australian market, and the local ADIs increased their market share to an estimated 80-85%[3].

During the course of 2016, the tide turned on this trend. APRA increased the level of capital that the banks needed to hold as a ‘buffer’ against their loans, prompting the lenders to rethink the composition of their loan books. They had a high proportion of commercial real estate and decided to reduce this exposure over time.

For example, many banks responded by tightening finance for residential developers over the course of 2016, through measures including stricter pre-sales requirements, lower maximum loan-to-value ratios and stricter geographic concentration limits[4]. As ADIs moved towards these increasingly selective and conservative credit terms, more flexible forms of finance from alternative lenders have been filling the gap.

This scenario has played out in other markets too. It is estimated that non-ADI lenders in Australia account for approximately 6 per cent[5] of total financial system assets, which is below the 40%[6] to 50%[7] share of their counterparts in Europe and the United States, respectively.

The US Federal Reserve’s guidance to reduce banks’ leveraged lending to businesses in 2016 saw the non-ADI sector increase market share[8]. Similarly, in the Netherlands, stricter capital requirements for banks have prompted pension funds and insurers to take a more active role in the secured mortgage origination market[9].

It’s fair to assume that a similar process will play out here in Australia; it is already gathering steam. For example, senior construction financing by ADIs has reduced significantly compared to five years ago, creating an opportunity for non-ADI lenders to capture market share, and generally at a higher price[10].

Focus on quality investments

As with any growing market, new players are entering this space and creating competition amongst established alternative lenders. However, Qualitas believes that the past decade has set our firm up for success in this environment: we have built trust with borrowers, delivered returns to investors and developed rigorous governance processes.

Having built deep relationships with top tier clients, we are ideally positioned to provide financing for quality projects that aim to deliver strong, risk-adjusted returns for investors.  We are positioned at the forefront of the commercial real estate debt sector as it evolves into a mature asset class. Having launched the Qualitas Real Estate Income Fund (ASX: QRI) in November 2018, Qualitas is now able to offer the benefits of this asset class to a retail investors. For more information go to: www.qualitas.com.au/invest

 

Disclaimer: This article has been prepared by Qualitas Securities Pty Ltd (ACN 136 451 128) (Qualitas Securities), holder of Australian Financial Services Licence number 342242. Qualitas Securities and its related bodies corporate and affiliates constitute the Qualitas group (Qualitas).

The information contained herein is for informational purposes only and does not constitute an offer to issue or arrange to issue financial products. The information contained herein is not financial product advice. This document has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person.  Before making an investment decision, you should read the publicly available information carefully and consider, with or without the assistance of a financial adviser, whether an investment is appropriate in light of your particular investment needs, objectives and financial circumstances. Past performance is not an indicator of future performance.

No member of Qualitas gives any guarantee or assurance as to the performance or the repayment of capital. 

All data in this document has been calculated using the most accurate sources available, however any rates or totals manually calculated may differ from those shown due to rounding. Figures may also differ from those previously disclosed due to adjustments made following period end.

 

[1] https://www.rba.gov.au/publications/fsr/2018/apr/pdf/03-australian-financial-system.pdf

[2] Australian Prudential Regulation Authority, Quarterly ADI Property Exposures Statistics, March 2018

[3] Australian Prudential Regulation Authority, Quarterly ADI Property Exposures Statistics, March 2018

[4] Reserve Bank of Australia, Financial Stability Review – April 2017, 2. Household and Business Finances,  https://www.rba.gov.au/publications/fsr/2017/apr/household-business-finances.html

[5] Reserve Bank of Australia, Financial Stability Review – April 2018, 3. The Australian Financial System,http://www.rba.gov.au/publications/fsr/2018/apr/australian-financial-system.html

[6] http://www.esrb.europa.eu/pub/pdf/reports/20170529_shadow_banking_report.en.pdf

[7] http://www.fsb.org/wp-content/uploads/P050318-1.pdf

[8] Kim S, M Plosser and J Santos (2016), ‘Did the Supervisory Guidance on Leveraged Lending Work?’, Liberty Street Economics site, 16 May. Available at <http://libertystreeteconomics.newyorkfed.org/2016/05/did-the-supervisory-guidance-on-leveraged-lending-work.html>.

[9] http://www.esrb.europa.eu/pub/pdf/reports/20170529_shadow_banking_report.en.pdf

[10] Reserve Bank of Australia, Financial Stability Review – April 2017, 2. Household and Business Finances,  https://www.rba.gov.au/publications/fsr/2017/apr/household-business-finances.html