A $400bn market with huge growth ahead

 A niche area of fixed income that shows all the signs of one day becoming mainstream in Australia – as it is in the US and Europe – the local commercial real estate (CRE) debt market is growing ever-bigger.

So says Andrew Schwartz, managing director and co-founder of Qualitas, an investment management firm and non-bank lender that matches capital from institutional and private investors with large commercial real estate projects.

In 10 years, Australia’s total CRE debt market has doubled from around $200 billion back in 2012.

“It will be hard to maintain that sort of CAGR (compound annual growth rate) but even if you flatline that over the last decade, we can expect around $20 billion a year in underlying growth,” Schwartz says.

“For every 1% of market share that non-banks pick up, that’s $4 billion of capital that will go to that segment. So even if non-banks gain 10% market share over the next decade, that could be a $40 billion or $50 billion increase – it’s a very fast-moving market.”

In the following interview, Schwartz compares the Australian CRE debt market with those of the US and Europe and outlines a couple of ways mum and dad investors can access the fast-growing space. He also reveals which areas of commercial debt he’s most bullish on for 2022 and beyond, as the COVID reopening progresses and inflation picks up.

Edited transcript

Australia’s commercial real estate debt market is already worth around $400 billion – how does this compare to other CRE markets around the world? Where do you see this market in the next few years?

Andrew Schwartz: Yes, it's now worth $410 billion, with banks now representing 90% of that market versus 10% for the non-banks.

It’s increasing in size all the time. The non-banks are now about $40 billion, having grown from about 7% to 10% market share. The market is not only growing but participation by the non-banks is growing. And that’s because real estate values are going up in value, across all asset classes.

If borrowers maintain their borrowing ratios, the size of the debt market increases at a corresponding amount. This means the total level of the asset class also goes up, so we probably shouldn’t be surprised.

But particularly in a pre-COVID environment, we also saw a lot of new real estate and infrastructure development funded by banks and non-banks, so that’s also fed into the increase.

Back in 2012, the total CRE debt market was just over $200 billion. Over 10 years we’ve basically doubled the size of the market.

I think it’ll be hard to maintain that sort of CAGR, I expect the growth will reduce, but even if you flatline that over the last decade, it’s growing $20 billion a year in underlying growth.

Even in lower growth years, the market has grown by around 4% and in 2015 and 2016, growth in the market peaked at around 9% a year.

One of the big outliers here is the size of total bank participation in Australia, at 90%. In Europe, this number is 53% and 40% in the US, so other players including pension funds and alternative lenders make up the balance. 

You’ve got this market that has doubled in the last 10 years, banks that are very heavily looped into the market, but Australia will probably become like the rest of the world in terms of non-bank lenders.

It really means that for every 1% of market share that non-banks pick up, that’s $4 billion of capital that will go to that segment. So even if non-banks gain 10% market share over the next decade, that could be a $40 billion or $50 billion increase – it’s a very fast-moving market.

How do you anticipate the fund will perform as rates start to tick up?

Andrew Schwartz: We work to a target return above the base rate, we don’t price ourselves as a margin over a base rate – that’s how banks price themselves, against the LIBOR or BBSW rate plus a margin. We tend to quote an all-up rate. 

And our average loan balance is only about 1.2 years of duration, which we do deliberately. That’s because we like to regularly reassess our investment risk.

Pricing is a function of the supply and demand of capital. So, when interest rates are very low – as they are now – with a huge search for yield by investors, you tend to find rates in the alternative sectors tend to come down.

On the other hand, if rates start to go up things like hybrids, bonds and corporate debt see rising returns, capital will be less available in the CRE market.

Once you have less capital in the market, rates of return in the alternatives sector will also increase because there’s less of it to go around. For example, in 2009 after the liquidity squeeze of the GFC, rates of return in alternatives were at a higher premium than where we find ourselves now.

The other aspect is how your securities behave as rates go up, and to gauge this you need to look at each asset individually. How elastic is the value against rising rates? You need to be very mindful of that.

You might think you’re taking a 50% loan-to-value ratio against first mortgage securities, but the value of those mortgages can change in line with interest rates, so you need to think that through at the time you’re originating the loans.

How easy is it for investors to access this asset class?

Andrew Schwartz: For retail investors, there are two ways to invest:

1. A listed fund, such as the Qualitas Real Estate Income Fund (ASX: QRI). It’s the only pure property-based LIT on the market. There are other credit funds but not pure CRE debt funds. The others are corporate loans, structured finance or a geographic mix of both product and location.
   
2. The second way is through an unlisted fund, which is generally called a mortgage trust. We don’t have a retail mortgage trust — we run a wholesale mortgage trust for sophisticated investors.
   

Each of these has pros and cons. For example, in mortgage trusts, if you want to redeem, there may not always be capital in the fund – so the only way to get capital is for the manager to sell assets. And often there are redemption windows, which might be quarterly or half-yearly, unlike on the listed side where you can get your money within two days.

Investors just have to work out what they’re more comfortable with.

Most of the Qualitas Real Estate Income Fund is currently invested in senior debt, is this the highest exposure you’ve had to this tier? What would prompt a shift in this portfolio weighting?

Andrew Schwartz: With around 93% of the portfolio in senior debt loans, we're probably a little bit underweight mezzanine now. Going through COVID, we wanted to stick primarily to first mortgages and were mindful that mezzanine debt tends to work best in development-type situations that are self-liquidating.

In self-liquidating scenarios, you've got a clear line of sight to the exit of the loan – there are sales, pre-commitments that will monetise the loan on completion.

During COVID there was less development activity occurring because you couldn't build, people couldn't leave their homes, and no one wanted to buy properties off the plan. Loans didn’t fit our ideal risk profile, so we went more overweight on first mortgage opportunities.

How much potential outperformance does the fund miss out on because of its overweighting of senior debt?

Andrew Schwartz: We could have chased risk if we wanted to drive up the total return of the fund. But you make these judgement calls based on the quantum of risk alongside your desired level of return. And our target return in that fund is the base rate plus between 5% and 6.5%. 

We were able to comfortably achieve the upper end of that without chasing mezzanine loans. We're probably a little bit underweight mezzanine right now, as we're emerging from COVID, and opportunities in other investments we like are starting to become clearer once more.

I think this highlights our disciplined approach. And that’s not just me banging my chest, but it demonstrates the benefit of experience in being able to read the market and balance the quantum of risk you’re being asked to take alongside your required level of return.

Next year we're going to reassess our mezzanine weighting and we already feel much more positive about 2022. In the absence of something like an unforeseen mutation of the virus that puts us all back into a lockdown – and we're not health experts, so we can’t rule that out – but I think we're now in the post-COVID emerging period. People are coming out of their houses again and retail's starting to bounce back.

And in the office sector, if you fast forward to 2022, people will want to go back to their workplaces. It's probably not going to be like it was, where people are going back five days a week. But for three or four days a week, people will return to the office.

There's already a lot more confidence, even just looking at the bustling Melbourne retail scene over the last few weeks in particular. You can feel how buoyant it is.

Looking at the Reserve Bank’s and government’s predictions about how strong the recovery's going to be, I totally agree that that is what's ahead of us. Greater confidence, consumers spending money, people returning to their office is all good for, ultimately, real estate markets.

Reopening borders and restarting migration will really unleash the real estate market because there's been such a lag in new development. There’s a whole catch up that's going to need to occur over the next two to three years, which will give the real estate market, including the CRE debt market, a huge push.

How does your portfolio look now compared to when you launched? And what do you think it might look like three or four years from now?

Andrew Schwartz: When we started the firm in 2008, CRE debt was not well understood. The firm’s DNA was very opportunistic at the time because we were mainly dealing in high-net-worth capital and less so in institutional capital. We were doing a lot of mezzanine lending back then, whereas most of our capital now is institutional.

Fast-forward 13 years and now mezzanine is a relatively small part of our business. With most of our investments in first mortgage loans, our largest transactions are close to $250 million.

If you said to me in 2008, "You're going to write a cheque of $250 million for a loan," I would have been very surprised. But that's how advanced the alternatives market has become.

There are many reasons for that. One is that any one bank is now often unable to write cheques of that size. And it's also linked to things like nimbleness and flexibility.

Most of the loan types we’re writing now were the predominant loan types the banks themselves would have done five years ago.

That’s a key point of difference in our approach – it's no longer that opportunistic mezzanine approach but is instead the non-opportunistic first mortgages, but with more flexibility than the banks typically would have provided.

Looking ahead, we’re going to see:

• Even more non-opportunistic lending
• More efficient sources of capital flows to the alternatives sector
• Better customer service with more flexibility for borrowers
• Rising market share to the non-bank lending sector.

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