Undoubtedly, the last few years have been difficult for advisors who have positioned portfolios for clients close to or in the process of retirement. Customers already in retirement have endured uncomfortably the long and steady downward trend in term deposit and cash interest to record lows.
For this group of investors, the fact that the rate cycle has finally turned and that rate hikes are back on the agenda is cause for celebration. But they should beware that interest rates – and therefore returns on their preferred yield-generating investments – won’t return to what they might consider “normal” anytime soon.
In addition, depending on the level of their ongoing exposure to bonds, some are likely to return the capital appreciation they previously enjoyed as rates fell over the past decade.
Chart 1: Average term deposit rates in March 2022
Since the Global Financial Crisis (GFC), private debt has grown in importance as an asset class. Although there are several subcategories of private debt, direct lending continues to grow in Australia. This growth is largely attributed to changes in banking regulations and subsequent bank deleveraging that occurred globally after the GFC. From an investor perspective, private debt offered equity-like returns, while allowing institutional investors to diversify away from equity market volatility.
In Australia, there is an additional dynamic. The Australian Prudential Regulation Authority (APRA) has publicly noted that “poorly underwritten, monitored and controlled credit exposures to commercial property (CRE) borrowers have historically proven to be a key source of credit loss for banks” .
As a result, APRA launched a thematic review of banks in 2016, to better understand the quality of underwriting and to rectify processes where necessary. Second, put in place monitoring to identify future deterioration of CRE loans.
The result of this review was that banks tightened their lending standards and restricted the real estate development industry to debt capital. As can be seen in Figure 2, development finance has fallen from ~9% of CRE exposure in 2016 to ~6% at the end of 2021; a drop of 33% over this period.
Banks have reduced their exposure to real estate debt primarily by increasing the conditions or “hurdles” that developers must clear to obtain financing. For example, the equity that banks require from developers has doubled since the APRA review, in addition to requiring significantly higher pre-sale debt coverage on projects.
Even when lending, the exhaustive and slow banking process can cause delays and uncertainty for developers, and as a result, they are increasingly looking for alternatives.
Chart 2: Exposure to ADI commercial properties ($M)
This funding gap has been filled by non-bank lenders, whose skill base lies in the appraisal, origination, monitoring and management of specialized loans. The main managers of non-bank lenders are generally from institutional companies whose capital comes mainly from institutions or family offices.
More recently, these strategies have been made available to advisors through platform-specific vehicles as well as Listed Investment Trusts (LIT). Even though the real estate private debt sector in Australia is still relatively small by global standards, around $15 billion to $20 billion, whereas in many comparable jurisdictions the market share is between 20% and 30 % ; representing a $90-100 billion market opportunity.
Investors have sought well-managed real estate private debt to complement fixed income portfolios for the following key reasons:
- Lower risk compared to other alternative assets or return options (e.g. basic real estate);
- Higher yield than traditional bonds;
- Security of the underlying real estate (CRE debt only);
- Diversification because the counterparties are generally medium-sized private entities;
- Very low correlation to equity markets; and
- Low volatility that can shake up portfolios during extreme events like COVID.
Alceon lends to medium-sized developers in Australia, with senior secured loans (usually a first mortgage) with a loan-to-value ratio between 45% and 65%. These loans are given to development projects (usually residential real estate projects, but sometimes commercial property) from high quality development companies, in Australia and some locations in New Zealand.
Given the size of Sydney and Melbourne compared to other cities, they dominate the locations of our counterparties or sponsors.
For calendar year 2021, the retail fund achieved an annual return of 8.03%. Alceon believes that in the current interest rate environment, risk-adjusted returns of this level meet the requirements of many income-oriented investors.
More importantly, these returns are uncorrelated to stock markets and are generated in Australia, through lending to an industry most investors are familiar with.
There are many active lenders in the market, with an income-generating investment product available, and this type of investment offers advisors an attractive option for their clients’ income-oriented portfolios.
And, as the non-bank lending industry increasingly fills the void left by banks’ withdrawal from development lending, this style of product has benefits for both its investors and its borrowers.
Omar Khan is Director, Real Estate, at Alceon.