Private credit
Interest rising | The case for real estate credit
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Drew Bowie
Managing Director
Published 10 December 2022
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A decade of accommodative fiscal and monetary policy, of generous returns for equity and real estate investors and clear forward and supportive guidance by central banks appears to be over.

Investor interest in private market alternatives is near all-time highs, reflecting sustained demand for strategies offering income stability, downside capital protection and protection against rising rates.1

A recent survey of allocation intentions of more than 800 global institutional investors shows real estate credit is in the top three choices for future allocation to private credit.2

Defensive in nature with a relatively attractive, resilient return profile, by design real estate credit can be shielded from the inflation challenges ahead. It can be an attractive through-the-cycle option for investors now both cyclically and structurally.

How did this relatively new asset class evolve in Australia? What are its characteristics and how will it deliver for investors through the cycle ahead?

Real estate credit 101

Valued at $3.2 trillion, the Australian private credit market has grown by 33% since 2015.3 To put this into context, the Australian Securities Exchange (ASX) domestic market capitalisation is currently $2.5 trillion.4

The origination and active portfolio management of loans by a non-bank lender (NBL) secured by underlying real estate assets across a range of sectors and geographies, real estate credit is a specific sub-sector and includes secured loans to fund the purchase of land, commercial or residential properties, completed or under development.

Real estate credit involves the provision of a loan to a borrower with the principal security being a mortgage over that borrower’s property. The most defensive position is a first registered mortgage, which gives the lender/investor the right to repayment from the value of the asset ahead of any other creditor or the borrower. It is often regarded as the ‘last money in and first money out’. It also gives the lender the right to control the property if the borrower defaults.

Other forms of real estate credit, such as second registered mortgages (“mezzanine debt”), are subordinated to the first mortgage and have more risk.

Its unique lending structure makes real estate credit increasingly attractive as interest rates rise.

Regulatory changes and changing risk profiles drive growth in NBL

Australia is early in the cycle for NBL, and there is potential for significant growth in the sector due to the changing nature of the lending market and its continuing fragmentation.

To date, regulatory changes have been the engine room driving NBL growth.

Tightened capital requirements for the banking sector introduced by the Australian Prudential Regulation Authority (APRA) post the Global Financial Crisis have shifted deal volume from the big four banks to a wide range of NBLs.

Lending by NBLs now represents 7.6% or $246 billion of the total private credit market, up from 5.7% ($139 billion) in 2015.5

The funding gap in Australia and growth of NBL has been propelled not just through structural change. Strong population growth is one of the key drivers of economic growth, the demand for real estate and real estate credit.

Australia’s population growth ranged from 1.5%-2.0% p.a. over the 10-years to the end of 2019 (pre-COVID). This was one of the highest growth rates in the world.6 Dramatically reduced by Australia’s COVID border closures, latest Treasury estimates suggest population growth is likely to return quickly. Budget forecasts are for an annual population growth rate averaging 1.3% over the next five years.7

Along with APRA’s capital tightening bank regulations, population growth should support Australia’s increasing demand for NBL alternatives.

Revised strategies for assessing risk

Economic and financial market variables have deviated from long-term historical trends during 2022.

A fundamental building block of asset allocation since the early 1980s has been the 60:40 equities/bonds portfolio. This diversified strategy provided investors with consistent and generous total returns driven by robust economic and earnings growth and low/negative correlation of returns between equities and fixed interest.

Capital market strategies for portfolio diversification and risk management have altered over 2022.

Higher interest rates have been damaging for both equities and bonds. Average total returns from the balanced 60:40 strategy turned negative over the first half of 2022 for the first time in 50 years. The average US portfolio is down by 12%-13% over the 6 months to June 2022, compared to the historical annual average 10-year total return of +10%.8

Investors are seeking private market alternatives for income stability with downside capital protection.

Diversification, inflationary hedge and downside risk I Capital preservation is key

Assets that can deliver investors with inflation-adjusted income security and capital preservation are keenly sought.

As the cost of capital rises and liquidity flows out of the system, alternative NBLs can capitalise on the greater risk premia of traditional asset classes and the unique properties of real estate credit.

Private credit has a historically low correlation to both listed equities and public market debt securities. It provides clear portfolio diversification benefits.

As a floating rate secured asset class, real estate first mortgage credit provides an inflationary hedge. Rate rises are passed through to investors as cash rates move higher. The payment of historically regular and stable income, adjusted for increases in the cash rate generates low return volatility.9

In addition, a key factor in understanding real estate credit is its relative security compared to alternative investment options. In a secured lending facility, it is equity investors who occupy the first-loss position in the event of a decline in value of the underlying asset. Downside capital protection is provided to credit investors, any change in capital value less than the equity is not passed through, forming an equity shield and cushioning downside risk.

A final layer of income and capital security for real estate credit investors is the low level of loan defaults in the domestic lending market. Australia ranks in the world’s top 10 for efficiency in enforcing contracts.10

Where to from here?

It is tricky to predict where financial markets are heading into 2023. Local and global government bonds and equities are volatile and allocating into cash is no longer a purely cautious play.

Defensive in nature with a relatively attractive, resilient return profile, by design real estate credit, especially first mortgage credit, can be shielded from the inflation challenges ahead. It can be an attractive option for investors now both cyclically and structurally.

Risk is always a critical component of investment and lending. Real estate credit is no exception, based in part on the nature of the product itself but also from risks in the market in which the facility is operating in. That is why it is important to find a specialist credit manager focused on prudent and disciplined analysis of credit risk on a deal-by-deal basis, with a proven track record of deploying capital at scale and delivering consistent performance through-the-cycle. In the hands of an experienced manager, the secured nature of real estate credit and its position in the capital structure can minimise income volatility and downside risk.


This insight is the first in our Real Estate Credit Investment Series, to view the full series please click here. For more information about our real estate credit capabilities and solutions, please get in touch.


Disclaimers

1. Q2 2022 Global Private Markets Fundraising Report, Pitchbook, www.pitchbook.com

2. 10 considerations for building strategic allocations to alternative credit, Think EQuilibirium, Nuveen, www.nuveen.com. The survey asked respondents for their investment intentions over the next two years.

3. MA Financial Group analysis of Reserve Bank of Australia, D2 Lending and Credit Aggregates (December 2021). Private Credit Market refers to ‘Narrow Credit’ (ex. Securitisation) in RBA data set.

4. ASX market capitalisation based on ASX Historical Market Statistics as published, August 2022, www2.asx.com.au

5. MA Financial Group analysis of Reserve Bank of Australia, D2 Lending and Credit Aggregates (December 2021). Private Credit Market refers to ‘Narrow Credit’ (ex. Securitisation) in RBA data set

6. Annual Population Growth Rate, Australia, Australian Bureau of Statistics, www.abs.gov.au

7. 2021 Population Statement, Australian Government Centre for Population, www.population.gov.au

8. Historical total return quoted is the 10-year period ending December 2021. Thoughts on the Market, Morgan Stanley, Allocation – Stock & Bond Correlation Shifts, 17 August 2022, www.morganstanley.com

9. Nuveen, 10 considerations for building strategic allocations to alternative credit, Think Equilibrium, www.nuveen.com

10. Australia ranks sixth in the Enforcing Contracts Rank, above Germany (#13), US (#17), New Zealand (#23) and the UK (#34). Source: The World Bank, Doing Business Archive, www.archive.doingbusiness.org

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