Big bank 12-month term deposits are ~0.3 per cent (CBA, May 2021) and are unlikely to change in the foreseeable future. Yields on Australian REITs are likely to continue to hover around 3.7 per cent per annum.
In this environment, greater attention will fall on the higher returns available from other asset classes, with real estate private debt or credit being a prominent contender.
This asset class, private debt secured by real estate, has been popular with family offices and wholesale investors for some time and more recently, institutional investors. Importantly for retail investors, including SMSF trustees and so-called mum and dad investors, this asset class is now accessible to advisers through retail managed funds.
Until recently many advisers have been unable to access the asset class because it isn’t widely covered by the retail research groups or it isn’t available on the large retail platforms. The net result is yields of 5-7 per cent generally generated by a diversified pool of underlying loans. Portfolio, risk metrics and industry exposure can vary across portfolios.
A key to understanding this change is the evolution of the big banks' attitude to the real estate market. Since 2016, banks have pulled back from financing real estate development, be it subdivision of land or development of blocks of apartments. One of the many ways banks have pulled back without turning the tap off completely is to increase the stringency of lending conditions such as significantly increasing the equity banks require from developers and also requiring higher pre-sale debt cover on projects.
This has created gap in the financial market which non-bank organisations have been happy to fill.
The non-bank finance sector in Australia is still relatively small by global standards, accounting for an estimated 10 per cent of the market. In many comparable jurisdictions, the market share is between 20 per cent and 30 per cent.
For borrowers – real estate developers and investors – feasibility is no longer just about cost of capital, though it is important. Increasingly it’s also about the speed at which non-bank capital can move and be structured to suit the needs of a borrower or asset owner. It is difficult for banks to match the speed and execution of a non-bank.
An academic issue regarding this asset class is what asset class is it – fixed interest or real estate?
An observation with much credibility in the literature is that a key factor is the structure of the debt and the place it sits in the capital stack. It’s argued that senior secured debt is most akin to fixed income given investors receive a fixed or floating return that has very little to nil correlation with investor outcomes for the equity component or the underlying real estate. Mezzanine, however, is more likely to have investor outcomes correlated to real estate equity.
Australian real estate private debt funds generally hold senior secured first mortgage debt, which sits at the top of the capital stack. This means it is the first to get paid and the last to lose capital should the underlying asset become impaired. The rates on offer to investors by funds may vary slightly based on the quality of the fund's lending criteria.
A prudent or risk averse approach would be to focus on funds that feature senior secure first mortgage debt with conservative LVRs, say in the range of 40-65 per cent. In this instance, should an underlying property becomes impaired, it would have to fall in value by greater than 35 per cent before investors lose any of their capital.
Given the interest rate outlook and yield compression across asset classes, the real estate debt market will continue to see demand from investors as they seek out regular income streams with downside asset protection.
Omar Khan is the group director-head of wholesale capital at Alceon.
