As with all sectors, it is reasonable to believe that when conditions are tough, the strong prevail. Real estate credit is no exception.
The opportunities for private lenders (also known as non-bank lenders) to finance the growing demand for real estate credit is part of a long-term structural shift in Australia’s lending market. The sector will play an increasing role in complementing the major lenders in servicing the commercial real estate debt market, particularly addressing the critical housing shortage, which is belatedly now receiving the attention of policy makers and headline news.
The success of real estate credit investing, however, depends not only on sound market fundamentals and the security of the underlying asset (preferably first lien mortgages over real estate). The performance, experience, and platform strength of the asset manager is a critical component in its ability to assess underlying value and exit strategies as well as navigate price pressures, ongoing macro volatility and financial market noise. There is a wide range of competency and investment approach in non-bank lenders – they are not all equal.
The relatively benign environment dominating the investment landscape until early 2022 provided protection for real estate credit managers of all sizes and description. Since then, the terrain has become more complex to traverse and decades old learnings have come back to the fore (if you had them in the first place).
What makes a great manager?
- Transparency: To be entrusted with other people’s money comes with great responsibility. Never losing sight of this and providing fulsome detail about company operations is critical. With non-bank lending substantially an unregulated market, listed companies provide the greatest transparency.
- Realistic to market circumstances: Low Loan to Value Ratios (LVR) is the catch cry for many a credit manager seeking investor capital. A 65% LVR sounds great; able to withstand the most extreme market conditions. This is true, assuming the underlying valuation is robust.
Understanding the fundamental real estate asset, the true depth of the market and identifying who will buy it at or north of the exit value assumed is fundamental to the initial assessment of LVR. Valuers perform a key role but are always constrained by backward looking data. Great managers are cautious around dependency on inflated valuations.
- Call upon experience: A great fund manager will be surrounded by experienced staff with expertise gained across multiple cycles and sectors and have established connected networks. Market intelligence extends well beyond consultant reports, utilising the cumulative intelligence of the entire organisation. It extends to understanding a workout, foreclosure, and recovery. It is through this specific experience managers gain a clearer insight into how structuring and negotiating loan documentation is critical to success.
- Financial capacity: Reinvesting in the business and planning for long term success, great managers have the capacity to underwrite transactions, invest in people and processes and focus on long term outcomes.
Great managers do not:
- Lend to their own development projects. As a defensive asset, a critical component of real estate credit investing is its ability to take control away from the equity interests if necessary. The manager is entrusted with this responsibility with an expectation it will do so in the best interest of all its investors. The ability to complete someone else’s project in a credit enforcement process is critical (including providing the project additional credit to complete).
- Over commit or over promise. Managers must take utmost caution in making further capital commitments on the reliance that it will be funded from returned capital. This must be tested, and stress tested again to ensure there is not an over commitment of capital availability. This is highly prevalent in the current market where return of capital is often delayed.
- Chase excess return with excess risk. A manager must be prepared to sit out of the market when conditions are not consistent with defensive investment strategies. A manager with diversified business interests has greater capacity to sit out of certain sectors as other business streams offset market slowdowns.
Strong growth for the sector, but a careful approach necessary
There have been tremendous successes in the real estate credit sector, providing stable returns despite asset value volatility and heightened construction risk. The market opportunity for great managers, and their investors, is enormous and complementary to a robust banking sector.
We see private credit markets playing a pivotal role in addressing Australia’s housing shortage crisis and encouraging greater participation from offshore capital into the Australian economy. Where investments are appropriately structured, we believe defensive and stable returns are deliverable. Based on the considerable data we have assessed relevant to the housing market we have great confidence in the fundamentals that should continue to drive both rental and capital growth. Falling supply alongside strong population growth provides a solid base in which to lend.
As always, challenges remain, and it is necessary to proceed with caution. The construction sector, while through the worst of it, remains under pressure. It is foreseeable that more builders and developers will collapse, but this can happen in all parts of a cycle. Builders go broke in good markets too.
In consideration of this, a great manager conducts scenario analysis around the cumulative effect of borrower and builder insolvency, time delays, cost increases, pre-sale or lease defaults, and even the untimely demise of the borrower or key delivery personnel. These things are outside a manager’s control and can happen at any time.
Cautious and patient deployment of capital the key to long term success
A prudent manager will make a range of assumptions and undertake stress testing in all macro conditions, from the most benign through to riskier settings. This assessment not only considers the robustness of the investment, but strategies to prepare the manager for these events.
Cautious and patient deployment of capital with a firm focus on long-term commitment to the sector and value creation is essential for successful real estate credit investing. Those who do will thrive; the strategy fundamentals and market runway are large enough for them to do so.
For more information about our real estate credit capabilities and solutions, please get in touch.
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