When unit prices don’t reflect reality
The longest bull market in history came to an end in March of this year, with COVID-related angst pushing share markets around the world into their biggest falls in many years.
The Qualitas Real Estate Income Fund (QRI), a listed real estate debt fund, was not immune to this panic, with its unit price falling from highs of around $1.60 (par with its net tangible assets) to $1.03 within days, before recovering to $1.50 in early June.
Certainly a roller-coaster ride for any investor, and some will say a natural part of taking on the additional risk of investing in the share market. However, the current unit price of QRI – and the volatility and trading discount witnessed across the last 3 months – is in our view simply not a reflection of the quality and stability of its underlying assets.
Here’s why: With all real estate lending, a loan always includes an equity buffer in the security property value to protect the lender from loss of capital. In QRI, the weighted average loan-to-value ratio is 64%, meaning the fund’s equity buffer is 36%. When the unit price falls, it means the market is effectively devaluing the underlying loans within the fund, implying there are loan impairments (i.e the risk of loss of capital if part or all of the loan is not paid back)). For the unit price to fall to $1.50, the fund’s equity buffer has been eroded completely and the implied value of the underlying loans has fallen by 8%, which equates to property values falling by a whopping 44% – a scenario which we believe is wholly unrealistic for Australian real estate.
What’s more realistic is that the current discount in the unit price – compared to the fund’s NTA – is instead a result of negative share market sentiment and a rush for liquidity. When attempting to assess the fair value of a real estate debt fund, this mismatch in pricing should be a primary consideration for any investor, also having regard to the quality and management of the loan portfolio. While share market volatility is just one example of the many and wide-ranging changes brought into our everyday lives this year, what hasn’t changed is the quality of our assets or our fundamental approach to real estate investing. Looking beyond this volatility reveals a number of compelling factors about the QRI fund that remain as true now as they did prior to the pandemic.
We take a hands-on approach to managing loan assets within the portfolio
At Qualitas, we apply a judicious investment process to source, filter and select suitable loan opportunities on behalf of our investors. We also actively manage each loan within the fund, right throughout its life cycle: every loan is reviewed individually on a regular basis and during the pandemic we’ve increased the frequency and intensity of these reviews to every 4 weeks. We track each investment in accordance with its investment thesis and expected performance, undertaking regular inspections of the real estate assets to proactively identify any issues.
We are not just a lender; we are experienced real estate experts who are also equity investors in property and can therefore inherently understand the types of issues that impact the borrower’s position. If the borrower does get into trouble, we can use our extensive property expertise to better manage the loan issues and related-transaction parties, all with the aim of ensuring we safeguard the loan performance and value from deteriorating. Qualitas are also co-investors in QRI, ensuring our interests are fully aligned with those of investors; our hands-on approach to working with our borrowers and managing the fund’s assets is designed to look after your capital, particularly in times like these.
The quality of our investments is proven
At Qualitas, we’re proud of the fact that since we launched QRI in 2018, there have been no loan impairments in the portfolio, and no deterioration in net tangible asset value – including during the pandemic. These facts are testament to the quality of the fund’s underlying loans and our effective approach to structuring and managing risk within the portfolio.
Furthermore, our specialist real estate experience and disciplined investment strategy means that the current composition of the portfolio is in our view appropriate for the market conditions we’re seeing right now. It has a good level of diversification across sectors (with a relatively high weighting to the more defensive residential sector), locations, loan types and borrower types, and a conservative weighted average loan-to-value ratio of 64%. We were patient when it mattered, resisting the temptation to take on more risk in the fund, resulting in a portfolio that has been able to better withstand the market shocks seen during this crisis period to date.
The fund’s robust security packages are designed to protect investor capital
We believe good investing means truly understanding risk and ensuring we have the right security packages in place to safeguard investors’ capital. Capital preservation is our top priority at Qualitas: all loans within QRI are subject to a robust security package which always includes a real property mortgage. These underlying assets are a tangible security and are a straight-forward asset class to understand, with their value based on easily understood key performance factors such as how well located the property is, vacancy levels, quality of the tenant and the experience of the builder for example.
Our borrower guarantees include registered charges over related transactions and entities, as well as interest reserve accounts (with typically 3-6 months’ worth of interest) held by the lender to ensure the borrower is able to meet repayment obligations should their primary interest servicing cashflow dry up.
Furthermore, around 98% of the loans in QRI are senior loans, giving us first priority for repayment in case of default, and 98% come with a personal guarantee. Many of our loan agreements grant us additional rights as a lender; if any of these extensive borrower obligations are not met, this results in the loan being in default, following which we have the right to commence enforcement of the loan collateral and seek early repayment of the loan.
Recent loan repayments and new deal parameters are favourable
While the recent market turmoil has undoubtedly been unsettling for investors, it’s important to note that all of the loans within QRI are being repaid in line with expected timings, demonstrating that the underlying sources of repayments are typically stable and sufficient. This is important because it suggests that even through this crisis, market conditions are far from distressed – buyers are still buying and stock is selling in an orderly fashion.
Remarkably, we are actually starting to get better quality loans for the same pricing as before the pandemic. In the current economic climate, banks have tightened their lending again and alternative lender competition has decreased, leading to a shortage of debt capital for borrowers, and better opportunities for alternative lenders such as Qualitas. We’re finding – to our favour – that borrowers are now seeking less leverage: recently-closed deals within QRI have incorporated more conservative loan-to-value ratios, better security packages and increased borrower obligations, further preserving our investors’ capital.
Market fluctuations are an inherent part of investing and are by no means an easy ride, but they can also offer valuable opportunities. We believe the current unit price discount could represent a rare chance to buy into the market at a time when implied valuations are supressed. For those able to look beyond the negative headlines, the good news is hiding in plain sight.
Notices and disclaimers
- 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 QRI or any other financial product. Before making an investment decision, you should consider the current Product Disclosure Statement (PDS) of the Trust, and assess whether the Trust is appropriate given your objectives, financial situation or needs. If you require advice that takes into account your personal circumstances, you should consult a licensed or authorised financial adviser.
- 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.