In an uncertain inflationary environment, is private credit the place to be?

For most of the past decade, as interest rates globally wallowed near zero and inflation was best described as benign, investors have been on a relentless pursuit for yield. And as smart investors know, one of the best places to find a decent yield has been the Australian property sector.

This investor demand has been reflected in the steady compression of yields over the past decade, from mid-to-high single digits across all property sectors at the start of the 2010s to mid-to-low single digits today.

That’s still healthy, with yield spreads to 10-year bonds still maintaining a positive spread in favour of property yields. There are also parts of the market where yields have recently increased, such as the retail sector, which is now beginning to recover as some of the more significant impacts of the COVID-19 pandemic ease.

But as we stand at the start of a rising interest rates cycle and with inflation expectations pushing 5 per cent due to a number of demand- and supply-side factors that show no sign of easing soon, smarter property investors are now looking beyond simply ‘a search for yield’.

Put simply, at this point in the cycle it’s not enough just to earn income. If your fund is offering you less than 3-5 per cent, you can fool yourself into thinking you’re doing well when you’ll be going backwards in real terms. With the sharp steepening of the yield curve, you can now find bank deposits offering 3.5 per cent if you are prepared to commit for a fixed term of three years. Compared to deposit rates just a few weeks ago of near zero, this is a very large increase and is potentially attractive for some. However, if the forecasts of inflation remaining above 5 per cent prove correct, these seemingly attractive headline rates will actually send you backwards.

What investors need now is shelter from inflation – and that means yields or total returns of 5 per cent-plus as a hedge against rising prices in the economy. Property – both equity and especially debt – can deliver those returns and that protection if you know where, and what, to look for.

There are sectors of the property market that we believe will be resilient to rising inflation, such as residential assets (including build-to-rent) and assets that rely on patronage, such as retail, accommodation and hospitality, as spending increases in line with rising wages. These are good options for equity investors seeking an inflation hedge.

However, the real winner in this environment is likely to be private credit – an area where Qualitas has deep experience, significant exposure, and a wealth of opportunities.

It is well known that debt is considered a safe haven in uncertain environments, particularly senior debt, which is why we’ve seen an increase in credit spreads in recent months. But this is a particularly good time for private debt funds, which are able to reprice both base rates and risk margins to the benefit of the funds and their investors.

In terms of base rates, a significant proportion of Qualitas’ debt book is based on variable rates that will rise in line with official rates. In this way, contrary to the cliché that higher rates are bad for property, they can materially increase returns to our funds and investors.

The better news is that these rate rises flow through immediately, where a landlord can typically only increase rents once a year. This means the lender is entitled to a greater share of a property’s cashflow until the rental increases come through to compensate the landlord. In this circumstance, it’s arguably better to be the lender.

At present, variable loans make up a large proportion of our unlisted funds providing investors protection against the effects of rising interest rates.

Risk premiums, represented as margins over base rates, are already rising in line with the uncertainty in the market. As fund flows between the RBA and the banks are withdrawn, the cost of capital is rising and liquidity is flowing out of the system.

As a result, those with liquidity are demanding greater risk premiums to compensate (see chart). And among those with liquidity in the current market are the alternative non-bank lenders.

5yr bond spreads to swap vs. RBA Cash Rate¹

The commercial real estate (CRE) debt market has doubled in size in the past 10 years and is expected to continue growing strongly, helped along by inflation. If property is inflating due to inflation, then debt levels will inflate with it.

Alternative lenders like Qualitas have been capturing an ever-greater share of the market from the banks and now make up about 10 per cent of all CRE loans, with forecasts that proportion will double in coming years.

In fact, we could see an even faster withdrawal from the market by the banks, which during uncertain times, tend to not increase their portfolios. As the alternative lenders step in to meet market demand they will be able to command higher risk premiums, which, again, will mean greater returns for the lenders and their investors – returns that should outpace inflation.

The other benefit of debt, of course, is that if economic conditions do deteriorate markedly, the extra security provided by debt (over direct equity) is where you want to be. Experienced managers will be keeping a sharp eye on loan-to-valuation ratios throughout this period of economic uncertainty.

For the first time in a decade, we are confronting both inflation and rising interest rates. Thankfully, and somewhat surprisingly after the challenges of COVID-19, we are doing so against the backdrop of strong economic, business and property industry confidence.

But investors will need to adopt a different strategy to their decade-long pursuit of yield. In the property sector, there are opportunities to shelter, and even benefit, from inflation. Investors will just have to look a little harder – and private credit is an excellent place to start.

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