Why the great Australian love affair with residential property is far from over

While the dream of the quarter-acre block may long have evolved into something more diverse, Australians have not lost their great love for residential property. After all, CoreLogic estimates saw home values increase 8.1% across 2023, and are tipped for further growth this year.

It’s an attractive market for investors – and beyond your typical worker heading into the bank for a loan. Institutional investors globally have been eyeing off the Australian residential private credit market, and Qualitas is seeing the enormous potential for private lenders to cement their place in the market.

“If you’re looking at forecast supply, that’s running at a decade low. You’ve got a massive imbalance in that sector, which is a disaster from a societal point of view. But from an investment thesis perspective, that means you’re lending into a very defensive asset class,” says Mark Power, head of income credit at Qualitas.

While lending, particularly private credit, may have risk connotations, Power argues that investing is not necessarily as risky as it seems. There are four different types of real estate private credit loans, each with differing risk profiles, and being conscious of diversification across loan types, industries and borrowers is all important when it comes to managing risk.

In this episode of The Pitch, Power discusses the different types of loans in real estate private credit and how to balance these in a portfolio. He also shares why Qualitas favours residential real estate in the current environment.

This interview was filmed on 21 February 2024.

Edited transcript

What are the different types of loans in this space and what are the different risk profiles for each?

Power: It’s really important to note there’s more than one type of loan in real estate private credit.

The first loan I’ll talk to are pre-development land loans. These are loans against a site that is generally in close proximity to one of the major capital cities in Australia. These sites are expected to be activated into a live construction project over the course of the next 6-18 months. It’s not land banking – we would never take zoning risk for instance, these are sites that about about to be activated through to construction.

If we then move forward from there, we look at construction loans themselves. These are when the projects are live and we look to fund the development of a particular project. At Qualitas, we heavily pivot into the residential market, we like that market because of the thematics underpinning it – but it can be broader than residential, it can also be office buildings, retail or industrial facilities. Once the assets are completed, there are further loan types.

Then, you are looking at investment loans. Investment loans can be against an income-producing property, so let’s say a developer recently completed a new shopping centre, and we’ll provide a loan against that shopping centre, and the debt would be serviced by the income stream coming out of that. Where we differentiate from a traditional financier on an asset like that is that we’ll provide a higher amount of leverage against the asset than what traditional financiers are able to do in the current environment. As part of those investment loans, we also do what I describe as asset repositioning. This might be a B-grade or C-grade office building and the developer wants to reposition to an A-grade property, which would involve new lobbies, new lifts, new HVAC (heating, ventilation and air conditioning) and the like.

Then, finally, there is a product we really like, a loan which is termed as a residual stock loan. That’s a loan against a line of recently completed, but unsold apartments. A developer might have a 300-apartment residential development and have pre-sold and settled 200 of those by the time the project is completed. Then we’ll lend against the last remaining 100 to release some capital or profit back to that developer to do other things. As those residential apartments settle, we’ll sweep proceeds to amortise the debt accordingly.

Each loan has different risk profiles. How do you balance that in your portfolio?

Power: Portfolio diversification is key. You don't want to be too long in any particular strategy because you get good risk mitigation by virtue of that diversification. We’ll look to diversify not just across loan type with a certain percentage of the portfolio in land, a certain percentage in construction, investment and residual loans but we’ll also diversify around borrower names as well. While we’re very much a relationship business and we like doing multiple investments with borrowers that we rate, by the same token, you don’t want too much concentration to any one borrower.

Geographic diversification is also really important. We focus very heavily on the major cities on the eastern seaboard in Australia. We like Melbourne and Sydney, that’s where we do the majority of our work because we see those markets as being the deepest, most liquid markets in both the physical sense in terms of real estate, but also on credit as well.

Are there any particular loans that you're favouring for the current environment?

Power: We’ve got very strong conviction in the residential market.

I’ve been in real estate credit for the best part of 34 years, and I don’t recall a time where there has been such a very significant disconnect between supply and demand in any one market.

You’ve got a situation where you have chronic undersupply in the market at present, and that’s illustrated by a residential vacancy rate of 0.8% nationally at the moment and a market in equilibrium is at 2-3%. So 0.8% is really low to start with.

You have massive demand coming through as well in terms of population growth, which is running at unprecedented levels. From a supply perspective, you’d normally expect supply to be running at very high levels to meet that high level of demand but at the moment if you’re looking at forecast supply, it’s running at a decade low.

You’ve got this massive imbalance in that sector, which from a societal point of view is a disaster but from an investment thesis perspective, that means you’re lending into a very defensive asset class. We like residential property for that reason. 

We’ve also got strong conviction in industrial, which is a market once again underpinned by insufficient supply of that particular product relative to the demand drivers running through it.

Off the back of that, are there any sectors that you're lower on at the moment?

Power: We’re cautious on office. 

That doesn’t mean we wouldn’t invest in office with the right sponsor and the right project with the right capital structuring behind it, but we are cautious. The reason we’re cautious is that it is very different in that sector. Vacancies are running at a very high level, the highest levels of office vacancy we’ve seen since the early nineties, and it is a function of the work-from-home/work-from-office hybrid environment, which has significantly reduced the demand for office space. 

It has also reduced the type of office space that the market wants because if you are an employer and trying to get staff back into the office, you want a really welcoming warm environment. What it has meant has been a real flight to quality as far as office is concerned. If we’re investing in premium A-grade buildings, there are still opportunities there or if it was a repositioning play to take it from B-grade or C-grade up to that premium A-grade, then that would interest us. 

But that whole sector is running the risk of large parts of it being stranded because if you think about a B-grade or C-grade office, which is no longer meeting the demands of the current market, those assets can get into a death spiral.  That's a part of the market we’re participating in, but very cautiously.