The property investor turning macro headwinds into tailwinds

These are trying times for Australia’s real estate sector. The RBA’s efforts to combat inflation have seen a sharp rise in interest rates since last May, coupled with a sharp economic slowdown – but with the added complication of strong demand combined with a pronounced supply crunch.

For these reasons, direct property investment is a trickier proposition these days. It’s also a head-scratcher for the many large Australian companies exposed to property – particularly the big four banks. Their all-important net interest margins appear to have mostly held up so far, according to recent results – but there’s a strong view they’re now headed south.

Mark Power, Head of Income Credit at Qualitas, recently discussed some of the ways investors can potentially benefit in this environment. An Alternatives asset manager, Qualitas approaches property from a different angle by investing in the private credit of commercial real estate.

Who is Mark Power?

With an industry background stretching back more than three decades - much of this time working for major Aussie banks - Power has observed the cut and thrust of the sector. For one thing, this has given him insight into the market participants “including those that might be best left to your competitors,” he says with a wry smile.

It’s also given him an intimate understanding of risk – both at the underwriting and the asset management side of the lending equation.

But perhaps the most important insight is on the regulatory front, having seen how the Australian Prudential Regulation Authority (APRA) engages with the banks. And the pincers of this oversight have drawn ever tighter since the GFC of 2007-2008.

As Power explains further below, this gives rise to what he regards as something of a “megatrend” for Qualitas’ specialised field of private credit.

What’s the appeal of private credit?

And why now, given the heightened inflation and elevated interest rate environment?

“We like commercial real estate private credit in this environment because it provides a strong hedge to inflation,” says Power.

“Because as rates rise – as they do in an inflationary environment – the borrowers of the underlying loans obviously have to pay more.”

“A very defensive part of the market”

Around 70% of Qualitas’ funds under management are invested in loans made to the residential market. “From an investment thesis point of view, we consider that part of the market a very defensive area to invest in, particularly given the current economic uncertainty,” Power says.

Why? Power emphasises the stark undersupply of residential property in Australia currently.

“In the 30-plus years I’ve worked in real estate financing, I can’t remember a time when the imbalance between demand and supply has been so great.”

And there are good reasons to believe the attributes underpinning this environment won’t disappear any time soon.

For one thing, population growth. In the 12 months to December 2022, population growth in the 15-plus years-of-age cohort expanded by 435,000 people.

“And in next two years, consensus forecasts suggest population growth will increase a further 900,000 people – who will all have to live somewhere,” Power says.

It also looks appealing from the demand side, with the supply outlook for the next three years running at decade-lows.

A “megatrend” for private credit investing

Power deploys an analogy of a “shrinking sandbox" to describe traditional financiers’ diminishing exposure to private credit.

You only need to look at the financial news pages of the last couple of weeks for a prominent reminder of this: the banking crises in the US and Europe involving Silicon Valley Bank and Credit Suisse."

“There’s a whole range of funding requirements that now fall outside the sandbox in which the traditional finaciers and banks can play. We don’t see that trend abating any time soon,” he says.

"That’s going to further empower APRA to ensure traditional financiers here take a very conservative approach to commercial real estate exposures,”

This plays into the hands of private lenders. While still subject to strict regulations, they’re able to provide lending services that are no longer within the remit of banks – and Power acknowledges that’s a good thing both for individuals and the broader economy.

“Banks are dealing with highly levered capital; they’re gearing their balance sheet nine or 10 times over. Whereas the alternative lending space is dealing with "unlevered capital" from offshore sovereign wealth funds, pensions funds and others, so it’s a more secure form of capital,” he says.

A new source of investment return

Power also explains one of the important commercial real estate product innovations driven by the rise of private credit: Residual Stock Loans. It sounds complicated but relates to the critical aspect of pre-sales for property developers and ties in with the above point about credit exposure restrictions of traditional banks.

“The pre-sale market is now tougher for many reasons,” Power says, referring to both the economic and regulatory environment.

“If a developer waited until they had 100% of their debt covered by pre-sales, they could be waiting years before they could activate a particular project. That then constrains the supply of residential accommodation even further," he says.

These Residual Stock Loans were developed by private lenders, enabling them to take a certain level of market risk and activate construction projects where between 30% and 60% of their debt is covered by pre-sales.

“In days gone by, when a bank would fund a project like this, there’d be no residual debt left at the end of the project because pre-sales would take it all out. But now, with the alternate lending market, developers might sell one-third up front, one-third along the way while they’re in the construction phase, and one-third left over at the end.”

Why is that so important? That residual one-third of the total debt can then become equity that a developer can access via a residual stock loan, often to begin executing its next project.

And from the perspective of alternate lenders such as Qualitas, the inability for banks to participate in these structures due to their capital provisioning restrictions is a huge benefit.

“We get outsized returns for the risks we’re asked to absorb…generating IRRs of between 10% and 11% from these loans,” Power says.

Which part of your strategy has served investors best?

Without hesitation, Power names the IPO of Qualitas in December 2021 as the greatest overall contributor, having allowed the firm to capitalise its balance sheet. The three core parts he highlights are:

• The ability to co-invest alongside investors
• The ability to underwrite transactions
• Greater credibility and visibility in the marketplace.

“It’s certainly increased the flow of funds coming into Qualitas, which has enabled us to deploy those across various strategies," Power says.

He also points to the success of the firm's medium-term growth strategy into private credit, which has gathered even further momentum in the last couple of years.

“We’ve looked to focus on larger ticket-size of credit transactions, which allows us to build greater scale and to generate higher returns for the risks were being asked to absorb. That's because the market (in that space) isn’t as competitive," Power says.

He notes that deals around the sub-$30 million level are often flooded with competitors - which can drive what he describes as "irrational outcomes". 

“We focus on loans of sizes averaging around $71 million, where we find we’re able to achieve superior returns relative to what we could if playing in that lower ticket size," Power says.

What's next?

And finally, I asked Power what he expects the future to look like for his part of the market. He believes the commercial real estate credit market in Australia has huge room for further growth. That’s because private credit accounts for only sub-10% of all CRE loans. Globally, this number sits at 48% - breaking down to 63% and 53% in the more mature US and European markets.

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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