Buying property isn’t the only way to gain exposure. In fact, real estate debt can provide strong returns and capital preservation for investors, regardless of property price movements.
There’s no doubt Australian investors have a love affair with property. But for the vast majority, their exposure is in the form of equity: owning a slice of the Australian dream, either directly or through real estate investment trusts.
Like any investment, this approach has its pros and cons. One of the downsides is that in an environment of high asset prices, ownership can be costly. Real estate is expensive to buy and the costs of servicing a loan are ongoing. This has pushed investment yields lower in recent times, putting a question mark over the sector for some investors.
But what if there were another way to make money from real estate, regardless of whether prices are flattening or when yields are falling?
There is, and it’s real estate debt. Investors make a return by being a lender rather than an owner, meaning they are less sensitive to price fluctuations and asset pricing bubbles.
What is real estate debt?
Real estate debt means that instead of owning an asset, the investor provides financing for a third party to own or develop it. Returns are generated by the fees and interest that borrowers pay.
If you invest in real estate debt, you’re acting more like a bank than an owner. Rather than having a mortgage to pay and an asset to manage, you’re providing funds for someone else to do it.
For example, instead of owning a single apartment, you’re lending to commercial borrowers who are building hundreds of apartments.
This is an asset class that’s attractive to income-focused investors, as it provides predictable returns in place of capital growth.
A growing asset class
Within the Australian commercial real estate sector, bank loans make up 93% ($355 billion) of the debt currently provided to commercial borrowers1. The remainder (~$25 billion) of CRE debt is provided by alternative lenders such as Qualitas. This sector, while small, is well-established and has been growing steadily, becoming more sophisticated in funding solutions for borrowers.
Flexibility is a key driver of this demand. The large trading banks can’t always provide the flexibility borrowers need. It may be that they don’t fall within the narrow ‘loan-to-valuation ratio’ that the bank wants to see. The bank may have restricted lending to a particular region or location because its exposure is very high there. Perhaps the development timeline doesn’t match up with the bank’s requirements. Or the type of security the clients can provide doesn’t meet the bank’s narrow parameters.
Against this background, borrowers are increasingly seeking out other financing options.
Another driver is the banks’ changing lending appetite due to tighter regulatory requirements. In recent years, the regulator (APRA) has required Authorised Deposit-taking Institutions (ADIs) to have a higher capital buffer and to reduce their exposure to certain sectors such as construction financing for residential development.
As a result, real estate projects that would have ticked the boxes for a bank loan a few years ago are now being declined. Alternative lenders have been able to fill that gap, thanks to their private capital sources and ability to structure deals more flexibly.
Capital protection a key feature
Alternative lenders focus on risk management and take security on the loans they make. Qualitas provides senior and mezzanine debt, where loans are secured against underlying assets by first- or second-ranking mortgages.
Typical secured real estate loans across the commercial real estate finance market include:
- Land Loans: secured against vacant or land with the potential for development. This includes undeveloped land capable of subdivision into smaller lots, land that has not been approved for development and land that has been approved for development.
- Construction Loans: provided to fund development and construction costs of real estate development projects. They are secured against land with the potential for development or real estate assets that are soon to be or are under construction.
- Investment Loans: secured against real estate assets that are income generating or have the potential to generate income on a going-concern basis.
For twelve years, Qualitas has been providing these types of loans to high-quality borrowers, and in doing so, has generated strong, risk-adjusted returns for investors. The returns vary depending on the type of fund and level of risk.
Qualitas achieves these returns through a focus on developing an institutional-grade governance structure, loan selection, risk management and a commitment to working only with quality borrowers. This has meant that since inception in 2008, Qualitas has not made a capital loss on any of its transactions.
Alternative finance – where to from here?
As major banks reduce their lending appetite in response to regulatory requirements, Qualitas believes that the alternative finance sector will continue to grow significantly, creating opportunities for investors while underpinning the continued strength of the real estate market.
Having established a strong track record, deep relationships in the sector and institutional-grade risk management, Qualitas is well-positioned to be a leader in this burgeoning sector.
For more information on the Qualitas Real Estate Income Fund, click here.
1.Australian Prudential Regulation Authority Quarterly Authorised Deposit-taking Property Exposures December 2020; RBA Financial Stability Review April 2021.
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.