Debt Funds: Time to lend

The real estate debt markets in Australia are beginning to attract global investors 

As local banks tighten property lending, Australia’s real estate debt market is in bud. In some sectors, such as construction and project financing, it is blooming.

The market is beginning to attract international players. There has been exponential growth in debt funds worldwide, and some of that money is finding its way to Australia.

Opportunistic players like Blackstone, Värde Partners, KKR, Oaktree and Lone Star are jostling for opportunities. Lower-risk institutional fund managers like Invesco, PGIM Real Estate and Forum Partners are also active at the edges.

Foreign players are determining how to engage in Australia. Should they partner Australian groups or go it alone? It is a question of execution, according to Andrew Faulk, head of Forum Partners in Australia. “Australia is a market that is adjusting following rationing of domestic real estate credit,” he says. “Investment debt returns now often outperform equity – and this has brought additional focus to real estate debt markets in Australia.”

Wayne Lasky, CIO of Melbourne-based alternative lender, MaxCap, says: “It is the end of the equity cycle and beginning of the debt cycle.”

Martin Priestley, senior director capital advisors with CBRE, adds: “The market is at an inflexion point. Relative returns from debt investment are as good as they get. With pricing where it is today, if you buy a retail property in downtown Sydney on a 4% return, it is equivalent to the return that you would get for seven or 10-year debt. A year ago, the differential between equity and debt returns was 5% to 6% for equity, compared with 3% to 3.5% for debt.” Priestley is now originating loans in Australia of about AUD100m (€66.9m) a month.

Invesco Real Estate managing director Ian Schilling says returns on stretched-senior debt with higher leverage are “in the high single-digit to low double-digit” field, while mezzanine debt is “low double-digit to mid-teens”.

Australia’s commercial real estate debt market stood at AUD255bn as of March, according to the Australian Prudential Regulation Authority (APRA). It peaked at AUD260bn in the June quarter of 2016.

That is a fraction of Australia’s more stable and profitable residential mortgage market. In the March 2017 quarter, Australia’s big four banks loaned AUD776bn to owner-occupiers, and a further AUD444bn to investors in interest-only loans. To cool the property market, APRA has progressively tightened prudential requirements on Australian banks. In the process, many investors, particularly from China, have been displaced.

This has come as a boon to non-bank lenders, which have now built up loan books totalling AUD115bn, according leading industry players.

And this is the space where large global names like Blackstone and its peers hope for a bite of the cherry. Media reports say KKR and Oaktree are in discussion with an Australian non-bank lender, Peppers Group, to establish a lending venture. Last November, Oaktree opened an office in Australia headed by former Macquarie Bank director, Byron Neath. Minneapolis-based Värde Partners has also established a presence in Australia.

“Whether it is Blackstone, KKR or Oaktree,” says a long-established lender, “they all need someone to do the back office work, someone who has the infrastructure to originate loans. They need a distribution channel.”

Last year, Blackstone agreed with Ausin Group, which specialises in selling off-the-plan apartments to offshore buyers, especially to Chinese, through its network of 24 offices around the world.

A source says: “Ausin could well be able to channel, say, AUD1bn of sales to Blackstone to fund. It is mutually beneficial – Ausin keeps the sale and Blackstone gets access to a pool of borrowers.”

But Andrew Schwartz, founder and group managing director of Qualitas, is sceptical of the depth of the foreign investor mortgage market in Australia. He says up to two-thirds of foreign buyers, especially Chinese, pay cash for their apartment purchases.

Schwartz estimates that “only 5% or 6% of total sales” in an apartment block are likely to access funding in Australia. Many will flinch at the high interest rates they have to pay to non-bank lenders. “I cannot see them wanting to pay around 9% for opportunistic housing debt,” says Schwartz, whose firm now plays an increasing role in alternative lending (see Qualitas: fast-growing lender).

Faced with tighter prudential requirements, Australian banks, says Priestley, are cutting back on property lending to generally. Their loan books consist mostly of profitable residential mortgages, followed by construction/project financing and investment loans. Of these three lines of business, residential mortgages are the backbone of Australian bank lending.

Priestley says the banks try to protect their mortgage business. The upshot is they are restricting lending to commercial real estate investment, especially to construction. The banks, he says, now have a classification called NTB (new to bank). They are unlikely to lend to NTBs.

Even with some of their existing borrowers, banks are weighing aggregation issues. They are wary of residential development, particularly where it is located in over-built locations, such as the inner Sydney suburb known as Green Square.

“Australian banks have retreated from the more risky assets and projects, and have clearly left a gap for non-traditional lenders,” says Steven Bulloch, head of Australia at PGIM Real Estate, which has been in the Australian debt market since 2012. “Today, most of the opportunity is in construction projects, and increasingly that opportunity is in providing senior debt.”

PGIM Real Estate provides funding to residential development projects in selected locations in Sydney and Melbourne, ranging from AUD25m to AUD70m. Its debt exposure is believed to add up to “a few hundred million” dollars.

Schilling says Invesco has stepped up its efforts to get into the debt market this year. “Nine of every 10 approaches we get are for residential projects,” he says.

Invesco’s head of acquisitions in Australia, Tim Meurer, says that Invesco began its debt lending programme last year by using capital from two strategies to lend AUD150m to a residential project in Brisbane. “We are selective and mindful that the residential sector is getting some headwinds, but we remain reasonably positive about the market fundamentals,” he says.

Australia’s big four banks have locked down the commercial real estate debt market, dubbed the 4-4.5% market – in reference to the current market interest rate. The standard term for such loans is three to five years.

But Lasky notes that the banks’ share of the market has fallen since the tightening. “They used to have up to 85% of the market. That has slipped to around 80%,” he says. This creates a niche for lenders prepared to take on longer-duration senior debt at a premium beyond the bank’s standard offerings.

Lasky says MaxCap recently launched its debut first-mortgage fund, raising more than AUD100m in commitments from institutional investors. “We have committed two-thirds of the fund to loans on an average [LTV] of 56%.”

Gresham closed its sixth fund this year, raising AUD500m. After running four private funds catering to mezzanine and preferred equity since it began offering debt in 2001, the Sydney-based company has positioned its latest two funds to provide unitranche, or stretched senior, debt.

Ami Simon, Gresham’s joint managing director, says: “We will lend beyond the 75% loan-to-cost ratio, and we also look at the [LTV] on the end product.”

APRA does not specify the value of construction or project financing. Its statistics show that land development and subdivision totalled AUD19bn, and that “other residential”, including property development, totalled AUD38.3bn in the first quarter of 2017. Simon believes the size of the market for construction loans in Australia is about AUD7bn.

Gresham and Qualitas have together raised AUD1bn this year to finance construction projects. Simon says: “We focus on construction because it offers relative liquidity, a natural exit and the higher leverage against costs is offset by the benefit of value-add.”

Today, debt capital for Australia is being raised from global investors and local superannuation funds. Two super funds, including AustralianSuper, have mandated MaxCap to source opportunities.

MaxCap has more than AUD400m in credit-approved funding from these mandates. In addition it is working on other mandates to fulfil loan agreements worth about AUD2bn, to be funded over the next 12 months.

Early overseas arrivals include New York-based Metlife, which IPE Real Assets understands has placed AUD1bn with CBRE to lend in Australia.

Michael Wood, co-founder of debt business Madigan Capital, says debt is seen very much as a core part of the diversified portfolio of an institutional investor. And Australia is considered an emerging market, compared with the US and Europe debt markets. Stumbling blocks to some offshore institutions, however, are foreign-exchange risk and a dearth of experienced local debt managers.