Lending for commercial real estate provides welcome alternative to bond markets

Times are tough for investors or advisers looking to add value through a defensive portfolio.

Defensive, or income assets, aim to provide income rather than capital growth.

They generally carry a lower investment risk than shares or property, with more stable returns in the short term but lower returns over the longer term.

For most investors, this means bonds. But the problem with investing in bonds is not just the lack of income from the all-time low (even negative) yields on offer.

The issue is that bonds no longer react positively to falling share markets — traditionally a major benefit of the asset class.

Take last year’s pandemic sell-off. Bond values didn’t rise, they fell. They’re simply not playing the defensive role they’ve played so well in the past.

Investors are left to either accept this unsatisfactory scenario or take on more risk. Or consider a third option.

An alternative source of income

If you’re running a defensive portfolio, a steady and reliable income is critical. Alternative assets may provide that elusive income you’ve been searching for.

Commercial real estate 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 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.

A growing opportunity

Within the Australian commercial real estate sector, bank loans make up 90% ($369 billion) of the debt currently provided to commercial borrowers.(1)

The remainder (about $41 billion) of CRE debt is provided by alternative lenders, a sector that while small, is well-established and has been growing steadily, becoming more sophisticated in funding solutions for borrowers.

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 alternative lenders.

As alternative lenders gain market share, the opportunity for investors also grows. Why? Because borrowers will pay a premium for the flexibility provided by alternative lenders: flexibility on the terms of the loan, the availability of loan options and the speed of funding.

Adding CRE debt to your portfolio

Commercial real estate debt is a good defensive and income-focused asset to hold alongside other income-generating asset classes. Benefits of investing in CRE debt include:

• A reliable income stream. The premium paid by commercial borrowers for alternative financing — in the form of fees and interest on the loans — translates directly into premium returns for the investors. Plus, these returns are agreed upfront, and locked and loaded for the duration of the loan.

• Portfolio diversification. CRE debt is unique in that it can fit into three asset classes: fixed income, property, or alternatives. An allocation to debt can also diversify your portfolio across the capital structure, reducing risk. It may be suitable for investors looking for less capital volatility than equity.

• Capital preservation. This is where the defensive nature of CRE debt shines through. CRE loans are secured by first or sometimes second mortgages over a physical property. If the mortgage security ever needs to be enforced, the investors are repaid before anyone else. Plus, the lender only lends a certain percentage of the property value, so there is an equity buffer to further protect investors from capital losses.

• Exposure to real estate. CRE debt gives the benefits of investing in real estate, but its debt-based nature means it is less affected by property price fluctuations. The regular interest payments of the underlying loans also mean the returns are more predictable than those from equity-based property investments.

LIT

Qualitas Real Estate Income Fund

Alternative Assets

View

Looking for regular income and diversification?

The Qualitas Real Estate Income Fund (ASX:QRI) aims to deliver investors a regular stream of income with the added benefit of diversification beyond shares and traditional property investments. For more information, hit the 'CONTACT' button below.

Footnotes

1. Australian Prudential Regulation Authority Quarterly Authorised Deposit-taking Property Exposures June 2021; RBA Financial Stability Review October 2021