A beginner's guide to real estate private credit
Australian investors have been blessed with strong share market returns for some time, primarily driven by a concentrated handful of companies and sectors on the ASX, such as the big four banks and mining stocks.
With such a highly concentrated portfolio, comes an elevated risk of whipsawing volatility and diminution of capital should these stocks underperform.
How can investors solve this challenge? By diversifying into asset classes uncorrelated to the share market.
Real estate private credit is one way to do this.
However, due to the Australian love affair with shares, private markets are typically forgotten about, under-utilised, and commonly misunderstood. This effect is compounded when considering real estate private credit, which due to the bad behaviour of a few, has earned the reputation of a risky asset class full of tricks and traps.
However, this asset class has the potential to offer higher returns and lower levels of risk and volatility.
With interest rates, market yields, and inflation at historically elevated levels, cash, fixed income, and asset-backed securities are increasingly coming into focus for investors as a way of generating income without taking on excessive amounts of risk or volatility. To most seasoned investors, bonds and term deposits are a well-trodden path to generating income, but real estate credit much less so.
Australia is a laggard in private credit. Offshore, real estate private credit is utilised much more broadly and is a key component of most well-diversified investment portfolios. However, due to reigning confusion and sustained mistrust we are missing this opportunity locally.
For those who have never invested in the space, real estate private credit sounds complex and a little overwhelming, but at its core is a simple concept if we break it down.
What is real estate private credit?
Private credit is the lending of money to an individual or a company (i.e. a borrower) where the debt is not issued or traded on a public market (such as the ASX).
When it comes to real estate private credit, in the event the borrower is unable to repay the principal and interest owing, the lender is:
- Legally entitled to take possession of a real estate asset(s) (land, buildings, etc) that they have taken security over via a mortgage, which is registered against the land title;
- Realise its value (for example, by selling it); and
- Use those proceeds to repay the outstanding debt.
Why it sounds familiar
Sound familiar? It should.
The same concepts that underly homeowner mortgages issued by banks also underpin real estate private credit.
As a mortgage-holder you would be familiar with repaying a loan with interest over a specified period of time. Investing in real estate private credit is no different, except that instead of being the borrower, you are the lender (that is, the bank). As the lender you are afforded all of the same protections that banks typically have.
So, why consider investing in real estate private credit?
There are several benefits investors can realise through real estate private credit, including:
1. Higher repayment priority than shares
Secured real estate debt ranks ahead of equity (shares) in the 'capital stack' meaning that - all things being equal - an investment into real estate private debt is more secure and less volatile than investing in shares;
2. Tangible real estate asset backing
In the event the borrower is unable to pay the principal and interest owed to investors, the lender can take possession of a tangible real estate asset (for example, land and/or buildings), sell them and use the resulting proceeds to repay any debt outstanding to the lender, significantly reducing risk of loss; and
3. Above-inflation returns
Returns available in real estate debt investments are typically more secure than shares and return higher than inflation. This means investors can maintain and improve their purchasing power in a high-inflation environment (that is, inflation is not 'eating up' and reducing your standard of living) whilst also dampening overall portfolio volatility.
It is not unusual in the current market to see first-ranking real estate credit offering after-fee returns in excess of 10 percent p.a.
Things to be aware of when investing in real estate private credit
When it comes to money, there are always going to be some unscrupulous characters to be aware of. There are some simple steps investors can take to avoid any tricks or traps when diving into real estate private credit. This includes:
1. Partner with a trusted manager who works for your benefit rather than their own
As with any managed investment, it is critical to partner with a fund manager whose investment philosophy aligns with your values and beliefs, who you can trust, and who has a strong track record of delivering returns regardless of market cycles and conditions;
2. Limited liquidity
Once you have invested in a real estate credit investment your capital is not accessible until the loan is repaid, so it is critical to build a real estate private credit portfolio around your expected requirement for cash (if any); and
3. Loan-to-value ratios
Generally, the higher the loan-to-value ratio, the higher risk of the investment, so it is important to choose a loan with a loan-to-value ratio aligning with your risk profile and your views on the performance of the real estate market.
Is real estate private credit for me?
Real estate private credit can offer strong returns, while diversifying your portfolio.
Due to the asset-backed nature of the investment, the underlying security property acts as an additional risk mitigant which means that the asset class can deliver very attractive risk-adjusted returns. The trick is always to be savvy about your investment choices.
Do your due diligence, partner with a trusted and experienced manager, and only take on risk aligned with your values and risk appetite.
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