Since launching the Qualitas Real Estate Income Fund (ASX: QRI), we have been asked a number of questions about the fund, the asset class and market conditions.
Given there are few comparable products on the Australian Securities Exchange (ASX), this isn’t surprising. Commercial Real Estate (CRE) debt is an established listed asset class overseas; however, it’s a more recent arrival on the ASX.
Qualitas, the Investment Manager of QRI, has written this article to answer to some of the questions about the fund and the asset class it sits within.
Are you worried about house price movements affecting QRI’s returns?
There are two economic cycles influencing QRI’s investment strategy: the property cycle and the credit cycle. Separating those two distinct (albeit connected) cycles is key to understanding the risks and return profile of a CRE debt fund.
The Credit Cycle is the expansion and contraction of access to credit over time. Australia has been experiencing a tightening credit cycle for some years now – meaning it’s more difficult to access loans. This is leading to structural change in the way commercial real estate financing is provided.
The commercial real estate lending market is worth more than $279 billion annually1, and to date more than 90% of lending has been provided by the banks (authorised deposit-taking institutions, or ADIs).
However, banks are reducing their exposure to this type of lending due to increased regulation and capital requirements. As a result, commercial borrowers are increasingly working with alternative lenders, such as Qualitas, to gain access to the funding they need to deliver projects and finance properties. This creates a growing market opportunity for Qualitas to write loans that can be allocated to QRI.
In this sense we see the current credit cycle as favourable to our investment strategy.
The Property Cycle – The property cycle also impacts QRI, but in a less direct way. Unlike owning property, a debt investment doesn’t depend on valuations rising in order to make a profit. The return is generated by the agreed interest rate (and any additional fees), not the capital gain.
For loans secured against real estate assets, which make up the QRI portfolio, the valuation of an underlying asset becomes relevant if the borrower is unable to repay the loan. When Qualitas is granted a mortgage over an asset, we ensure the valuation covers the loan amount with an adequate buffer.
We do this by requiring conservative loan-to-value ratios, usually a 65-75% for mezzanine and 50-65% for senior debt. This provides a significant buffer, so that even if the asset value were to decrease, we would be well-placed to recover the loan amount as well as the interest charged.
In this way, asset prices play a part, but we take a number of steps to protect our investments from short-term fluctuations.
A slowing property market can also affect the development and investment activity of CRE borrowers – if fewer developments are commenced or fewer properties are bought and sold, for example. However, this reduction in demand comes off a high base, and activity is continuing regardless.
We expect to see fewer developments in the short-term, but those going ahead will emphasise quality and location, to ensure buyer demand. Similarly, long-term property investors will continue to acquire assets. When the market recalibrates, savvy investors with access to available capital are usually attracted to the market, taking advantage of the lower prices.
At what point will QRI start to deliver its target return?
To meet the target return outlined in the PDS, Qualitas needs to deploy the capital in the fund by lending it to suitable borrowers for suitable opportunities.
In order to maintain credit quality, we do this progressively in what’s known as the Initial Investment Timeline (outlined in Section 4.12 of the PDS). This is based on what we believe is reasonable to make the best use of investor funds, while ensuring we choose only quality investments and achieve good portfolio diversification.
The current market opportunity is focused on senior debt, where demand has increased due to the banks’ pull-back in appetite and their prescriptive approach to credit assessment. Their credit policies are such that if there is one risk, a bank will say no, rather than structuring around it.
By contrast, Qualitas is able to take a more flexible approach, looking at the merits of each lending opportunity. With extensive experience in origination, due diligence, structuring, execution and loan / asset management, we are able to manage risks while generating returns.
What security do you take over the loans you provide?
QRI is predominantly comprised of senior, first-mortgage loans. This means that Qualitas takes security over the asset and in the event of a default, has the first claim on it. If this happens, Qualitas can either take possession and sell the property, or hold and rent it out for income.
A smaller proportion of QRI’s portfolio is allocated to second-mortgage loans. These are an important source of capital for real estate developers, who use the funding alongside senior debt.
This type of loan is usually subject to a second-ranking mortgage, so 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.
It should be emphasised that taking possession of an asset is not Qualitas’ preferred outcome, and it has not happened during our ten years in operation. We take a very active asset management approach, and as specialist real estate financiers, understand and monitor risks during a project’s lifecycle. If issues emerge, we work closely with our borrowers to find a solution.
When managed well, CRE debt has the ability to provide predictable, ongoing income to investors while providing protection by means of secured real estate assets. Qualitas is committed to careful management of the QRI portfolio, with the aim of meeting target return.
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1APRA Quarterly Authorised Deposit-taking Property Exposures September 2018 (released 12 December 2018)
This communication has been issued by The Trust Company (RE Services) Limited (ACN 003 278 831) (AFSL 235150) as responsible entity of The Qualitas Real Estate Income Fund (ARSN 627 917 971) (Fund) and has been prepared by QRI Manager Pty Ltd (ACN 625 857 070) (AFS Representative 1266996 as authorised representative of Qualitas Securities Pty Ltd (ACN 136 451 128) (AFSL 34224)).
This communication contains general information only and does not take into account your investment objectives, financial situation or needs. It does not constitute financial, tax or legal advice, nor is it an offer, invitation or recommendation to subscribe or purchase a unit in the Fund or any other financial product. Before acting on any information contained in this communication, you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs.
While every effort has been made to ensure the information in this communication is accurate; its accuracy, reliability or completeness is not guaranteed and none of The Trust Company (RE Services) Limited (ACN 003 278 831), QRI Manager Pty Ltd (ACN 625 857 070), Qualitas Securities Pty Ltd (ACN 136 451 128) or any of their related entities or their respective directors or officers are liable to you in respect of this communication. Past performance is not a reliable indicator of future performance.