Why commercial real estate debt is becoming a hot income asset class

Even though investors are confronted with an ultra-low interest rate environment, high-income opportunities still exist.

One asset class paying relatively generous distributions is commercial real estate (CRE) debt, where non-bank lenders such as LARK Asset Management borrow capital to provide commercial loans for large property projects and pay investors distributions more than 7% annually.

Of course, this begs the question: why would a borrower pay interest rates from the 2000s era given where domestic monetary policy is today? LARK Director Peri Macdonald explains three factors are driving growth in non-banks' loan books.

First, major and foreign banks are being forced to curtail CRE lending due to tougher APRA capital requirements. Second, non-banks provide relatively flexible lending conditions. And most importantly: technology. Non-banks are able to approve loans far quicker than the big end of town.

“When you’re a developer trying to undertake a land transaction, planning process and execute a large project, the flexibility and speed to market is something you’re prepared to pay for.” – Macdonald

These tailwinds provide funds like the LARK Mortgage Income Fund a pool of high-quality borrowers and projects to invest in and charge interest rates that support distributions of above 7% after fees. At the same time, the fund has recourse over property developments to manage risk while also providing regular liquidity windows.

Find out more about the trends driving CRE lending by non-banks, the developments LARK is financing in Australia’s growth corridors, and how the fund works by clicking below.

Preserve your capital by investing in your future

The Lark Mortgage Income Fund (the Fund) focuses on generating regular returns from primarily real property-based loans secured by first ranking registered mortgages over a mix of real property investments in capital cities and leading regional centres. Find out more.

Edited transcript

Hi, my name is Peri Macdonald. I'm a director of Lark Funds Management. I'm really pleased to talk to you today about the Lark Mortgage Income Fund, which is aiming to deliver investors a return in excess of 7% per annum, net of fees. And it's doing that through investing in a portfolio of high quality commercial real estate investments secured by registered mortgages. What I want to talk about today is the key features of the fund, Lark Funds Management and who we are, the commercial real estate debt market, and then touch on the initial portfolio that we are investing in.

In terms of the key features of the fund, as I said, we're aiming to deliver investors with an annualised return of 7% net of fees. A key feature of the fund is that we will pay distributions monthly, so investors are getting that regular, stable income. The fund is open-ended. However, after an initial 12-month term, investors will have the ability to redeem via quarterly redemption windows. So the fund does have some liquidity in it as well. One of the key things about Lark Funds Management is the experienced team.  I also wanted to highlight a high level of alignment with investors in the fact that directors and shareholders of Lark Funds Management are significant investors in the fund in their own right.

Lark Funds Management sees two very experienced fund managers coming together in Lucerne Investment Partners and Ark Asset Management. Lucerne Investment Partners are a leading private wealth manager and fund manager in their own right, through the Lucerne Alternative Investments Fund. Ark Asset Management is a leading manager of boutique private debt funds and, amongst other things, manages the Murray Direct Mortgage Fund, which has been in existence for nearly 50 years, having established in 1974. In addition to these, the directors across both entities have significant experience, not just in commercial real estate finance, but in development and investment. So we have a deep level of expertise and experience across all stages of the real estate life cycle.

When you look at the commercial real estate debt sector in Australia, it's been dominated by Australian banks and, to a lesser extent, foreign banks. The sector at the moment is approximately $280 billion in size. Non-bank makes up about 6% of that, or $15 billion. However, we see that growing significantly over the next three to four years. It's really growing for two reasons. Firstly, the Australian banks are reducing their exposure to commercial real estate because of capital requirements that have been imposed on them by APRA. What that means is the cost of capital from a risk-weighted investment perspective in commercial real estate is much greater when compared to, say, residential mortgages. At the same time that's happening, we're also seeing non-bank debt becoming a much more acceptable and real alternative for borrowers. And these are borrowers right across the spectrum from high quality to lower quality. So we're seeing the non-bank sector grow from about 16 billion currently up to about 40 billion, in our view, over the next three to four years.

We often get asked, why would a borrower choose non-bank over bank? Particularly when you look at the cost of those two, with non-bank being more expensive. There were really three reasons for that. Firstly non-bank generally provide more flexible conditions. These might be conditions around the level of pre-sales required for construction funding to start, as an example. Secondly, non-bank will generally provide a greater amount of leverage, i.e. a greater level of debt. And thirdly, and perhaps most importantly, speed to market. The non-bank sector can generally review and approve funding in a much faster and importantly transparent way than you see the major banks doing. When you're a developer who's trying to undertake a land transaction, get through a planning process and commit building, the value in flexibility, greater leverage and speed to market is something that they're prepared to pay for. And that's really where the opportunity for investors comes with the non-bank sector in commercial real estate.

I'd now like to touch briefly on the initial portfolio that the fund is invested in, which is across five lines, three geographies, four sectors and four different borrowers. The first loan is land inside the urban growth boundary in the Northwestern corridor of Melbourne. Land that's going through a planning process that will see it ready for development in about two to three years' time. The second loan is a land and construction loan in Pymble on the Upper North Shore of Sydney. It's funding an over 55's development in a premium location in Sydney's Upper North Shore. Thirdly, a residential subdivision in the Ripley Valley in the Western growth corridor of Brisbane. The Ripley Valley is one of the highest growth areas in Australia at the moment. The fourth line is a landline for a commercial site in Church Street in Richmond on the fringe of the emerging Cremome office and retail precinct. Finally, the fifth line is a landline for industrial land in an infill location in Sydney's Southwestern growth corridor.

So what we're seeing initially is a portfolio that has significant diversification across geographies, across borrowers, across sectors and across the types of loans with a mix of land and land and construction loans. The fund issued its first units on the 1st of September and immediately invested in two of the investments that I've just mentioned. In September, we declared a distribution of 7.7% net of fees, so the fund is already achieving in excess of our targeted return. In October, the fund will make two to three further investments and we're forecasting a distribution of between seven and a half and 8% net of fees again in October. So, importantly, the fund is already delivering in excess of that target return and it's generating that return out of that existing well-diversified portfolio across geography, sector, borrower, and top of line.

In summary, the Lark Mortgage Income Fund is a great opportunity for investors to get exposure to a portfolio of high quality commercial real estate non-bank debt investments. It's already delivering on its target of in excess of 7% per annum. And it's paying that distribution monthly, delivering a stable and secure income stream. It's a pooled fund, diversifying risk across the portfolio of high-quality investments and it's being delivered and managed by a very experienced management team, not just in funds management and commercial real estate finance, but across the whole lifecycle of real estate. I'd really love to welcome you as an investor in Lark Mortgage Income Fund. If you'd like more information, please visit our website at larkfm.com.au, or click on the button below. Thanks for your time.