Where to look for income when bonds are expensive

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For mortgage fund managers, there's nothing like taking a long view of investment markets and applying strict prudential discipline when it comes to staying out of trouble and continuing to pay investors.

"A lot of people who are looking at investments only look at things recently," says Lucerne Investment Partners Executive Director Michael Houghton. "They only know what they know from their own experience."

In this interview, Houghton draws on decades in the market to paint a picture of historic Australian banking failures such as Rothwells, Tricontinental and Pyramid.

"These are all lenders that went broke," he says. "But there was no scrutiny; there was no real regulatory supervision going on. If you look at those events, you can start to see some really distinct differences, then till now."

Houghton touches on the recent case of Mayfair 101 and explains the prudential mindset Lucerne uses to protect investor capital.

This has more to do with analysing the capacity of a borrower to pay than the price performance of the property itself.

View the interview below to see Houghton explain the advantages of mortgage trusts for investors who have been disappointed by credit trusts and bonds.


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Why commercial real estate debt is becoming a hot income asset class

Edited transcript

Why do you like the mortgage space vs traditional bond and credit options?

It's a really interesting question because we have been allocated to credit funds and bonds, but the lower interest rates go, the more expensive they become. I think a lot of people don't understand the relationship between yield and price when it comes to those assets. It became a really prevalent conversation with investors through the second half of 2020, because through the COVID crash, as we know, everything correlated to one and all went down, bonds and credit funds equally.

RMBS or residential mortgage-backed securities typically also were impacted heavily, even bank hybrids were down 15%, 20% through that period. So a lot of people don't understand, "Well, hang on, I'm in this. Why is it that the price has gone down when it's meant to be paying me an income?" Having that conversation about that relationship between yield and price has been a really good exercise to have gone through that period because it does give us insight into the question you've just asked and allowed people to see the difference between how they perform.

So a mortgage fund is something that's paying you income, irrespective of what happens, so as long as the borrower continues to meet their obligations. There's no price behaviour on the loan itself, and the underlying asset is where the price action might take place.

But we think with all the prudential requirements and oversight that we put in when looking at mortgages, that's probably one of our least concerns, so long as the borrower is able to meet their obligations.

How does the asset class perform through property and economic cycles? 

It depends which mortgage fund you're in, I suppose. If you're in one that's investing in residential mortgages, then you might see potentially some impact, but again, it's driven by what the price of the underlying asset does. So long as the individual borrowers continue to meet their obligation, that in and of itself isn't a major concern.

We participate in the commercial real estate market, so that has different behaviours and characteristics, and also the loan to value ratios in that market is far lower than a residential market. That's one of the reasons we don't participate in the residential market.

What we're more concerned with than what you have seen through cycles is that you've got a borrower that's capable that has the capital behind it, they're able to continue doing what it is they do, and that the asset can be supported by them and the loan that they've taken to fund that asset purchase. So, what we're really concerned about and what you do see through various market cycles is continuing to get that 7%, 7.5%, whatever it is that you're targeting at the time to continue to pay investors. Because they're not looking at the price, their only concern is 'is my unit generating the income? When the time comes for me to redeem that or to have that loan repaid, will I get my capital back?' That's what we manage too.

I might just go a little further and talk about something that, again, I'm showing my age here, but a lot of people who are looking at investments only look at things recently. They only know what they know from their own experience or the time that they've been invested or participating in the market. So, mine goes back a bit further. Since the times of the Rothwell's bank in WA, since Tricontinental, which was State Bank of Victoria owned Merchant Bank, since Pyramid Building Society, et cetera.

These are all lenders that went broke, and they were lending to commercial real estate, they were lending to residential real estate, but there was no scrutiny, there was no real regulatory supervision going on. It was claimed to be taking place, but it really wasn't. If you look back at those events, you can start to see some really distinct differences then to now how people are wanting to invest, particularly how we approach those investments.

In recent times, typically someone like ourselves and others who are professional investors in the market look at a Mayfair 101 as a really good recent example, and look at that and just wonder how is it even being able to continue as it is?

But it's not our market, it's not what we want to participate in, it's not what we do, but there are still those out there that get by. What you've got to look for is, and to be able to stay through those market cycles is the prudential elements that you apply to any loan that you make.

What role does the asset class play in an investment portfolio and what weighting would you attribute to it?

It's an interesting question because it's going to be investor-specific. One of the things that we've spoken about in the past and that we always speak about with our investors is what are your objectives? What sort of risk are you prepared to take? What sort of investments are you wanting to do or not wanting to do? As the case may be.

One of the things that typically come up, particularly those in the later stages of their self-managed super fund and are looking to transition from accumulation phase into pension phase is income. So for those investors, when they've got more of an income focus, you still need to have growth assets in there, but you're going to maybe be more biased towards generating a return.

Something like this could therefore be 10% or 15% of the portfolio, typically because it's providing them with their cash return that they need then to collect the pension and allows their growth assets to remain through the market cycle and continue to perform.

You don't want to be selling your growth assets when they're under the most stress because the market's pulled back. That's where we see a mortgage income fund sitting in a portfolio.

Look, it could even be higher. It depends on the investor, depends on the mortgage income funds that they're investing in, and also the risk. One of the things that we do do is look at pooled funds versus contributory funds. The difference being a contributory is just one loan to one asset, and that's it, whereas a pooled fund is one loan or one investment you make as an investor that's spread across multiple assets. By that, you're diversifying your risk within the fund. So then you're having only to assess the ability and capability of the manager themselves, and that they're able to make good loan decisions.

How are you able to maintain a 7%+ yield to investors in such low-interest rate environment? Will this target shift as interest rates lift?

We do think that rates will increase on the mortgage fund as interest rates increase within the market. That's only because it does become the same impact for everybody, borrowers and lenders. As for how we're able to offer the rate that we are on the Lark Mortgage Income Fund, for example, with a 7%+ return objective, well, there's two things that we're doing. One is we are taking a lower management fee, which helps give a higher return to the investors, and we're also looking at loans in segments and sectors that are highly competitive.

But while we're focusing on tier one, tier two borrowers and assets, we're also looking at and aware that it's becoming a competitive market. So, we're saying no to those that are trying to price take and more using our existing market.

We've got repeat borrowers, we've got strong relationships with stakeholders and other participants in the marketplace, and there's a lot of what we do that benefits them, that even paying a slightly higher interest rate makes more sense, because of several factors.

One is they may not get that funding from a traditional source, typically banks. They've retreated from the market significantly because residential home loans are a lot cheaper and therefore more profitable for banks to make money. Private lenders afford the opportunity to a borrower to be quicker to develop whatever it is they want to do with the asset.

So if they are buying to hold and get a permit to do construction, or if they're buying land to subdivide and then sell to residential property owners in one of the growth corridors, those sorts of things can get done much quicker if the funding's available now, rather than wait six, nine months to get the funding. It's still even paying maybe a 1% higher interest rate for them on their cost of capital and the return on equity that they're seeking, that still adds up and makes a lot more sense.

What are the criteria used when deciding what property project to allocate capital to? 

Look, we're very traditional in the way that we approach lending. There's a lot of work that goes on in the due diligence phase of looking at a loan. That includes using external third party professional services providers from quantity surveyors and valuers to assess the merits of a project. We also look behind who it is that's come to us. What capital they've got behind them, what sort of experience they bring, if they're in construction, for example. We are very unlikely to lend to somebody that's doing this for the first time. We're also looking at the asset itself, where it's located.

So at the moment, there's a couple of transactions that we're looking at that are in growth corridor, some residential housing, both in Southeast Queensland and western suburbs of Melbourne.

Also though, there are other areas that we're looking at and funding that don't just fit into residential. We've also funded a hotel development that is still probably a year or so away from coming to fruition. But again, we look at who's behind that and the types of things that they're bringing to it and why they're participating and what can we support them with.

So direct property has a different yield profile, certainly, and it also has a different risk profile, because you are actually owning the asset, so you are reliant on capital growth, as well as income. I think one of the things that a lot of people know with property, particularly for a commercial landlord, so you're buying the property to have it as an investment and get a commercial tenant, you wouldn't want to have been owning one of those for the last 18 months, because you'd be giving a lot of rent relief and not earning much income.

But even before that, if you're owning in some of the more traditional areas where it was seen as a good place to own a property, whether that's Chapel Street in South Yarra or Burke Road in Camberwell, or Bridge Road in Richmond, sorry, they're all Melbourne suburbs for people who are wondering, you were getting yields on those ones of 1.5% to 2.5%. That's never going to be something that you're making a lot of money off, so what you're really hoping for there is that you continue to see your rent increase so that those yields will continue to boost the capital or the value of the property.

So a mortgage fund in the way that we're looking at it, which is lending to borrowers and allowing them to purchase an asset and either develop it or hold it for a future permit situation, it's all about their ability to repay the loan and their ability to service that loan.

We do a lot of work to make sure that they can do that, that they've got the strength behind them to do it. Sometimes we even build the servicing component of that into the loan amount to ensure that our investors are not in a situation where they're not receiving capital. So one's income, one's capital in my opinion to a large degree. That'd be the key difference in the way that we would see it.


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