The commercial real estate debt upside Down Under

Martin Priestley, TH Real Estate’s head of debt for Asia-Pacific, explains why Australia and New Zealand are attractive markets for commercial real estate debt managers seeking relative value in the region

Q In terms of the jurisdiction and type of asset, where do you think the most attractive areas for real estate debt opportunities are in the Asia-Pacific region today?

Over the last five years in Australia, we have seen a steady decline in the amount of commercial lending the banks can do, creating an opportunity for institutional investors.

Tightening of regulatory capital and liquidity requirements have decreased the level of capital banks have available to assign to commercial real estate debt. As a result, banks have become more selective about lending to the sector.

Construction lending for residential development was the area where banks retreated first, although this is a specialist area where we have not been actively participating.

Subsequently, we have noticed the major financiers becoming more selective in lending to commercial investment-grade assets. Consequently, the market is now quite open and there are opportunities for non-bank lenders and debt funds to lend into the market against globalised assets and construction.

From our perspective, we prefer to invest in stabilised assets, so we have started looking for opportunities predominantly in the office, industrial and retail sectors, as well as specialised assets, including ‘build-to-rent’ and student accommodation.

Q Given you are based in Sydney, what is attractive about the Australian market in particular?

Our research shows that many Australian cities are among a group of what we call “future-proof” cities globally – sizeable cities with high levels of transparency and stability, and at the same time, backed by mega-trends set to increase and transform the demand for real estate over the coming decades.

Australian cities have high levels of sustainability, relatively high per capita productivity and favourable demographics. The percentages of wealthy households with income above $100,000 are among the highest within the Asia-Pacific region, while strong levels of skilled immigration drive steady population growth.

Sydney is the nerve centre of the country’s commercial and financial activities, and along with Melbourne ranks among the top 10 most liveable cities worldwide; we see these as fundamental factors to support real estate and therefore real estate debt over the long term. Brisbane and Perth are not far behind when TH Real Estate puts them through the analysis. On a regional basis, Canberra and Adelaide are two other great metropolitan statistical areas (MSAs) for selective lending opportunities. In saying that, there are quality assets pretty much across all our state capital cities in Australia and the primary cities of New Zealand

Q How does commercial real estate debt compare to other forms of real estate in the region – what is attractive about this strategy?

Commercial real estate debt presents very competitive relative value, compared to fixed income and direct real estate. Commerical real estate debt is a well-understood asset class. It is fully transparent and highly researchable. If you look at a particular asset, then dig very deeply into an aspect like the quality of the asset and its location, you can understand quickly the relative value compared to other asset classes. On a risk-adjusted basis, returns from commercial real estate debt are at least as good as equity and arguably better compared to alternatives with the same sort of quality information and certainty of income flow.

Well-managed commercial real estate debt can provide performance protection through diversified, stable income streams. It benefits from a substantial degree of downside protection provided by the ‘buffer’ of the sponsor’s equity and the structuring which is tailored to each loan. As real estate equity markets currently experience significant volatility, elevated valuations and heightened uncertainty, an investor focus on income is a welcome addition to the portfolio.

Q Are the investors targeting commercial real estate debt in Australia and Asia-Pacific typically based in the region?

We have seen a high level of interest mostly from APAC with some European and US enquiry, which has grown significantly over the last two years and we expect to see it continue to grow.

There are quite a few debt funds now focused on high-yield and high-return financing, targeting predominantly construction and/or mezzanine financing. Traditionally, more conservative investors including pension funds from different countries and sovereign wealth funds are focusing initially on the senior debt space, then expanding into value-add, staying away from areas such as residential construction.

Asian investors find it hard to get returns from their home markets. For instance, if you think about the interest rate levels in Korea or Japan, it is difficult for lenders to achieve mid-range returns. These investors have been investing in the US and Europe and for them, Australia is another way to achieve threshold returns and portfolio diversity.

Additionally, Australia and New Zealand are the markets where you can achieve returns which are getting close to, or are already above, the targets managers are looking for. The risk profile is relatively well understood. There is a transparency in the market and there is a reasonable amount of product or transaction flow in our region.

Q Any regulatory headwinds or tailwinds that might cause volatility in the commercial real estate debt space that you are focusing on?

Local banks in Australia and New Zealand previously dominated CRE lending but now have less appetite to lend into the market due to the increased capital and liquidity requirements that are pressuring the bank sector. Also, the debt funding provided by the banks is relatively short-term. For investors who are looking for long-term returns, which we are, this market provides the opportunity, and so the local regulatory requirements are contributing to the attractiveness for the third-party investors.

Q Looking at where we are in the cycle, how can investors in real estate debt in the region best protect themselves in the event of a downturn, how is it likely to impact the market?

We are in the late stage of the real estate cycle. However, real estate debt is a way to achieve attractive levels of return with less exposure to any late-cycle volatility or a market correction.

Commercial real estate debt also presents competitive relative value right now when compared to fixed income and direct real estate. So, if you look in the Sydney market, as an example, we are seeing certain transactions exchange for capitalisation rates of 4-5 percent compared to similar levels of returns in debt while lending against say 65 percent of the value of the property. Admittedly there is limited upside but also limited downside. Understanding the market at a local level combined with comprehensive due diligence is always critical.

As a minimum, Australasian commercial real estate loans include covenants, which are put in place to protect the lender in the event of capital value or income declines. These typically include loan-to-value and interest coverage protection agreements, so they will, in all cases, have ratios which need to be maintained throughout the loan.

In relation to the coverage ratio for example, if a situation presented where, for whatever reason, the cashflows being generated by the asset started to decrease, the interest rate coverage ratio test will be activated and help protect the investment through some form of debt reserve provision or accelerated repayment requirement. This will enable lenders to work with the borrower on the solutions to get the loan back on the track well ahead of there being any scope of non-paying or default.

This article is sponsored by TH Real Estate and first appeared in the commercial real estate debt supplement that accompanied the October edition of PDI.