Over ten years ago, the Global Financial Crisis (GFC) saw the stock market crash, and a recession took hold across most of the developed world, with Australia being a rare exception. While stocks have since gone a way towards recovering it is remarkable to think that it would take the ASX 200 rising over 13% from current levels (5886) to return to its pre-GFC state of 6,696 (as at 2 November 2007).

Compounding this shock to the global economic system, the GFC was followed by what the ASX conservatively describes as “a global environment characterised by significant uncertainty” largely as a result of unexpected geopolitical events like the election of US President Donald Trump, US-China trade disputes and the British decision to leave the EU.

Real estate debt emerges as an asset class

In this new environment, investors’ asset allocations can now turn to relatively new forms of investment. Prior to the GFC, the banks reigned supreme, particularly in the area of real estate lending. The idea of investing in real estate debt was uncommon, to say the least. When banks reduced their capital dedicated to real estate development, a market void evolved.

As non-banks filled the void by providing private debt, the idea of real estate debt as an investment class became more accepted and common. Today, it’s a major industry, with $85.2 billion in global commitments from institutional private debt funds, according to international research body Prequin. With real estate now the most popular collateral for private debt funds, why should you make it part of your portfolio in 2019?

The young are particularly risk averse

There are more young investors than ever globally. A recent ASX study (https://bit.ly/2Wv5vt6) shows that the number of investors aged 18-24 has doubled between 2012 and 2017. It’s unsurprising to see that the primary foci of these investors is different to those of retirement age, but no matter which group you look at, that same study indicates that the needs of all investors have changed. Investors are seeking stability, and they’re willing to accept lower returns to achieve it.

What is interesting is this preference gets more pronounced the younger the investor is. 81% of young investors (categorised as those under 34) want stable or guaranteed returns, compared with 60% of retirees and 67% of older investors. Similarly, young investors are happy with an average 8.2% return, compared with an expected average return of 9.2% amongst older investors.

There’s a practical reason for this. Many young investors started considering investing following the GFC and during a global recession, and since then they have experienced an uncertain global environment, and that’s had an impact on their risk appetites. While shares do still factor into 31% of these investors’ portfolios, many are reducing their exposure in favour of safer, more reliable choices with 44% of young investors holding cash.

Sophisticated investors have a wider buffet of investment choices

Australia’s regulatory regime allows any investor who has had a gross annual income of $250,000 or more in each of the previous two years or has net assets of at least $2.5 million to be deemed a Sophisticated Investor. Once so categorised an investor has access to a wide range of investments that a retail investor can not invest in.

Is real estate debt a property asset class?

When you talk to investors about property, investors have in their mind a range of options including:
– ASX-listed Australian Real Estate Investment Trusts (AREITs),
– Unlisted retail property unit trusts and mutual funds, and
– Directly held property.

In all of the above investments, despite the structure, the underlying investment is in ordinary equity in property. This means in the event of highly negative events these investments were both the most exposed to a loss and the most volatile in terms of value over time.
Real estate debt, on the other hand, is not equity. It is either first or second mortgage or an unsecured but preference position. As a development project faces headwind and the value of the equity declines, the value of the underlying real estate debt may not change at all.

How Real Estate Debt Works

The major advantage of real estate debt is its risk-reward profile. Debt is backed by hard asset collateral (usually existing real estate), and lenders only lend up to a percentage of the initial value of that hard asset, so the value of the debt investment is insulated from asset value declines up to the value of the full amount of the equity provided by the developers and other equity investors. This strategy of mitigating risk in every possible way has a downside in that is that investors tend to earn a fixed rate of return. Midway through an investment a rezoning or uptick in property prices can considerably elevate the returns on a development. However, the extra profit flows to the ordinary equity investors as real estate debt usually commands a fixed return. On the other hand, when there is a blow out in costs due to unexpected rock in a proposed basement then the reduction in profitability all comes off the ordinary equity and the real estate debt provide does not suffer.

As risks decline don’t returns go down as well?

If two or more investments have the same return over a given time period, the one that has the lowest risk will have the better risk-adjusted return. The trick, then, is not just to look at returns from different investment choices, but to look at them in relation to the risks. The 30-year returns (1 July 1988 to 30 June 2018) include cash 6.1% p.a; international shares 7.4% p.a.; Australian bonds 8.0% p.a.; listed property 8.5% p.a.; Australian shares 9.1% p.a. and US shares at 10.6% p.a. (see https://bit.ly/2FWYlIV)

Those already investing in real estate private debt funds agree. 86% of those investing in private debt funds were satisfied with the returns in 2016, and 46% planned to increase their allocations in the future.

What Does Real Estate Debt Have Over Other Options?

Steady income: the returns aren’t sky high, but real estate debt provides investors with steady, fairly high yielding income typically on a monthly basis. Debt returns are usually in the range of 8% to 10% when secured by a first mortgage and higher with other structures. This is in excess of historic returns for other asset classes and with considerably less volatility.

Diversifying your portfolio: allocating capital across a large pool of loans with different terms, loan types, property types, locations, and this mitigates the risk of a single loan exposure. On top of that, issuing senior debt secured by a first mortgage means that debt is senior and sits ahead of any mezzanine debt, preferred equity, or equity, so offers the investor to be in the best position of what is referred to as the ‘capital stack’.

Low correlation with other asset classes: as Dorado’s David Giles explains, “It’s uncorrelated to the rest of the market. Your piece in the capital stack is capped out, so you’re taking the volatility of the asset out of it and getting a steady return.”

One for one value: “There’s a cracker reason for investing in real estate debt” Dorado’s Peter Packer notes, “When you invest a dollar in real estate you only get about 90c of net exposure, because you’ve got all the transaction costs on the way in and in the future further transaction costs on the way out. When you invest a dollar in real estate debt you get a dollar of debt. That’s a very big positive.”

Short lending period: because real estate debt is often associated with development projects, the lending terms are usually around 6-24 months, making it an excellent option for those not wanting to lock up their funds for too long.

Lower risk: because of the structure of the loans, investors take on minimised risk. Loans are secured against property, which acts as insurance of investors’ capital. Even if in unusual circumstance the borrower defaults the real estate debt is at the head of the queue when the property is sold.

Know Your Objective

As with all investments, real estate debt is not without its risks. There are several things to consider before taking the plunge, not least of which is understanding your own expectation of risk versus return. While the ASX study shows young investors overwhelming seek stable or guaranteed returns, it also shows 21% of the most risk averse profiles are expecting returns over 10%, exposing a disconnect between the reality of risk profiles required to generate the desired returns.

One aspect of real estate debt’s safety is that its returns are capped. While this means less risk, it also means returns are limited by the interest rate on the loan, so investors have to be clear that their safer bet will have lower returns than other higher risk options.

As with all investments, it’s important to really understand your objective when you’re making an investment in real estate debt. If you’re making an allocation by reducing your fixed income bond holdings, for instance, you will tend to seek very stable returns. On the other hand, those making allocations by reducing equity holdings may have an appetite for higher risk-reward position. (https://bit.ly/2RtLPls).