How to earn income from property while minimising the risks
Commercial Real Estate Debt is widely accepted as an asset class in the institutional and wholesale investment sector. Over the past ten years, Qualitas has created a number of discretionary debt strategies for private and institutional clients, offshore pension funds and family offices, before creating the ASX-listed Qualitas Real Estate Income Fund (ASX: QRI).
Commercial Real Estate Debt means that instead of owning an asset, the investor provides financing for a third party to own or develop it. Returns are generated by the fees and interest that borrowers pay.
To put it simply, if you invest in real estate debt, you’re acting more like a bank than an owner. For example, instead of owning a single apartment, you’re lending to commercial borrowers who are building hundreds of apartments.
Investors may benefit from the income, diversification and attractive, risk-adjusted returns that the asset class can provide.
Attractive income while minimising the risks
There are several features of Qualitas’ approach that make our investment products attractive to income-focused investors looking to minimise risk.
Predictable Returns - When an investor buys a property to own, they often expect capital growth to deliver some or all of their returns. But price growth is highly variable depending on location, timing and asset selection.
By comparison, real estate debt is simpler to value and predict. As a lender, the investor will agree a price (the interest rate) and a time period to repay it (the loan tenor). While there is no upside from capital growth, there is also less downside risk.
Risk Mitigation - Before Qualitas originates a loan, we undertake rigorous due diligence to identify and manage the risks of the deal, looking at the borrower’s track record, the details of the property and the guarantees available.
We also take a mortgage over underlying real estate assets to protect our investment, and ensure a loan-to-value ratio that minimises the risk of making a loss. Since inception in 2008, none of Qualitas’ invested deals have made a loss; in fact, all have achieved the forecast return.
Responsive to Cycle - The average tenor of loans made by Qualitas ranges from 18-24 months. This means that we are able to be responsive to market conditions, and we are not locking in deals today that are subject to market conditions three or five years from now.
Our four investment principles
Qualitas has four investment principles, against which all the investments are assessed:
• Quantum of returns: Qualitas will seek to accurately forecast returns from an investment as well as the components that form those returns – i.e. payment of interest and fees, capitalised interest and fees, early repayment fees and other similar components based on the relevant supporting contractual agreements.
• Timing of returns: A fundamental principle of the Qualitas Group’s investment philosophy is to seek to forecast, with a reasonable degree of certainty, when the investment is originated, the timing for interest payments and the expected timing for loan repayment. This will be predicated by way of contractual arrangements and actively monitoring the investment.
• Assessment of known risks: Qualitas will seek to diligently consider and assess each material risk that may have an influence on a given investment. This does not mean the Manager will not take risks, rather it will seek to identify and to the maximum extent possible mitigate all inherent material risks.
• Ability to exert influence over known risks: Having considered and analysed the known material risks for each investment, Qualitas will then seek to invest based on being able to structure a secured real estate loan that reasonably mitigates those specific investment risks, thereby exerting a degree of meaningful influence over those identified risks.
Understanding the cycles
There are two economic cycles influencing our investment strategy: the property cycle and the credit cycle. Separating those two distinct (albeit connected) cycles is key to understanding the risks and return profile of a CRE debt fund.
The Credit Cycle is the expansion and contraction of access to credit over time. Australia has been experiencing a tightening credit cycle for some years now - meaning it’s more difficult to access loans. This is leading to structural change in the way commercial real estate financing is provided.
The commercial real estate lending market is worth more than $281 billion. However, banks are reducing their exposure to this type of lending due to increased regulation and capital requirements. As a result, commercial borrowers are increasingly working with alternative lenders, such as Qualitas, to gain access to the funding they need to deliver projects and finance properties. This creates a growing market opportunity for Qualitas.
In this sense we see the current credit cycle as favourable to our investment strategy.
The Property Cycle - The property cycle also impacts our investments, but in a less direct way. Unlike owning property, a debt investment doesn’t depend on valuations rising in order to make a profit. The return is generated by the agreed interest rate (and any additional fees), not the capital gain.
For loans secured against real estate assets, the valuation of an underlying asset becomes relevant if the borrower is unable to repay the loan. When Qualitas is granted a mortgage over an asset, we ensure the valuation covers the loan amount with an adequate buffer.
We do this by requiring conservative loan-to-value ratios, usually a 65-75% for mezzanine and 50-65% for senior debt. This provides a significant buffer, so that even if the asset value were to decrease, we would be well-placed to recover the loan amount as well as the interest charged.
In this way, asset prices play a part, but we take a number of steps to protect our investments from short-term fluctuations.
A slowing property market can also affect the development and investment activity of CRE borrowers - if fewer developments are commenced or fewer properties are bought and sold, for example. However, this reduction in demand comes off a high base, and activity is continuing regardless.
Similarly, long-term property investors will continue to acquire assets. When the market recalibrates, savvy investors with access to available capital are usually attracted to the market, taking advantage of the lower prices.
In terms of the current market, residential constructions starts have slowed and this has shifted demand towards land and investment loans (retail and office sectors). Demand for mezzanine construction loans is lower, while demand for senior land loans has increased as developers hold onto sites in readiness for the next phase of the property cycle, and need funding to do so.
How we filter deals to ensure quality
We review each investment on its merits, making sure it meets our deal filtering process. Essentially, we are looking for a quality asset and a quality borrower. In particular:
- The client, their experience and financial position - We gather detailed information about the client which includes their business operations, track record, management team, company owners, financials and property portfolios.
- The quality of the asset we will be funding - Qualitas loans are secured by real property assets, so it’s important that we verify the asset’s quality if we were to take possession, such as whether it could be resold or leased out, the location, and its supporting demographics.
If it’s a construction loan provided to a residential project, for example, we will look into the pre-sales achieved and profile of the purchasers, the location, the builder, the construction contract, the site specifics and the overall desirability and market appropriateness of the end product.
If it’s a land or investment loan, we’ll consider any potential cashflow and the plans for future use or development.
As such, the investments we filter out are those that don’t match our risk appetite due to the experience/track record of the borrower, the dynamics of the particular asset, or the structure of the particular deal.
For example, construction loans that would not meet Qualitas’ deal selection are inexperienced residential developers demonstrating difficulties making their project feasible / profitable in the current market environment. Perhaps they bought a site when land values were high, are struggling to obtain sufficient pre-sales (indicative of poor market timing or low product acceptability), or they are failing to achieve favourable development approval outcomes.
Understanding and mitigating the risks
This asset class is based on providing loans to borrowers, secured by real estate assets. So, one of the key considerations is the credit risk – the risk that the borrower cannot make interest payments or repay the loan resulting in loss of income or the principal of the loan.
What are some of the reasons why a borrower can’t make these payments?
- Interest: This could be due to cash flow issues. For example, the borrower is using rental income from a retail property to pay interest on the loan. The retailer renting the property goes bankrupt and cannot pay rent, so the borrower thus does not have enough rental income to meet interest. They can, however, use other sources of income to avoid defaulting on interest payments.
- Loan repayment: a default on repaying the loan means the lender can take possession and sell the property to recover the loan. If the value of the property has declined substantially and eroded the equity buffer, there may not be enough to recover the loan. They can, however, use other sources of funds to avoid defaulting on the loan repayment.
Qualitas mitigates these risks by undertaking extensive due diligence and credit risk assessment of all our loans and borrowers. It is important for us to understand who is borrowing the money, their capabilities, their experience and financial backing. Not only does this mean we can select the best borrowers and best properties, it means we can understand the risks and write loan terms that best protect us from these risks.
What are your long-term return expectations?
Returns are dependent on the investment strategy of each of our funds. The Qualitas Real Estate Income Fund has a target return of 8% (net of fees and expenses). This is a target only, there is no guarantee the Trust will achieve its objective.
Want access to a steady stream of income?
As one of Livewire’s premium partners, Qualitas has committed to educating investors about income investing through this instalment in the Livewire Income Series. To find out more about the income options that Qualitas provides, please click the 'contact' button below.
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Tim is responsible for the firm’s real estate finance activities and was responsible for establishing the Sydney presence of the firm. He has over 20 years experience across real estate financing markets.