Risk, reward, and reality: What’s happening in commercial real estate debt

If you follow the financial press with any degree of frequency, you might have noticed that there have been a lot more articles recently about private credit and commercial real estate debt (CRED) managers having to assume control of assets and properties because loans have gone bad.

And whilst these situations are real and represent risks for investors, it is also true that these situations are not necessarily representative of what’s going on across the space – in the same way that the problems at a single equity fund manager, are not necessarily representative of what’s happening in the equity market.

What we want as investors is relatively simple. Yes, we would love to buy the next Nvidia five years before it skyrockets, but outside of that, we want stable, risk-adjusted returns that allow us to sleep at night.

Being invested in an area of the market that is growing and capable of providing some visibility over the long-term is also important. It could be argued that the commercial real estate debt (CRED) ticks all those boxes. 

So, to better understand what is really going on in the space, and where the risks and opportunities lie, I spoke with no less than three of the team at CRE Debt and Equity specialists, MaxCap Group; Bruce Wan (Head of Research), Haley Devine (Director, Wealth management), and Bill McWilliams (Chief Investment Officer).

A growing funding gap and emerging investment opportunity

According to Wan, the size of the CRED market in Australia is around half a trillion dollars.

Traditionally, banks dominated this space, providing debt funding for office buildings, shopping centres, industrial assets, student accommodation, and residential apartment blocks. However, due to regulatory constraints and risk weightings, banks have reduced their exposure, creating a significant funding gap that non-bank lenders are now filling.

This shift represents a fundamental change in the market structure, making a once highly exclusive and profitable space increasingly accessible to general investors.

"What was a set of investment opportunities locked behind a very cosy banking oligopoly is now increasingly available to general investors," Wan notes.

Macroeconomic factors impacting the market

While private credit and CRED present as attractive investment opportunities, macroeconomic conditions must be carefully monitored. Factors such as interest rates, inflation, economic growth, and population trends all play a role in shaping market dynamics.

"We've gone through a soft patch in economic growth, and while we don’t expect a dramatic rebound in activity over the next 12 months, inflation has moderated and interest rates are expected to come down slightly," Wan explains.

"Private credit, especially CRED, remains a sector of strong interest for investors because of its stability and attractive risk-adjusted returns, even in a challenging macroeconomic environment."

Population growth continues to fuel housing demand, making residential real estate a key focus area.

"We remain strong believers in the residential market, whether it’s build-to-sell or build-to-rent projects," says Wan, adding, "There’s an ongoing housing shortage, and private lenders have an important role to play in addressing that”.

At the same time, the commercial sector is seeing signs of stabilisation. "Office and retail faced significant headwinds over the past couple of years, but we're now seeing some positive shifts," Wan adds.

"More people are returning to offices, and retail sales trends are improving, particularly outside of Sydney and Melbourne. These signs suggest the worst may be behind us in those sectors."

Addressing Australia’s housing shortage

As noted above, a key sector of focus is residential real estate, where demand significantly outstrips supply.

"We are absolutely looking at a long-running housing shortage in Australia," says Wan. Population growth of approximately 500,000 people per year is driving demand, while supply constraints persist.

"Simply, we are not building enough housing to put a roof over everyone’s head."

Recognising this imbalance, non-bank lenders are prioritising residential development funding.

"We are most bullish and optimistic on the residential sector because of this demand-supply imbalance," Wan adds.

However, challenges remain, particularly in securing labour and managing cost pressures. While construction cost escalation has eased, lenders must scrutinise builder profitability and cost structures to ensure projects remain viable.

Providing flexible capital to enable development

Beyond funding, non-bank lenders play an active role in supporting developers.

"We provide flexible capital, and that’s our point of differentiation against the banks, which tend to be portfolio-driven and operate within a fixed box," McWilliams explains.

By working closely with developers, non-bank lenders can create tailored financing structures that help get projects off the ground, even in challenging market conditions.

What about the risks?

The CRED market requires meticulous oversight, particularly when it comes to construction risks, where things have admittedly become more challenging in recent years according to MaxCap.

The strategy to deal with this, says McWilliams, is built on rigorous due diligence and ongoing engagement with key industry players.

“In addition to the usual things that we should be doing—attending monthly PCG meetings, speaking to quantity surveyors, and ensuring subcontractors are paid—we maintain strong relationships with builders on a national level. We conduct quarterly reviews and obtain regular financial updates on these groups, allowing us to assess both individual and industry-wide performance” says McWilliams.

Beyond external relationships, MaxCap’s internal structure also provides a point of differentiation.

“We keep a staff of internal quantity surveyors and valuers because we need visibility on the ground with specific projects.

"If the manager you're investing with does not have people in these roles, the question I would ask is: what corners are they cutting in terms of oversight?”

This internal expertise enables us to identify risks early and engage proactively to mitigate potential issues before they escalate,” says McWilliams.

Appropriate resources and expertise are also important when the inevitable happens – problems arise and projects don’t go according to plan. These are known in the industry as workouts, and rely on the ability of the managers to see the project through, or, in some cases, take over the project – all in the pursuit of protecting investors’ capital.

“Managing positions that don’t go exactly to game plan is part of our job. Even with the best sponsors, builders, and locations, market forces can disrupt projects.

The important thing is structuring deals correctly from the outset and having an experienced team to step in when needed", says McWilliams. 

The past two to three years have presented challenges, admits McWilliams, including rising interest rates and valuation uncertainties. Nevertheless, strategic structuring and active management mitigate risks.

“If you’ve structured it right, dealing with the right sponsors from the beginning, market challenges don’t necessarily mean greater risk of loss,” Wan explained.

Pipeline growth and heightened due diligence

Despite the economic challenges, there remains plenty of opportunity to be had. 

"Our pipeline is actually the biggest that it’s ever been," says McWilliams.

However, he adds that deal execution is taking longer.

"It’s a lot harder to get projects off the ground, so while we’re having early conversations with clients, it takes much longer to get to financial close."

Due diligence has also intensified.

"We are looking at our opportunity pipeline, which is as large as it’s ever been, but some transactions don’t pass the sniff test once we get into DD," McWilliams explains.

The MaxCap team has implemented more rigorous risk management measures, including "three lines of defence across our credit risk process," to ensure only the best transactions make it through.

Diversification as defence

According to Devine, a key element of risk mitigation lies in diversification. She adds that in work-out situations, it is best to be in a diversified, deep, liquid fund.

“Our MaxCap Investment Trust, the first mortgage fund, currently has around 50 loans and is growing rapidly” says Devine, adding that “The larger the fund, the less material any single exposure becomes".

This strategy ensures stability, even in turbulent market conditions. To put that in perspective, portfolio structuring follows investment parameters similar to an equities portfolio, balancing risk and return.

“In the office sector, we recognised early that there would be headwinds and adjusted our asset allocation accordingly. We apply a top-down macro lens alongside our bottom-up borrower analysis to ensure exposure levels make sense” says Devine.

Macroeconomic outlook and strategy

Looking ahead, macroeconomic factors will continue to shape investment opportunities, with Wan noting that whilst the outlook remains challenging, it generally always is.

And despite economic uncertainties, Australia remains a highly attractive market.

“International investors are looking at Australia because of our stable geopolitical and economic environment. Even though the economy is weak and rates remain high, private credit—particularly commercial real estate debt—is drawing significant attention”, says Wan.

As noted above, MaxCap remains bullish on residential markets over a 1-2 year horizon.

“We still need a lot of housing, whether built-for-sale or built-for-rent. People need roofs over their heads, and we are happy to support that demand”, says Wan.

"We are fairly agnostic about the specific types of residential housing we support—whether it's land subdivisions, apartment blocks, or co-living spaces—so long as the product is in the right location and meets market demand," McWilliams explains.

"The focus is always on delivering the right projects in the right locations". 

CRE Debt and Equity specialists, MaxCap Group

MaxCap Group, a strategic investment partner of Apollo, is a leading Australian Commercial Real Estate Debt investment manager. With $7 billion Funds Under Management and Advice, we have a long-standing reputation for pioneering financial investment products and a stellar track record of delivering strong and sustainable risk-adjusted returns to investors.