Real Estate: is now a good time to invest?

Warren Buffet’s famous piece of investment advice is to “be fearful when others are greedy and greedy when others are fearful”.

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

In fact, real estate debt is a burgeoning asset class in Australia, with local and offshore investors increasingly turning their attention to it.

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 debt space for the past decade, forging a strong track record of returns for investors by responding to the opportunities that the market cycle presents.

A changing debt landscape

Qualitas invests across the capital structure, from senior and mezzanine debt through to equity, depending on the specifics of each deal.

Senior 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 not only increased opportunities for alternative lenders, it has adjusted the pricing of such loans and made 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, 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.

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 sharemarket 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. The first was that 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 when the credit crunch came.

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 understand and closely monitor development risks. A report by a bank-appointed quantity surveyor is backwards-looking, whereas Qualitas meets regularly with developers and identifies emerging risks. We know what we’re looking for and which questions to ask.

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 indeed further up the risk curve than traditional senior debt – but it attracts a price premium as a result. Specialist lenders like Qualitas, 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

In a period when house prices are moderating, or even falling in some areas, it’s easy for investors to get nervous. However, there are several factors that aim to protect Qualitas’ investors.

The first is the nature of secured debt investments – there is a buffer created by the fact that we only lend 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, in our view real estate debt is less sensitive to asset price fluctuations than real estate equity investments. Moreover, the ongoing interest payments mean that income is a 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 of these facts in mind, in our view, 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. 

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.