Qualitas sees green shoots in construction financing after pandemic challenge

There’s no question it’s been challenging across the property construction space. In fact, ASIC data found that 1,709 construction companies across Australia went into administration between July 2022 and April 2023. There’s been some big names in there – the likes of Porter Davis, Probuild and Qattro, amongst others. Even Metricon barely starved off extinction mid this year.

Qualitas is optimistic about the future for the construction sector and has even secured significant additional funding on this front, announcing an additional $750 million commitment from an institutional investor in August.

In fact, Andrew Schwartz, Group Managing Director and Co-Founder of Qualitas, believes the worst of the insolvencies of the large commercial builders is likely to be behind us (although smaller builders are another story). 

“Construction costs increased through the COVID period with supply side issues.

In particular, it took a while for recalibration, particularly around realisation values to come into the market, but we do see a lot of green shoots for the next cycle of the market and hence why we’re receiving a lot of capital commitments for Australian residential construction at this point of time," Schwartz says

He notes the key opportunities are in Australia’s undersupplied residential space. Around 70% of Qualitas portfolios are focused on this area.

In this episode of Expert Insights, Schwartz discusses the outlook for property sectors, why construction financing is generating interest for investors, and the opportunities and challenges he sees across the property market.

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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 direct property investments. 

Edited transcript

What is your view on the current macro environment?

Clearly, inflation and the consequential uptick in interest rates has had an effect on property. The economy is showing relatively low growth but against very full employment. Those employment numbers are translating into higher wage structures and wage increases quarterly numbers are showing up at about 3.6% - 3.7%. 

It's an unusual environment where you've got relatively full employment. You've got relatively strong wage inflation coming through the system, you've got sticky inflation at 6%, albeit it's expected to taper off in the next couple of years, and a higher interest rate environment. 

When you take those macros together with the fact that you've also got now geopolitical uncertainty, there's a lot for real estate investors to really carefully think through in this environment. 

You've recently announced significant raising on the construction financing side. What opportunities are you seeing?

We're really optimistic on construction financing. Outside of the banks, we're most probably one of the largest alternative construction financiers in Australia. 

The reason we're really positive on it is that our major focus is on residential property, and we see that sector of the market as exceedingly strong. Notwithstanding the macros that I've just been through, which one has to have very strong regard for..

Residential property has less than 1% vacancy rates, you've got significant population growth and immigration, which we've talked a lot about, and it takes time to put product into the market. 

So by the time you actually decide, 'I would like to do a development' to the time somebody is actually occupying a building, it could be three years, it could be four years from that moment in time.

The market has been caught very short. Construction costs increased through the COVID period with supply-side issues. It took a while for recalibration, particularly around realisation values to come into the market, but we do see a lot of green shoots for now the next cycle of the market and hence why we’re receiving a lot of capital commitments for Australian residential construction at this point in time.

What challenges are you monitoring in real estate and will you be making changes to your asset allocation?

Well, sticking to construction first;

I hope that this won't come to bite me this next comment, but I feel we're most probably through the worst of the large commercial builders having some form of insolvency type event.

A lot of the more experienced builders are actually forward ordering their raw materials, they're keeping those offsite, so ensuring they've got adequate working capital to meet construction commitments is a really important part of our analysis and focus. These are the types of things that we're very focused on in construction. 

More broadly to your question, for us, it's really about supply and demand of the specific property, location - can never go past that - consumer-demand, occupier-demand, the capital structure that is being proposed. They're the various areas that we're really having a lot of regard to.

What is something you think the market has missed when it comes to investing in this space?

But in terms of the medium to longer-term outlook, it's about the cashflow sustainability and the ability to escalate your cashflows from the date you actually purchased it. 

And I think some sectors of the market can more easily achieve escalation. An example of that is residential property. You've got very tight supply in the market, you've got exceptionally strong demand and you're seeing rentals escalate, depending on where you are, by as much as 10% in various major cities. You're getting fantastic growth in the underlying asset class. 

Now, there might be others where you're not getting that. Office is an example where you've got work from home, you've got an excess supply in the market. You've got vacancies generally running at 15% of the market. You've got leases that are coming up that you can't renew at the same rates as what you previously had. You've got flattening, maybe lowering, cashflows, a higher interest rate environment, and you would have to be more cautious about that particular sector. 

As a lender, we would have to be more cautious about that particular sector of the market at the moment. 

They're the things we think very deeply about.