Investing in CRE Debt: Choosing the right Manager makes all the difference

One of the unique features of the Australian property market is that the big banks dominate commercial real estate (“CRE”) lending, one of the largest sectors within credit markets.

Within the commercial real estate sector, bank loans make up 93% ($355 billion) of the debt currently provided to commercial borrowers. The remainder (~$25 billion) of CRE debt is provided by alternative lenders, a sector that while small, is well-established and has been growing steadily and becoming not only more sophisticated but diverse in funding solutions for borrowers.

The growth of the alternative lending sector creates an attractive opportunity for both offshore and domestic investors as borrowers look for more flexible forms of financing than what banks can provide. Banks in recent years, due to regulation and uncertainty in the market, continue to withdraw from the lending market (characterised by more rigid and restrictive lending). As alternative lenders gain market share, the opportunity also grows for investors to gain exposure to the CRE debt market.

And the benefits of investing in CRE debt could be compelling: a predictable and regular income, capital preservation, asset class diversification, and exposure to property without the equity risks of investing directly in property.

For most of us, it’s not possible to invest in this asset class directly unless it’s through an investment manager. With more than fifty alternative lenders in the Australian market with various levels of experience already offering a range of investment vehicles and funds, an investor needs to be well informed when choosing a quality manager.

From our experience as an institutional manager, there are three key areas that any potential CRE debt investor should be conducting as part of their due diligence and always research the lender by closely looking at the manager’s core investment principles.

1. Do they instil strong governance within their investment principles?

· Look for a manager with excellent fund governance and risk management capabilities as this demonstrates disciplined, transparent and responsible lending. Low-quality lenders may get away with neglecting proper governance in a rising market, but risk exposing investors during a downturn.

• Check the make-up of their investment committee, board or trustee to make sure there are high calibre and experienced members including a level of independent oversight of their lending activities. This ensures balanced decision-making and that your interests as an investor are properly represented.
• Take a good look at their investment processes and the intensity of their investment due diligence. Do they actively manage their loan performance throughout the lifecycle of the loan, or do they take a hands-off “set and forget” approach?
• In our experience, the managers who are proactively managing and reviewing their loans regularly are able to anticipate issues earlier to ensure loan performance is not impacted, hence protecting investor capital and investor return.

· Have they embedded ESG into their investment process? An ESG policy demonstrates global best practice in the industry and in our view is considered a prerequisite for any tier 1 manager.

2. Are they experienced in managing risk where it matters?

• An experienced manager will also instil discipline in appropriately pricing their loans commensurate to the risk taken for the current market conditions. It is important for investors to verify that the manager understands pricing for risk and is undertaking the appropriate level of risk to achieve target returns. An experienced and quality manager will never go up the risk curve for the sake of achieving excess returns.
• Some lenders just lend, while others are also equity investors in property which, due to being higher up the risk curve, requires more skill. This type of alternative lender can offer better value for investors by virtue of their wider skill set and experience, especially if required to assist borrowers with managing any difficult loan performance or project issues which may be outside a typical lenders’ capabilities.
• A manager that is a specialist in CRE has a solid and meaningful track record when it comes to previous deals. A local presence is advantageous given operating in the CRE debt market requires in-depth understanding of the local market environment.
• Do they have experience in a broad range of property asset classes, loan types and regions? Have they lost any capital or faced any critical performance issues? If yes, how did they work through these? Have they worked through difficult market cycles and what have they learned from this experience?
• A quality manager should have no conflicts of interest when it comes to representing their investors. The best practice is to invest in only one part of the capital structure for the same transaction – always. Intercreditor conflicts can arise if lenders represent different interests (i.e. senior, mezzanine and/or equity) within the same transaction on behalf of more than one investor as there is always a risk that one investor may be disadvantaged.

3. Are they in control of their capital and decision making?

• A key advantage for a lender is retaining decision-making control over their lending capital which is very attractive to borrowers. They can do this by a) avoiding syndicated loans (more than one lender), so that all their loans are bilateral (i.e. they are the sole lender), and b) not relinquishing decision-making control to third-party investors, so they needn’t consult any external parties in their lending decisions which means the lender can respond to borrower requirements and changing market conditions in a timely manner.
• The ability to make discretionary lender decisions is hugely appealing to borrowers, which benefits you as an investor because the lender is able to negotiate better terms on their loans that are more aligned to their investor’s target risk and return.
• Borrowers value working with one reliable lender to minimise negotiations and ensure certainty of funding. This creates higher demand for that lender’s loans, who is then able to command a better deal for their investors. Experienced and reliable lenders who are trusted also get a lot of repeat business from the same borrowers.
• Borrowers also want to deal with a lender who has the authority to tailor the conditions of the loan to suit their requirements, as well as work through any issues commercially.

Before you invest

While this isn’t a complete list, researching these three important areas when choosing a CRE debt alternative lender will give you a solid base on which to make an investment decision. A quality manager is always transparent on the above areas and strongly values the trust investors instil in them to manage their capital.

About Qualitas

Qualitas is an Australian-owned property investment specialist, managing $2.8 billion across both debt and equity investments and is well positioned in the Australian market due to our long-standing local presence and deep borrower relationships built on trust and repeat lending over many years.

In our 12 years of operation, we’ve closed more than 130 debt deals and have incurred zero losses of capital which is testament to our disciplined investing.

Visit our website qualitas.com.au to learn more about how you can benefit by investing in commercial real estate debt with a trusted local manager.

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