Qualitas on bridging the growing debt gap

This article is sponsored by Qualitas.

The retreat of traditional financiers from the commercial real estate lending market in Australia has left a capital vacuum that is set to grow in the coming years. The leading players have seen their market share decline from 87 percent to about 72 percent in the past decade, and increasingly stringent international banking regulations under Basel IV are further diminishing their appetite.

Mark Power, head of income credit, and Dean Winterton, global head of capital, at Australian real estate investment manager Qualitas, argue that with the big banks declining participation, alternative lenders are jockeying for position in a market set to expand by some 6 percent annually over the next 10 years.

What sectors in the CRE debt market are offering increased opportunities?

Mark Power: The level of pipeline in build-to-sell residential construction projects is the strongest we have experienced at Qualitas. Australia suffers from a chronic undersupply of residential dwellings, particularly across the eastern seaboard and capital cities where the residential vacancy rate is running at circa 1 percent. A market in equilibrium is 3 percent, so 1 percent is very low.

That is also why we have seen incredibly strong rental growth over the past couple of years. In Melbourne, Sydney and Brisbane it exceeded 15 percent in 2022, and in 2023 it will likely also be in the low double digits. The market is adjusting to that, and there is a need for credit across BTS and build-to-rent residential projects.

This is manifesting itself in pre-development land site lending as developers position themselves for the start of the next cycle.

We are seeing a strong pipeline in the BTS apartments space, mainly the high-end owner-occupier style product. Then there is the rental-type product, large projects of 400 to 500 apartments which traditionally used to be BTS for the private retail investor group but is now going down the path of BTR.

The supply and labor chain disruptions on the back of covid-19 had dramatic cost escalations here and were running at such a rate that it was difficult for developers to get a handle on where their construction costs were going to land, and how that was impacting their feasibility. Meanwhile, the gross asset value of a development has been increasing and with construction costs stabilizing, these feasibilities now stack up. A growing number of projects are now moving again.

There is also demand for residual stock lending against completed but unsold apartments from the tail end of the last cycle. We provide a line of credit against those to release capital for new projects.

Dean Winterton: The total return you get from a construction loan is marginally higher than our completed product. We manage A$2.5 billion ($1.6 billion; €1.5 billion) of construction loans; it is a core competency.

Is the outlook for residential different for houses versus apartments?

MP: The outlook for both is positive but they do move quite differently at times. During the pandemic, housing prices rose by more than 25 percent over an 18-month period across Melbourne, Sydney and Brisbane while the apartment market was subdued. The delta between housing and apartment prices rose to an unprecedented level. There is still a significant delta between apartments and houses.

We are also seeing a shift from housing through to apartment living, both from an ownership and a rental perspective, as the housing market is becoming increasingly unaffordable for a large cohort of the population.

Apartments have not traditionally featured in Australia’s housing stock but 30 percent of the one million new dwellings that were built between 2016 and 2021 are apartments. The whole populace of Australia, and particularly new Australians, are very familiar with apartment-type living – it is becoming a more permanent feature of the dwelling landscape here.

DW: We have relied on population growth and migration for more than 50 years so this is a bipartisan sort of commitment. During covid, we turned off the tap to immigration and we expected there would be a backlog, but I don’t think anyone realized how big it would be.

Somewhere between 500,000-560,000 new Australians, mainly from the Asia-Pacific region, have come into our economy in the last 12 months. The historical annualized average pre-covid was approximately 190,000. It will likely start to moderate to around 350,000 after 2025. Our denominator is 26.5 million, so this is an additional 1.2 million Australians over the next three years.

MP: The OECD forecast for Australia’s population growth out to 2031 is 13.4 percent, and Australia always overshoots these forecasts. If you compare that to other parts of the world, the US is forecast at 5.9 percent; the UK is 2.6 percent and Germany is flat.

Are you also active as an alternative lender outside the residential market? 

MP: The strong demand for new dwellings feeds into the entire real estate cycle because you need more shopping centers, logistics capacity and once we get through the office recalibration process, we are still going to need more offices as headcount continues to head north. There are also opportunities in asset repositioning plays, particularly in office, with strong sponsors that we would still look at with the right sort of structuring.

DW: We are agnostic about sectors in the CRE spectrum. We have done office, retail, and a considerable amount of logistics, but historically we have a longstanding track record in residential and in the last three to four years increasingly BTR.

We are very institutional in commercial lending and our loans are around the $70 million-$100 million mark, or even greater for construction loans. There is only a limited number of private funders that can provide that level of capital in Australia as there’s not the depth of capital in the private market like in the US or the UK.

What is more important when considering residential investments? 

MP: We lend to the top quartile of developers, businesses that have been around for 10, 20 or even 50 years, with a very strong balance sheet and liquidity position. They are companies that are sophisticated, with strong management structures in place that have seen several real estate cycles and have navigated their way through those.

Other criteria we focus on are the location of projects, making sure that they are the right products for the location and ensuring that they are rich in amenities with good connectivity to public transport and easy access into the CBD. We also focus heavily on the design of the product, looking at how it interfaces with the market and the location.

Over 75 percent of our exposure in lending is to Melbourne and Sydney. We are now doing more in southeast Queensland because that market has matured, and we think it is a much more stable environment than it has been historically.

DW: Our geographic focus is underpinned by our client capital, more than half of which comes from offshore institutional clients. We are fortunate to have two sovereign wealth funds on our client register, both of which have large mandate commitments with the firm.

We have had success in inflow both from abroad and domestically, but the significant uptick in inbound enquiry from offshore institutions is due to the relative risk return and attractiveness of the Australian market across the CRE spectrum, and more specifically in the CRE debt space.

One element is the heightened interest rate environment. The other is the relative attractiveness of Australia as part of the Asia-Pacific region. It has low correlation to Europe and the US, and a high correlation to the Asia growth story.

What differentiates the Australian CRE debt market from other markets globally, and how can investors access debt opportunities in the region?

Dean Winterton: The Australian Prudential Regulatory Authority has continued to raise the bar regarding lending criteria following the introduction of Basel III in 2015 and Basel IV earlier this year. The opportunity commercial banks have to lend in the commercial space is increasingly constrained around all the usual metrics. 

The big four Australian banks – Commonwealth Bank, Westpac, NAB and ANZ – have slowly reduced their participation with growth now at about 3 percent per annum, and diminishing slightly each year. The delta between that figure and the 6 percent growth of the alternative lending space is a very rich vein and an opportunity for organizations like Qualitas. 

Mark Power: The big four banks are required to hold more capital on their balance sheet relative to their European and US counterparts. The loans we are doing are the same that the banks were doing pre-GFC, and the sort of metrics we are structuring with our loan books are highly consistent with how banks were structuring back then. The whole alternative lending market is still emerging, and that allows our investors to get outsized returns for the risk they are being asked to absorb. 

DW: Investors can access CRE debt opportunities in Australia through listed vehicles and unlisted vehicles. This is through both open- and close-ended structures across the credit spectrum including construction debt, senior debt or tactical credit as well as separately managed accounts for larger institutional investors.