A 10% allocation that can increase returns over the long haul
In an era when large swathes of fiscal stimulus are flooding markets creating unpredictable outcomes, the prospect of inflation and a little stability goes a long way.
"The magnitude of the debt that's being created through this period, I think, you've got to go back a very long time in history in order to get something even remotely similar," said Wayne Lasky, managing director and co-founder of MaxCap Group.
He believes that a more disciplined approach to the market will help level out the noise created by the influx of temporary stimulus measures, such as the nearly US$2 trillion in US Federal stimulus and a rapidly expanding balance sheet closer to home.
"What if you included a 10% allocation to real estate debt? What might that do to returns?" asked Lasky.
Well, MaxCap asked University of Technology Sydney (UTS) to investigate exactly that. The study looked at a 10% allocation over a 20 year time period and determined that "returns increased, the volatility in the portfolio came down, and, importantly, the Sharpe Ratio grew and the Sharpe Ratio really is looking at returns in excess of the risk-free rate," he said.
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Where are we in the cycle at the moment?
If you do have somebody who has a definitive answer on that, I would recommend you walk in the opposite direction.
The confluence and magnitude of factors, be it the federal stimulus and the budgetary stimulus, or the QE from a monetary policy perspective is really astounding. We understand the rationale for it, which is to create a bridge here to get through the crisis and to have vaccines rollout, hopefully with the efficacy that is expected, so that businesses can return to normal. But the magnitude of the debt that's being created through this period, I think you've got to go back a very long time in history in order to get even get something remotely similar. And I think that's certainly got to be a concern. I think there's also the prospect of some inflation on the horizon. That's not necessarily a bad thing either by the way. And certainly, the Reserve Bank would like to see it come within the 2 to 3% buffer.
But I think what we are seeing is an acceleration of trends in commercial real estate sectors. When it comes to the broader economy I think we can expect to see a real boost, and a boost that we're not likely to see too often.
You can see that with the IMF increasing their growth expectations. They increased at 1%. That doesn't all happen very often. It's going from 3.5% to 4.5% in a short period of time, and that could jump again. So I think there's a lot of volatility in the market, and I think that's really important when an investor is contemplating their portfolio and thinking about strategic allocations moving forward.
I think it's important to not get too carried away. It's really important to try and block out a bit of the noise and really take a disciplined approach to look at the fundamentals underpinning the market less so than temporary measures that are creating a stimulus for a shorter period of time.
A study with UTS shows a 15% return for a blended CRED portfolio. How do you get to those returns?
That's looking at the last 20 years of data. So, that spans two crises and multiple sector downturns as well as obviously a 28-year economic growth cycle. It's important when you're thinking about the debt relative to other asset classes, even if you take out some of the higher-yielding debt products, so like mezzanine debt or debt that is preferred to equity, which can have a disproportionate effect on returns. Even for senior debt over that period of time, the first mortgage was delivering double-digit returns.
Now it's true to say that returns particularly about 18 months ago, started to compress a little bit because there was a lot of capital that came in from offshore, but that really stabilised in the last 12 months. I think when you think about that study that we did, what we were looking at, the primary focus for that study was to say, what if you looked at a traditional investment portfolio? Sure, it might have some equities exposures and might have some bonds and some cash. And what if you included a 10% allocation to real estate debt? What might that do to returns?
The study looked at that over a long time horizon and what it was able to determine is that the returns increased, the volatility in the portfolio came down, and importantly, the Sharpe ratio grew. And the Sharpe ratio is looking at returns in excess of the risk-free rate.
So that's on a per unit of risk. That's critically important because therein lies your risk-adjusted returns. When you're thinking about the commercial real estate debt in a portfolio context, really what it's doing is it's performing a really important stabilising act because it's very lowly or negatively correlated to a lot of those other asset classes. So in times of crisis, or extended periods of economic uncertainty, you tend to see the real estate debt continue to perform very strongly. And so that's a real feature of real estate debt in a portfolio. But of course, the thesis is you should have a well-diversified portfolio. When we looked at the study, it was looking at the inclusion of debt into a well-diversified portfolio.
What makes the Australian market attractive to offshore investors?
I think the first point is that capital certainly has mobility, so it can cross and does cross international boundaries. Sophisticated and experienced investors will seek out asset class opportunities with managers that are able to consistently deliver alpha. So, thinking about alpha as performance, it's the active returns delivered and commercial real estate definitely falls into that bucket.
When we're thinking about the rationale, first and foremost, it's strong, reliable returns. And I would say outsized returns compared to the risk. In addition to that, particularly offshore investors are looking at geographic diversification. So they know that the Asia Pacific region is a high-growth region, certainly compared to North America and continental Europe. They know that it's not easy to get access to the Asia Pacific region, as such, because it is heterogeneous. But Australia is one of the core markets and it's a great place to invest. We have a reliable rule of law, we have relative political stability, we've got relative economic growth, and we certainly also have strong long-term fundamentals. For the past many decades, our population has been growing at three times the rate of the U.S. and the UK.
And I think we'll look back in the fullness of time at this moment and understand that this was a little blip on the radar relative to that population growth. And of course, the health issue must be dealt with, but I think in the medium term for all the reasons that people wanted to come to Australia, I think we can add a few more important ones to that list.
There are other factors though at play, for real estate debt, in particular, it carries an exemption to withholding tax. So from an offshore investor's perspective, that means that there's no tax leakage leaving the country. And that's typically 10% so that's pretty compelling for this asset class.
The other feature of real estate debt is the thesis from a global allocator of capital's perspective. They are particularly on the lookout for asset classes that are experiencing structural dislocations. Because when you see structural dislocation, you'd typically get mispricing and often you have an opportunity to scale your investment. Certainly, a lot of the very large families or the very sophisticated large pension funds and insurers are looking for the scale and the sustainable nature of that investment over the period of time. So I think it's a confluence of factors, but there are pretty considerable tailwinds at play at the moment.
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