As the world grapples with the threat of the Coronavirus, financial markets have experienced significant volatility in recent weeks. Against this background, it’s timely to revisit the features of Commercial Real Estate (CRE) Debt and its diversification properties and why, in times of market turmoil, CRE Debt investments may provide a diversifying overlay to investor portfolios.
Features of CRE Debt
Commercial real estate (CRE) Debt is where loans are made to commercial borrowers who require funding for real estate purposes. The loan may be used to purchase improved, developable and vacant land, or for property buildings, both completed and under construction. The land or property is mortgage collateral for the loan, and investors derive income from the fees and ongoing interest paid on the loan.
Listed CRE Debt funds provide access to this type of investment by bringing together multiple loans and holding them within a diversified portfolio.
A Listed Investment Trust (LIT) comprised of CRE Debt is essentially a collection of loans that are carefully selected, originated and actively managed by the Investment Manager. However, it does this in a liquid format, as units in the Trust can be bought and sold on the ASX.
There are two distinct advantages of an investment in CRE Debt as opposed to the underlying real estate as follows:
1) The return on the loan is agreed upfront and is locked and loaded for the duration of the loan.
2) Downside protection from falling equity values is provided up to a certain level (calculated as a Loan to Value ratio) so worst case, if a Borrower is unable to repay the loan, there is always an option of realising security as a secondary means of seeking repayment of the loan. Of course, should the loans be carefully selected, an exit of a loan should just occur through the ordinary course, being a refinance of the loan or a sale of the underlying security by the Borrower.
An important point to note is that a LIT structure, as a trust, requires the Investment Manager to attribute all income (after fees) to investors. In contrast, a listed company only pays dividends at the discretion of the Board.
Capital preservation and stable valuations
Another important feature of CRE Debt is that loans can be secured by mortgages over a physical property.
The first or second ranking simply refers to the order in which creditors are repaid if the mortgage security ever needs to be enforced.
The key point is that when an investor holds a mortgage, they are first or second in the queue if things go awry and they need to become a creditor. Not only does the lender take security via a real property mortgage, but the lender only lends to a certain % of the property value hence there is an ‘equity buffer’ as another source of lender protection.
This is where secured debt investments are very different to equities. In general, shareholders in a company come last in the line of creditors, should the company fail. They can quite conceivably be left with nothing.
By comparison, the ability of a lender to take possession of a real asset aims to provide capital preservation for investors, as there is a physical property behind the investment.
I believe that this also means the net asset value of the fund is very stable. The value of the loans doesn’t fluctuate in the same way that the value of a property does.
By comparison, listed Real Estate Investment Trusts (REITs) can experience volatility in their capital value due to changes in the underlying value of the properties, as well as the investor demand that determines the unit price. (Read more about this topic here).
Australian Property market exposure
Like any portfolio, the quality of the underlying investments is paramount in a CRE Debt fund. The Manager should only lend to quality borrowers with quality real estate projects or assets.
Qualitas undertakes rigorous due diligence to ensure this is the case for every loan we fund, and this analysis is a core part of what our investment team does day to day.
Moreover, loans in the QRI portfolio are limited to Australia (currently 100%) and New Zealand (currently 0%), which protects investors from the type of global instability experienced in recent weeks.
As I pointed out in a recent wire, while Australia is facing economic headwinds, the property market has several advantages at this stage of the cycle. The low cost of capital – due to record-low interest rates – is likely to protect asset values in many sectors and the real estate sector may become a key beneficiary of the current monetary policy settings.
In my experience, volatile market conditions - such as we are experiencing now - prompt investors to seek safety in bricks and mortar. This has certainly been observed by Qualitas – even with the bushfires and emerging Coronavirus issues, we have seen strong demand for CRE loans in the first months of 2020.
Ultimately, this type of CRE Debt investment provides exposure to the domestic property market, but with the additional diversifying factor of being debt-based. For example, investors who already own property through their own home, investment properties or REITs, can still benefit from the property market, but in a different manner.
In a low-interest-rate world characterised by instability, CRE Debt provides an option to investors seeking income, capital preservation and diversification.
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The Qualitas Real Estate Income Fund (ASX:QRI) aims to deliver investors with a regular stream of income with the added benefit of diversification beyond shares and traditional property investments. Click 'Contact" below to find out more.
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) (Trust) 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)).
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