The hidden Australian market ideal for recessionary periods

The Commercial Real Estate (CRE) debt market is no ordinary exposure to property. It involves wholesale commercial loans to property investors and developers. 

Andrew Schwartz, Group Manager Director and Co-founder of Qualitas, believes that it can be an ideal investment for the current environment. That’s despite the fact property has been receiving more than its fair share of negative headlines at the moment.

“What makes CRE debt ideal in a recessionary environment is the fact that you’ve got protection of somebody else’s equity against an asset that may be recalibrating its price,” he says.

In this edition of Expert Insights, Schwartz explains how the CRE debt market works, the opportunities Qualitas is finding, and the risks investors need to understand.

Edited transcript

What is the CRE market and what makes it unique compared to other alternative asset classes?

The CRE debt market is an asset class that alternative investors such as Qualitas participate in. I like to define it as wholesale commercial loans to property investors and developers. It’s easier to talk about what it excludes. It is not housing loans to mum and dad investors – that’s really the domain of the Australian trading banks. These are wholesale loans secured by mortgages against real property and your borrowers (generally property investors and developers).

How does CRE debt differ from mum and dad real estate investing?

The Qualitas core strategy is really around real estate private credit in real estate. It’s a relatively new asset class that hasn’t previously been available to retail investors. I think investors have been constrained in the past to purchasing physical real estate or syndicate interests in real estate in order to enjoy the benefits of real estate ownership. What private credit does is offer access to an asset that was previously the domain of the banks in providing loans to real estate borrowers. Private credit funds such as the Qualitas Real Estate Income Fund
(ASX: QRI) enables more retail-based investors to enjoy what institutions have enjoyed for many years which is being the provider of loans to real estate investors.

Does Qualitas operate like a bank given similar underlying exposures and borrowers?

In some ways we’re very similar to a bank in terms of our processes, asset management and governance. We’ve taken the things that I believe the banks do extremely well. 

Ultimately we’re not a bank and we’re looking to make returns on our investment that aren’t bank-like. When we’re deploying capital, we’re not constrained by the same things that traditional financiers are constrained by.

For us, it’s always about how much more risk or structuring can we take into our equation and how much do we get paid to take those various risks into our structures? If we feel the return more than compensates us for incremental risk, then we’re able to think like this. To that extent, we definitely don’t think the same as a bank. For our borrowers, it really enables us to give much more flexible solutions than I feel they could otherwise get.

How will the upcoming Basel 3 capital requirements for banks influence performance?

It’s going to put more pressure on the alternative sector as traditional banks and those that are APRA-regulated are required to put more capital aside for property lending activities. It puts more demand on groups like Qualitas to have other solutions for capital to meet what is a growing market. 

It’s actually the same story that has been happening for at least a couple of decades where the regulator is more focused on the traditional banks and how they use capital for their activities. Our business is not regulated in respect of how we deploy capital, we’re certainly regulated for how we raise capital in terms of the actual fundraising. but on the deployment side, that's an unregulated activity. When you have more regulation being imposed on the banks, in a way, we’re a beneficiary of that because it puts more demand on our capital.

What makes CRE debt ideal in recessionary periods?

What makes CRE debt ideal in a recessionary environment is the fact that you’ve got protection of somebody else’s equity against an asset that may be recalibrating in price.

Where you are the owner of an asset, you suffer the first dollar decline in the value of the asset but equally, you get the first dollar of upside in the value of that asset. That’s one of the benefits of being the owner of an asset. 

In a more recessionary environment, and certainly one where asset prices are recalibrating, we are seeing that debt is a great place to invest money and take shelter from falling asset prices. You just need to make sure that your loan-to-value ratios can sustain any reductions should they occur in the value of properties. You also need to recognise we’re in a period where interest rates, base rates and risk premiums are increasing. This means my first call against the asset and the right to that cash flow is going up. And yet, I don’t really have the negative downside risk of falling asset values one can sustain in a more recessionary environment.

Can you discuss some of the opportunities you are finding in CRE debt at the moment?

The theme of this year has really been around much larger transactions for the alternative sector. Qualitas recently announced a $600m first mortgage financing for a particular development. If you had said to someone 10 years ago that an alternative financier would do a $600m financing, they would have been very surprised. People would have said, ‘isn’t that really the domain of the banks when you get into that type of size?’ That was a very attractive financing, both for the borrower and for Qualitas because it enabled us to move very significant capital and be paid appropriately for the quantum of capital. Equally for the borrower, they didn’t need to deal with large groups of banks and mezzanine lenders. They just had to deal with Qualitas providing a one-stop solution for their needs.

Another example is we’re doing a lot of residual stock financing with developers over completed apartments. At the moment, completed apartments are selling down relatively well, mainly because vacancy levels are so low and buyers need to live somewhere. They can see the completed apartment. It’s an accelerator. A lot of developers holding stock will come to someone like Qualitas and get an inventory loan or residual stock financing loan where we release capital to them against one line of apartments. That would be another good example of where the alternatives are investing at the moment.

What are some of the risks that CRE debt investors should be aware of in the current market?

The main risk is understanding that markets are recalibrating and ensuring that, if you are investing through a manager, they are experienced in understanding the effects of specific assets in that environment. 

If we progress to a more recessionary environment, look at the underlying cash flows of borrowers and understand how vulnerable they are to changes in discretionary spending levels and changes to asset values. This ensures you haven’t stuck your neck out too far in respect of a debt secured against an asset and you’re at an appropriate loan-to-value ratio. Those would be the two big headlines of what I’d say you really need to think about at the moment.

Do you seek equity-like returns with debt-style security?

If you’re looking for a new kind of opportunity beyond shares, fixed income and traditional property investments, the Qualitas Real Estate Income Fund (ASX:QRI) could help you diversify your portfolio and meet more of your goals by investing in the growing opportunities of the commercial real estate (CRE) debt market. Learn more about the fund here.

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This is the second wire in a three part series of Expert Insights. You can read the first part below:

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