An "enormous vacuum" is creating a big opportunity for Australian real estate debt investors

Commercial real estate, and commercial real estate debt, have not been without challenges recently. Rising interest rates have changed the goalposts for many projects, and we've seen numerous commercial builders fail across the country.

Whilst the sector is facing a tough time at the moment, there are also some strong, long-term, structural tailwinds in play - namely the undersupply of housing and high immigration levels.

All this is to say nothing of the regulatory shift that has seen the major banks move out of this space, allowing non-bank lenders to fill the void.  

"The regulator has looked at the banks and determined that they're overexposed in commercial real estate debt and disincentivised them through a number of different regulatory instruments... which has created an enormous vacuum in the Australian market" says Brae Sokolski, executive director at MaxCap.

So, how does one make sense of the space right now? Furthermore, how does one determine the good opportunities from the less so, as everyone rushes in to fill the void?

For his thoughts on this and more, Sokolski joins me on an episode of The Pitch, helping to educate investors on commercial real estate debt. 

This interview was filmed on Tuesday 13 February, 2024

Edited transcript

LW: For those that aren't familiar, can you talk about the landscape for commercial real estate debt?

Brae Sokolski: Commercial real estate debt encompasses all real estate other than detached housing or assets that are typically the domain of home loans. It's a very diverse and broad asset class and a very significant part of the overall credit landscape in Australia.

LW: One of the things that's happened recently is banks have moved out of this space and non-bank lenders like yourselves have moved in. Why has that happened?

Sokolski: There's been a huge paradigm shift in Australian commercial real estate debt over the last decade, and it's been driven by regulatory impositions, particularly from APRA, where they've wanted to tighten the scope of lending for what we call Australian deposit-taking institutions (ADIs) but better known as banks and particularly the four major banks.

The regulator has looked at the banks from a global perspective and determined that they're overexposed in commercial real estate debt and basically disincentivised them through a number of different regulatory instruments to ensure that they are less able to lend to commercial real estate debt, which has created an enormous vacuum in the Australian market.

LW: Brae, you talked about an enormous vacuum. Let's put some numbers on this. How big is the opportunity?

Sokolski: It's hard to get a handle on the data for the total size of commercial real estate debt. We measure the ADI exposure, which is around about a quarter of a trillion dollars. The ADIs used to occupy around 90% of the total markets. They had a veritable monopoly over commercial real estate debt in Australia.

In 2015, which is around the time those regulatory impositions were prosecuted and the bank started to move away from the CRE debt, around $30-40 billion was created as an opportunity for non-bank lenders to step into the fold, and that's continuing to grow. When you look at it in the context of European and American markets, which are much more sophisticated, banks typically occupy about half of all commercial real estate lending. In Australia, they're still well over 70% and there aren't any particular targets being set by APRA. But our house view is that inevitably APRA would like banks to be closer to half of all commercial real estate debt in this country.

LW: So you're expecting that this trend will continue?

Sokolski: I think it's an inexorable movement away from traditional major bank lending and towards the non-bank sector. Interestingly, whilst there's been some hurt and dislocation in the market for borrowers, from a longer-term perspective, it's healthy for the Australian market.

LW: Is that because of a lack of competition?

Sokolski: Exactly. A lack of competition, but also a homogeneous product. The banks look at transactions through the same lens. It's very much driven by policy, and they're not specialists in commercial real estate. So having non-banks there that look at things from a more commercial lens is more agile. Specialists in real estate have enabled better solutions for borrowers.

LW: Brae, you've provided a nice segue there talking about the rise of non-bank lenders and companies like MaxCap. How do you go about investing in this opportunity? What are the key characteristics that you focus on when you are looking at this big pile of deals that no doubt comes across your desk?

Sokolski: I referenced previously in terms of the fundamental difference between the major banks and non-bank lenders - specialisation. That's what we focus on - real estate. We do nothing else. So, when we approach lending, first and foremost, it's about expertise and understanding the asset class. So we have a decentralised model whereby we have offices across Australia and we have experts in real estate on the ground, understanding what we're investing in.

It's also about understanding the borrower and the builder (if it's a construction loan). Once again, you can't do that from an ivory tower and you can't do that via analytical models. You do that with a qualitative assessment of what you're lending to and who you're lending to. And I think that's what sets us apart: the level of due diligence we do, our intrinsic understanding of the market, and our network and connectivity into the real estate community.

LW: Brae, it sounds like relationships are paramount. How long has it taken to build up some of those relationships? I would imagine that takes quite a deal of time.

Sokolski: Absolutely. I mean, close to the two decades that we've been now operating, we've built and cultivated those relationships. I'm still lending money to some of the first borrowers I did so pre-GFC. There are borrowers that we've now had well over 20 transactions with. So it's not about monopolising the business with those large-scale investors or developers in the real estate market, but it's about being their go-to lender.

LW: It has been a challenging period for commercial real estate debt. Viewers might be aware of the problems in the US. I know the Australian market is vastly different, but specifically, how has MaxCap gone about meeting that challenge and dealing with some of those issues we've seen in the space?

Sokolski: We don't try to hide from the fact it's a very challenging environment for the construction industry and our construction loans. Construction lending is a critical component of what we do and I think over the last few years when things haven't been going to plan for developers and builders, it's really where the MaxCap experience and expertise have come to the fore.

It's very easy for lenders to take the high ground and beat their chest when things are going well, but I think the crucible test of a lender is how they respond when things are difficult and things aren't going to plan during a facility. I'm very proud of the job my team have done, the investment team and particularly the credit team, in being able to do the deep dive into transactions, work closely with the counterparties, and ensure that we are preserving the interest of our investors and that we getting repaid. And our reputation is not just preserved coming out of this period - but enhanced.

LW: Challenges don't last forever. The sun comes up the next day, interest rates will peak eventually and things will start to look more positive. Give us the elevator pitch for investing in commercial real estate debt right now.

Sokolski: First and foremost, we can look at our track record and the fact that during this incredibly difficult period, we continue to trade effectively. We continue to deliver our returns to our investors. Coming out of this, I think the asset class itself is strong, but within it, I think we, as a manager, are even stronger.

And people talk about interest rates. Well, this is an asset class where interest rates actually improve our returns. Part of what's so attractive about CRE debt is that we invest in the margin above the base rate. So even when there have been these significant escalations in interest rates and a lot of them unforeseen, our investors are benefiting from it. It's certainly not to their detriment.

We measure all our returns by the opportunity cost for our investors, which at its base level is cash on deposit. So, if our margin can effectively withstand interest rate increases by being over and above the base rate, I think we deliver quite a unique return profile to investors just by virtue of that.

I think the other huge benefit for this asset class and why it's the senior debt at its core is fixed income is the downside protection. Once again, we can withstand significant deterioration in asset values and still be safe, and that holds us in very good stead in periods of volatility.

MaxCap Group is a commercial real estate investment specialist

To find out more about Australian Commercial Real Estate investment opportunities, please talk to our team today at mit@maxcapgroup.com.au or visit our website here.