The asset class with first dibs on rising rates

Investors are looking for shelter amid rising inflation and interest rates. So where can they go? Private credit could be one place.

"Private credit allows investors to do is be on the right side of the equation for rising interest rates," says Andrew Schwartz, Group Managing Director and Co-Founder at Qualitas. 

In comparison to equity-like investments, private credit lenders have first priority to any cashflows that come out of the property. 

The Qualitas Real Estate Income Fund (ASX:QRI) invests in a diversified mix of investment loans, residual stock loans and construction finance. The fund targets return of the RBA cash rate plus 5-6.5%, and has achieved annualised return of 5.85% for the June month. 

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Qualitas Real Estate Income Fund

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And before you jump the gun and assume that the current crisis in the building sector would necessarily mean crisis in private credit, think again. 

"This is probably the most asked question I'm getting in all of my various travels, including with our over overseas investors at the moment who are saying what is happening to construction in Australia right at the moment?" 

"I think we're through the worst of it."

In the following interview, Schwartz takes us through the qualities that make QRI a potential inflation hedge, the loans that make up the portfolio, and the insulation private credit enjoys from a faltering property market. 

Topics discussed:

• 1:00 - Qualitas Real Estate Income Fund (ASX:QRI)
  
• 2:10 - Getting on the right side of the rates equation
  
• 3:15 - Australia lagging the world
  
• 5:50 - Yield target
  
• 6:30 - Retail vs institutional wish lists
  
• 8:00 - Historical performance
  
• 10:00 - Buffered against market falls
  
• 12:30 - Australian building crisis
  
• 15:00 - Distressed debt
  
• 18:30 - Construction outlook
  

Qualitas' beginnings, and where it is today

Qualitas was founded 15 years ago. We're an ASX-listed company, alternative real estate investment manager. Our last reported assets under management was $4.22 billion, primarily in private credit. Over the last 15 years, we've done 219 transactions and 80% of those transactions have been in real estate private credit.

An institutional product made available to retail clients 

The Qualitas Real Estate Income Fund (ASX: QRI), better known by ticker code of QRI, is our listed private credit fund, and it's a $600 million fund. It's a listed investment trust, so that means that all of its various investments have passed through income directly to investors, given it's of a trust nature.

What's in the portfolio?

It's got sufficient diversity across predominantly first mortgage loans, which comprise roughly 80% of the portfolio, a few mezzanine debt loans, average loan to value (LVR) ratio of around six 67%, but all backed by commercial real estate mortgages.

An asset class made for rising rates 

I think that the primary reason is that we're going through a period of higher interest rates and there's a lot of investors that are looking at how do they really best shelter themselves from the rises in interest rates and outperform in both nominal and real terms the effects of inflation. I do think that what private credit allows investors to do is to be on the right side of the equation for rising interest rates. Whereas with equity type investments, the lender has a first priority to any cash flows that may be coming out of the property. The benefit of being the lender is that you get the first right to those cash flows, and as interest rates increase, you've got an increasing right to really participate in those cash flows as well.

Australia lagging the world

In the US and Europe, the banks really only participate somewhere between 40% to 60% of the commercial real estate debt market. It is true that in Australia the bank participation rate is significantly higher than it is in other parts of the world. So in Australia, when we first started Qualitas some 15 years ago, the banks were approximately 95% of the total commercial real estate debt market. Today they're about 90%, but still as you point out, quite far away from the overseas experience where the banks can be... I think the number used was 48% of the total market.

I think the reason for that is really around just the historical context of the banking system in Australia. You know, one needs to remember that superannuation funds really only got going in the 1980s and really the other large participants in the market would be the superannuation funds who have capital to also invest. But I think to date, they really haven't shown that they're major participants in the market. That's not my way of saying they're not in the market at all, clearly they have got some market share, but not to the same extent as the overseas experience.

Not just any old real estate

Attractive yield

Institutional and retail investors want the same thing

Qualitas has 80% of all of its investors are institutional in nature and that comprises of some Australian super funds, European pension funds, the government sovereign type funds that have got behind Qualitas into either private credit or more opportunistic type investments. I think that one of the reasons why we brought QRI to the market through the IPO was to really give retail investors a similar access and pathway that we were giving our institutional investors. And so both mandates are very similar in that they're seeking to allocate capital into a market where there's generally a shortage of capital at this point of time, and to take advantage of sizable out-priced returns really by moving capital into what is a relatively more shallow and capital starved market at this point in time. I think the answer to that is they are looking for similar things, just totally different access points.

Private credit isn't swayed by property equity

I think generally pretty well. And you've got to answer that into two parts because QRI specifically is a private credit vehicle, it's not a REIT that buys office buildings and shopping centres and is looking for capital growth. So the most important thing to remember is the model doesn't rely on prices going up in order to make money. That's what a REIT does, it's basically looking for either underlying rental growth or cap rate compression, asset prices go up, the growth of it outperforms the debt assumptions, and the investors generally do well through equity capital rises. That's not the model of a private credit vehicle, because ultimately you give somebody a loan, you charge interest. You can only ever get back your interest, you can't get back more than that. What you're looking for is periods where there's enough stability in the underlying asset prices to make you feel that you have got very good security in the event that something was to go wrong in a hypothetical scenario, you need to be well secured, but at the same time, really to be able to enjoy greater cash flow from the underlying property. One thing that you can say about inflation is that interest rate rises go hand in hand with inflationary times, which is what we're going through at the moment. I do believe that investors in private credit funds, all things being equal, which means working in a normalised market, you can always have external events that fall upon you, but in a normalised market, you should expect interest rates to rise in inflationary times, and you should normally expect returns to go up in private credit vehicles.

Private credit vehicles have less exposure to falling property prices than direct property investments

We're not the equity in the property. As I was saying, when you give somebody a loan, really all you can do is get your principal back, plus the agreed level of interest. Obviously, you don't want equity to reduce to a level where you have insufficient security to cover your loan, but I think that's what a good manager who's worked through multi-decade cycles is able to do. They're able to look at each underlying individual property and say, how does that property behave in a more inflationary time? 

Properties behave differently depending upon the underlying cash flow of the property. A good manager can navigate those matters and ensure that they take security on the right property, at the right loan-to-value ratio, to earn the returns that they've set themselves for that particular loan and the fund.

Golden era for alternatives

We are inundated at the moment with opportunity because we are uncorrelated to the equity markets. That might seem counterintuitive to the broader market, given the level of uncertainty and the recalibration, but personally having worked through these markets for a number of decades, I'm almost afraid to tell you that it's getting up to some 35 years of working through differing markets. What often happens in these markets is traditional lenders sit more on the sidelines. More astute investors see this as a time to invest into the property market, or be it, you have recalibrating pricing that's going on in the market and it pushes more demand on the alternative capital providers to step up and meet those requirements. As a group overall, I can say that we are experiencing a heavier level of pipeline relative to what we've experienced over the last few years. But I would also say I'm not surprised by that given the more counter cyclical nature the private credit is to the more broader market.

The worst of the building crisis is behind us

So this is probably the most asked question I'm getting in all of my various travels, including with our over overseas investors at the moment who are saying what is happening to construction in Australia right at the moment? I think we're through the worst of it. The reason I make that statement is because if you wind back to construction contracts that were put in place before March 2020, which is the onset of COVID, nobody knew COVID was about to hit Australia so it wasn't priced into construction contracts. But now people understand all the issues to do with supply side shortages, labour shortages, rising prices, lockdowns that stopped labour from getting to site. So therefore all the new construction contracts that have been put in place over the last 12 to 18 months have been able to factor all of those things in. Builders have been able to understand the need for greater levels of contingency, the need to source goods to site earlier than they would normally have done in a pre-COVID environment.

I think that for new construction contracts that are being put in place, I'd like to think that the risk profile of those contracts is less than let's call it the legacy contracts of the pre-COVID type contracts. But if you also consider the average construction contract goes for about two years, we are getting down towards the back end of those legacy construction contracts. Now, to the extent you have problems in construction contracts, it's normally on the back end of a construction programme so I think it's a time where private lenders are more micro on asset management of existing contracts. To answer more directly your question, at Qualitas we are micro on our asset management, we're reviewing all of these contracts on a six weekly cycle. I don't think that there's any systemic issue that's going through the various portfolios on construction. But having said that, we are very micro on how we're analysing it and staying ahead of the curve and the wave on any particular issues that can arise.

We haven't actually seen a lot of distressed debt, and we are set up for distressed debt. So what I mean by that is not through QRI to be precise, but in other strategies, we have been mandated to look for opportunistic returns, which includes distressed debt, and to date, we've not seen any distressed debt come through our portfolios. Now, the only caveat I put on that is that's a look back statement and we are entering a time where we have higher inflation, higher interest rates. So I do think that all investors in those in opportunistic type investment need to be more open to that asset class over the next two or three years, given the change in the environment in markets at the moment. But I feel that for very astute investors, they see that as opportunity that may come through the markets as opposed to necessarily being this huge insurmountable problem. They actually see it the other way around, which is the opportunity for that dislocation to lead to an investment class that has not been evident for literally, I'd say, the last 20 plus years in Australia.

Don't hang around for equities to return

The world's changed at least for the foreseeable future in that we've gone through a period where every time that there was an economic problem, governments around the world reduced interest rates to stimulate the economy. We went through a relatively negative episode on the March 2020 COVID pandemic. Governments all around the world injected enormous amounts of capital into the economic system in order to provide a level of insurance or monetary capital stimulus into various economies. And that has really led to a whole lot of supply related issues because of the pandemic itself, but in many cases over stimulated the economy.

And so what you're now seeing is exactly the reverse policy of what we've seen for a very long period of time, which is governments putting up interest rates. I think we're in for that cycle for quite some period of time, so I'm more focused on really that cycle and what the effect on that is on private credit and on our equity portfolios. But I do believe that for private credit, so long as you can remain confident of your underlying security values, which as I said earlier is what a private credit manager does, I think that one is to benefit from being on the right side of that rising interest rate equation.

Growth outlook for the construction industry

I remain positive around construction volumes going forward because I think there's an underlying need for construction. But it's going to be an asset by asset class type analysis. One could take a view that perhaps there's less construction in offices because of the advent of work from home, and greater levels of surplus vacancies in office buildings might lead people to build less office. I think major infrastructure will require significant new construction, but I also think asset classes like residential, which as a house we continue to be relatively positive about, will also require new construction as well.

We form that conclusion because if we look at the underlying supply of residential, particularly medium to high-density residential, the level of completed apartments has been coming off for several years. If we look at the underlying demand, vacancy and rental rises that have been experienced across the country, I think that one could deduce from that, that there needs to be more supply put into the market over time and therefore more construction. Certainly, just looking at the Qualitas capital inbound inquiry, people who want to mandate us for that type of activity, we're not seeing any slowdown of fresh capital, particularly from offshore wanting to get set into that type of opportunity.

Inflation will settle back to 2-3% over 10 years

Base case is I think we are continuing to track northerly on inflation. So if you look at the US, UK and Europe, their inflation at the moment is between 9% and 10%. It's a staggering number. I mean, it's literally 50-year highs for inflation. Australia's last reported inflation was just a little bit over 5%; I think it was 5.1%. There are inflation numbers out later this week, so there'll be more clarity on it. If I had to guess, I think that it's a fair probability that inflation will be higher than the current 5.1%. I do believe that we're in for a period of rising inflation. Interestingly, if you look at the inflation swap curve, so what that means is long term expectations of inflation over the next 10 years, it's actually showing that the financial markets believe that inflation over the next 10 years will be in a 2% to 3% band and not a 10% band.

If you're somebody, and I'm one of these people, who believe ultimately financial markets do get it right, what that is implying is that this inflation is a short term effect in the market, not a long term effect. But it does mean that we do have to contend with rising inflation, it'll be met by government and reserve bank in particular with rising interest rates and they will... Central banks, reserve bank will seek to get that back into their band of 2% to 3%, which financial markets are saying that will be achievable and this is more of a relatively short to medium term than a long term. I do think there are risks to that analysis, but that is our base case assumption.

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