Why own when you can loan?

With interest rates at record lows, many investors are looking at new ways to generate income. Listed equities and real estate trusts are already popular, however, debt-based real estate investments are generating increased interest.

The key difference between equity-based and debt-based investments is who owns the assets. For commercial real estate, investors become part-owners of assets by purchasing, for example, units in a Real Estate Investment Trust (REIT) – known as A-REITS if they are Australian. The underlying assets typically generate their income from rent.

An alternative to owning real estate is to provide loans to these asset owners. The Qualitas Real Estate Income Fund (ASX: QRI) is made up of a portfolio of loans to commercial real estate market participants. The income it pays to unit holders is generated by the interest payments and fees that borrowers pay.

Loans secured by mortgages

These loans are secured by predominantly first-mortgage real estate assets, with some second mortgages. This means if the borrower defaults on the loan, the lender can take possession of the assets over which it holds a mortgage. ‘First mortgages’ or ‘senior loans’ mean the lender is the first in the ‘repayment waterfall’ – in other words, the first creditor to be paid. Second mortgages are behind the senior lender, but ahead of other creditors, while the asset owner gets paid last.

This type of investment provides regular income through interest payments, which QRI passes onto investors on a monthly basis (i). It also helps to protect capital, being secured by real estate assets.

The loans are used for a range of purposes, including purchasing land, repositioning an existing asset, undertaking pre-development works, or construction of a new building.

Figure 1. Overview of Qualitas Real Estate Income Fund

Diversification opportunities

A diversified portfolio normally includes a number of both equity-based investments (such as shares), and debt-based investments (such as bonds).

Commercial real estate debt can act as an additional diversifier by providing exposure to the property sector, but with attributes comparable to bonds, such as ongoing income and capital preservation through secured assets.

Bonds, which are based on loans to companies, may or may not take a security to protect the lender. When they do, not all the assets are tangible, meaning protection for the lender can be limited, depending on the underlying assets.

With QRI’s commercial real estate loans, there is a real asset behind the loan, similar to the way a bank takes a security over a residential home when the customer takes out a mortgage.

Valuations and volatility

A key feature of the QRI model is that loans are either impaired or unimpaired. Unimpaired means that the lender expects 100% of their capital back; impaired means there is an issue with the loan and, due to particular circumstances, the lender expects to receive less than the original loan amount. The fluctuating valuations of real estate assets don’t have a direct impact on the income being produced as the loan principle doesn’t move with market movement, and by extension, limited impact on the net asset value of the trust. As long as the borrower is able to produce enough cashflow to repay their loan, the asset value is less relevant.

By owning real estate assets that have the potential to change in value, REITS have the potential for considerable volatility in terms of either yield or capital value. Two of the factors affecting the price of REIT units are 1) the value of the underlying assets, and 2) the investor demand on the secondary market (such as the ASX).

While this may generate upside, it could make it difficult for investors to buy into the trust at a satisfactory price in a rising market. Increasing property valuations may also make it challenging for the trust to acquire assets at a reasonable price, thereby affecting the relative yield. The result is that performance of single funds within the REIT asset class may be mixed.

For example, the top six A-REITS had an indicated dividend yield of between 2.24% up to 7.03% as at May 2019. In the same period, one trust (ASX:CMG) increased its 12 month return by 50% while another’s returns (ASX:SCG) fell by 8% (ii). Myriad factors including sentiment, price, sector and capital availability, have created large variances.

Against this background, the increased availability of commercial real estate debt investments provides an additional option for generating income in portfolios. While providing exposure to real estate, the debt-based nature of QRI means it is less affected by property price fluctuations. The regular interest payments of the underlying loans also mean the returns may be more predictable than those of equity-based property investments.

Looking for regular income and diversification?

The Qualitas Real Estate Income Fund (ASX:QRI) aims to deliver investors with a regular stream of income with the added benefit of diversification beyond shares and traditional property investments. Click 'Contact" below to find out more.