Qualitas shines a light on Australian commercial real-estate investment

Andrew Schwartz, Melbourne-based group managing director at Qualitas – an investment manager active in Australian commercial property debt with A$2 billion (US$1.5 billion) of committed capital – shares a perspective on the commercial property as an investment destination. He discusses the future direction of the market and the advantages of debt over equity at the current point in the cycle.

The property market is rarely out of the headlines. How confident can investors be in Australian real estate?

The consensus view is that the US will continue to hike interest rates. Conditions in Europe have been subdued for a considerable time – arguably for the last decade – and geopolitical risk is also high.

If we compare this with Australia – which has had uninterrupted economic growth for 27 consecutive years, is close to full employment and is at the low end of the Reserve Bank of Australia’s CPI target – Australia is an attractive investment destination from a global perspective.

It is particularly attractive for European investors seeking new frontiers based on low yield at home. These investors view Australian property debt as having low correlation to their core strategies. We are certainly seeing a greater influx of capital into the region, and Australia can expect to be a destination of choice for overseas capital.

Does the sector outlook change when you are looking specifically at property debt?

An “equity zone” is one where real-estate valuations are rising and where the banks are heavily competing and cutting margins to win debt business. As an equity investor, if I can raise cheap capital through a banking system which is particularly competitive and can deploy this capital into real estate which is increasing in value, this is a very good risk-adjusted place to be investing.

Our view is that we are very much in a “debt zone” at the moment. Real-estate valuations are moving sideways and might even be coming off 1-2 per cent, while banks are no longer competing and in fact are thinking about reasons not to engage in transactions.

At Qualitas, we prefer to be the lender in this situation. We will receive better risk-adjusted returns providing the debt relative to deploying equity, particularly during a sideways movement in asset prices.

You noted that real-estate valuations are softer than they were. What do you expect to happen to property asset prices over the next couple of years?

As a general comment, when we look at property cycles we are seeking to discover whether there is true, underlying demand for the subject property. In other words, whether we consider it to have a natural occupier and a long-term sustainable cash flow.

We are going through a period of relatively subdued asset prices in the residential market. What gives us comfort is the fact that vacancy levels are relatively low across the nation – including being about 1.5 and 2.5 per cent respectively in Melbourne and Sydney. Some would argue this is effectively no vacancy at all, because one or two out of 100 properties are likely to be temporarily vacant at any given time due to demographic shifts or changes in family life.

Overlaying this, rental growth is very strong in the inner-city ring of Melbourne at a time when asset prices are going sideways elsewhere. This has caused residential property yield to rise while at the same time the market has seen increased volume of residential property.

It feels like the residential property market could get quite short of supply going forward. Taking all these factors together, we are relatively positive about the shape of this sector over the next couple of years.

How do your observations around the state of the Australian residential property market differ from what you’re seeing in the commercial office sector?

The commercial-office sector is completely different, being much more driven by interest rates, yields and capitalisation (cap) rates. Cap rates in Melbourne and Sydney are currently relatively tight, which reflects the historically low interest-rate environment we are in.

Investors are very excited about the prospect of returns and the possibility for rental income to increase substantially over the next three years. After this, the extent to which new supply coming into the market will sustain rental growth really comes down to market expectations.

We are generally positive about the commercial-office market, based on the level of overseas capital which continues to view Sydney and Melbourne yield as attractive on a global scale. This continues to underpin strong cap rates.

“Our view is that we are very much in a ‘debt zone’ at the moment. Real-estate valuations are moving sideways and might even be coming off 1-2 per cent, while banks are no longer competing and in fact are thinking about reasons not to engage in transactions.”

Are there any other drivers of commercial rental growth? We have heard the suggestion that consumers’ increasing expectations around fast delivery in the online retail space – which are migrating towards same-day delivery – is driving performance of property on the fringes of inner cities.

Yes, I think that’s fair. The warehousing that the growth in online shopping, and the rise of companies like Amazon, requires is a total change in the logistical distribution of how we used to think about product-to-consumer space and in the various stages of the delivery process.

In my view, demand for logistics and warehousing-type facilities will be robust going forward and, perhaps, more traditional retail needs to recalibrate in respect of lower retail sales.

The good thing about providing property debt rather than equity is that we don’t necessarily make our money based on a view of the upside of a property. Rather we focus on how much potential downside we think there is in the asset and whether our principal and interest is protected.

In the high street, having regard to the fact that retail preferences around logistics and distribution are changing – for example, how millennials want to live or renting versus ownership – and including a more negative overlay to ascertain how much it can withstand before we are affected is much more aligned with how a property lender thinks.

What is attractive about property credit in particular, and why does it work in the current climate?

First, it is very defensive. The borrower’s equity sits in the first-loss position providing downside protection to a reducing valuation.

The owner invests equity because it enjoys the upside of the property and, in doing so, takes the valuation risk off the table. From our perspective, having someone else’s equity in the structure is comforting in the event there is a downside correction to the valuation of the property.

The other thing we like about property credit is the fact that it is short term. We don’t provide long-dated loans – we are very short duration and our loans are typically 12-24 months. This shorter period enables us to reset interest rates as appropriate if our property-market views change.
There is a third aspect. Unlike more traditional equity – including property equity – the level of profit and when it will be received is agreed up front in a debt transaction.

Banks are taking on more of an intermediary than a lender role in the current environment owing to tightening of their underwriting standards and capital requirements. What sort of opportunities does this present for a firm like Qualitas as an alternative financier?

The segment we operate in is commercial real estate. This is not home or corporate loans, or unsecured loans. These are loans secured against physical commercial real-estate assets.

Commercial real estate in Australia includes development real estate which, for the purposes of Australian Prudential Regulation Authority (APRA) calculations, also includes high-rise residential building developments. This is a A$270 billion market.

In Australia, the banks fund 80-85 per cent of this market. This is very unusual compared with the UK or US, where it is about 40-60 per cent and where pension funds and large alternative financiers fill the gap.

Because the banks have dominated in Australia they are very price-competitive and there hasn’t really been a need for alternative financiers. The focus by APRA on the quantum of property that the banks hold mortgages over, together with the royal commission and general spotlight on the banks themselves, means banks have started to withdraw from the sector. We have also seen many highly talented executives with many years of experience leave to join organisations like Qualitas.

For every 1 per cent of commercial real estate the banks give up, A$2.7 billion of debt capital must be found for the property sector. Over the last 10 years, groups like Qualitas have emerged with a real capability to take on bank-like procedures, focusing on filling this gap in the Australian marketplace.

Does your longevity in the market give you a competitive advantage?

I believe it does. The Qualitas brand stands for a high level of quality and credibility. We have completed 109 transactions, at least 75 per cent of which have been in real-estate debt and the rest as equity investments.

At one level, 109 sounds like a lot. But for a 10-year-old firm it means we have said no to a significant number of deals. We could have completed 109 transactions each year.

We have been very selective around the investments we have made. We look for different characteristics and undertake considerable risk filtering before committing to any debt investment.

“The good thing about providing property debt rather than equity is that we don’t necessarily make our money based on a view of the upside of a property. Rather we focus on how much potential downside we think there is in the asset and whether our principal and interest is protected.”

Historically there have been opportunities for investors in the mezzanine part of the structure, but banks stepping out of the space have opened the door to senior debt. Is mezzanine investment still the biggest opportunity?

This is a good question. A decade ago, it was fair to say groups like Qualitas focused on mezzanine debt because the banks were exceedingly competitive in volume and price.

The banks remain price-competitive but have reduced volume and lending ratios, to the extent that companies like Qualitas have established institutional mandates. These companies have done this not only to be able to compete directly but to provide volume the banks are unable to deliver in the current environment, and to do this based on more flexible terms and conditions than a traditional bank loan.

Through this evolutionary process we have created stretched first-mortgage positions which combine first and second mortgages. This means we no longer need to have subordination agreements that dictate how the first mortgage behaves in relation to the second. It also means we require a single set of documents and a single lawyer, while it is a much more efficient way of providing debt to a borrower.

This doesn’t mean there are no mezzanine debt requirements in the market, but volume is considerably lower. Where mezzanine does exist, it is generally because of a legacy agreement a borrower is unwilling to give up or because of an excellent relationship with a bank they are unwilling to put at risk.

Does this mean there are advantages to maintaining complementary relationships with banks – specifically around extended mortgages?

The banks have reached a point where they like dealing with sophisticated debt investors like Qualitas. They recognise that our funds are well capitalised and that we provide a complementary pool of capital that sits behind theirs in transactions. Our relationship with the four major trading banks is very strong and the banks take comfort from having us involved.

However, I think it’s clear the market has evolved. One example that illustrates this is the A$222 million size of a transaction we are currently working on. The challenge for the banks is that they can’t reach this quantum of volume on one transaction without syndicating – they tend to be individually capped at around A$100 million.

Groups like Qualitas can provide the full volume through our fund mandates, and the loan to cost is more favourable because we can look at a stretched rather than a traditional senior position. From the borrower’s perspective this is a compelling proposition for several reasons: the interaction is with a single party, and this party can provide a stretched position and provide some equity relief.

If commercial property debt is a good space for investors to be in at the moment, how can you and other investors take advantage?

Qualitas is launching a new listed credit trust: the Qualitas real-estate income fund. It will be the first Australian Securities Exchange-listed pure property credit fund.

We are genuinely excited to be providing the market with this opportunity because investors have been unable to access this type of exposure. It responds to the requirements of some of our investors who have told us they really like what Qualitas does, but a Qualitas closed-end fund is a multiyear commitment and does not provide liquidity to the investment base.

We are targeting a raise of A$300 million with a hard cap of A$500 million, and investments will mainly be first-mortgage positions with an ability to take development exposure and mezzanine debt into the portfolio. We are targeting an 8 per cent return per annum to be paid on a monthly basis.

How does the investment proposition you are discussing differ from investing in a vanilla fixed-income bond?

The main factor is that we don’t have duration risk. If interest rates increase we can keep resetting the return profile because cash comes through the fund on a regular basis.