Commercial Real Estate Debt: Bridging the income gap

I have recently met many investors who have shared one common concern: their challenge in finding a stable and dependable income stream.

I empathise with their struggle. COVID-related fallout has forced companies into caution, with seven of Australia’s largest financial services companies either cutting or deferring dividends over the past couple of months. Westpac and ANZ have suspended dividends, NAB slashed its interim dividend from 83c to 30c a share (1), while companies in sectors directly affected by COVID shutdowns – such as travel & leisure, airlines and oil & gas – are also cutting their payouts (2).

Many retirees rely on dividends for their primary source of income, and with some forecasts predicting dividends for 2020 to fall by more than a third compared to 2019 (3), investors are turning to other asset classes in their search for stable income. Bank deposit rates have fallen steadily for over a decade, while bond yields sit at historical lows and have fallen further in response to the COVID-19 pandemic. 

Many trillions of dollars are now invested in negative yielding bonds across the world – a truly incredible trend.

Among these genuine challenges, Commercial Real Estate (CRE) Debt is an asset class that offers compelling benefits for those seeking income. A CRE debt investment seeks to generate monthly income by providing loans to commercial borrowers who require funding for real estate purposes. Its income stream is generally predictable because the loan interest and fees are agreed upfront, so this “fixed income” is known for the duration of the loan. The investment also provides capital preservation and portfolio diversification; its loan value does not fluctuate – unlike equities – and it ranks ahead of equity in the capital structure.

In the current economic climate, banks have been withdrawing from the lending market, leading to a shortage of debt capital for borrowers, and better opportunities for independent lenders such as Qualitas. The Qualitas Real Estate Income Fund (ASX:QRI) model is simple: we actively manage a book of thirty loans provided to well-established Australian commercial property investors and developers. We know all of our borrowers individually, and the loans are high quality. 97% of the loans are “first mortgages” (meaning Qualitas has priority over other lenders if a borrower defaults) and 98% have the benefit of a personal guarantee.

We are by nature conservative in our investments and this approach has ensured there has been no loss of capital to our investors since the company’s inception 12 years ago. 

This is the third major economic crisis that I’ve personally worked through and I try to remember that time is your best friend when it comes to property investing. 

In 2019, Qualitas decided not to take on too much additional risk within the fund at a time when there were several opportunities to do so. Coming into 2020, we had built up a substantial cash buffer, which has so far served our investors well. The QRI fund’s loan-to-value ratio sits at a conservative 64%, while the average loan maturity is just over six months which offers the opportunity to improve returns.

COVID has affected different parts of the economy in different ways; in the CRE market, certain sectors have been impacted more than others. Hotels and leisure-related activities are under pressure, while those industrial assets that have a long-term secure income may actually benefit from the economic upheaval. Investors have had to redefine the term “prime property” to place less emphasis on location and more on the underlying source of income.

We have scrutinised our loans in great detail, but our original investment thesis holds true, and our fundamental strategy has not changed. We typically lend to borrowers who are well diversified in terms of their own investments, reducing the risk that they won’t be able to meet future loan payments. The short-term nature of Qualitas’ loan maturities also enables us to seek top-up equity if required and obtain better loan terms. In addition, approximately half the loans have the benefit of an interest reserve account, which we can draw upon if the borrower found themselves in trouble.

But I am all-too-aware of potential risks: some properties could be too reliant on rental income from shuttered businesses; residential property rental could be hit by unemployment; while construction sites could close if the country ever faces a level four lock down. However, we have access to sinking funds securing on average seven months’ interest the fund’s low loan-to-value ratio also means that it is well insulated against a potential fall in property prices.

There are also compelling opportunities right now, as banks tighten their credit supply and lending competition dries up, leading to more favourable terms for those lenders still in the market. This is a trend we have already seen in the portfolio, with new loans closed in April and May incorporating better terms and pricing. In addition, the volume of new loans remains sound, and new sales of completed apartments are above expectations.

For investors searching for that elusive, stable source of income to meet their investment needs, CRE debt may be a viable and compelling asset class, which aims to provide not only dependable, predictable income, but also capital preservation and portfolio diversification.