Real estate lending underpinned by strong fundamentals

Returns on credit investments are facing downward pressure in 2025 as official interest rates and bond yields fall.

Yet, for investors, returns of 8% to 10% p.a. are achievable even as private credit managers experience tighter margins and competition intensifies.

Declines in inflation and an economic slowdown has brought down market interest rates and with that, interest rates on private credit transactions. As competition for business rises, it is crucial for private credit providers to closely monitor risks to maintain returns as there are still plenty of opportunities for smart financing solutions.

A housing shortage in Australia will likely underpin strong returns from residential construction lending. The Urban Development Institute of Australia (UDIA) 2025 State of the Land Report recently forecast a supply shortfall of around 400,000 dwellings for the combined capital cities by 2029, driven by persistent underbuilding relative to population growth and ongoing challenges in the construction sector. Housing supply shortages are likely to continue given elevated costs and labour shortages. All of this bodes well for lending towards the construction of small-scale housing projects.

Despite the media beat-up on construction lending in the real estate market, private credit managers can employ a range of rigorous strategies to mitigate the risks associated with construction lending. Good lenders will conduct thorough assessments of both the borrower and the builder, including reviewing historically completed projects, undertaking an assessment of a project’s current financial position and scrutinising all project documentation such as planning approvals, construction certificates and building contracts.

The type of project and size matter too. Generally speaking, lending on smaller scale residential projects can be safer than lending on larger-scale residential and commercial developments. Lending on general residential developments is generally less risky than for commercial projects because demand for housing tends to be more stable than demand for commercial property. Smaller scale residential projects have the added advantage in that they are generally less complex and easier to complete than larger scale projects.

Another way to reduce risk is by focusing on lending to infill housing developments, that is, the development of housing in areas with an established housing supply. This may involve the rejuvenation of existing housing stock such as building townhouses on a previous single dwelling site, which is limited in supply but experiencing healthy demand. This is very different from lending on high-rise residential developments where the construction of hundreds of units can increase risk for both the developer and the lender given the relatively high supply of units coming to market at the same time and potentially applying downward pressure on prices.

It's all about risk

Yet another way private credit managers can reduce risk for investors is by managing the lending process very closely, as well as allowing for contingencies. Allowing for contingencies is critical as construction projects can be unpredictable, with the potential for unexpected site disruptions, price fluctuations and regulatory changes or delays impacting on the delivery of projects. Contingency allowances provide a financial buffer to accommodate these issues without jeopardising the project.

Lenders like Vado Private set realistic contingency amounts, typically ranging between 5% and 10% of the overall construction budget, based on the project’s complexity and risk profile.

In contrast, lending to larger projects generally carries with it higher risk due to the complexity and scale of the projects, more protracted planning and regulatory processes, longer lead times and construction programmes , and the resultant exposure to economic cycles that occur over the course of the project.

Lending to smaller residential projects is typically lower risk yet can deliver interest returns to investors of between 10% to 12% p.a. for quality transactions, which bodes well for delivering meaningful returns to investors.

Look for a track record

For investors, first and foremost, they should evaluate a private credit manager's track record, expertise and risk management capabilities. Look for a proven history of successful lending, experience in complex loans and credit industry knowledge. Review the total number of loans the manager has funded, and check that the manager has experience across different types of lending transactions.

Investors should ask about the quality of loans funded and loan recovery on principal and interest, the number and percentage of bad loans or defaults in the lender’s portfolio, as this reflects the manager’s ability to manage risk effectively and resolve problem loans. Selecting a reliable private credit manager requires due diligence to ensure alignment with your investment goals and risk tolerance. By checking their track record, loan quality, potential conflicts of interest, and risk management practices, investors can invest their money more wisely and look forward to favourable returns.