Property Point: Where Qualitas is stamping its place

Hi, I’m Laura Daquino. Welcome to Property Point, a podcast dedicated to all things property investment in Australia. 

In the hotseat today is Tim Johansen, Managing Director of Capital and Debt at Qualitas. 

Qualitas is one of Australia’s non-bank lenders, with $2.3 billion under management. 

Tim says the level of demand coming from private developers is above the availability of finance right now. As we know, developers, which Qualitas lends money out to, are finding it more difficult to get loans from the banks and even the non-banks. 

Yes, thanks Laura. I think there’s definitely a recalibration of the markets occurring.  Firstly, I think that’s mainly occurring in the financing market, so what you’ve seen happen over the last few years is a gradual wind-back from the major banks participating in the real estate debt market and that’s been attributable to a number of things, including, just a time in the cycle of real estate. Markets in real estate do operate in cycles and we’re currently in a cycle now that particularly in residential where it’s come off a strong period of growth and the residential market is now resetting itself for the next cycle, so I think banks have generally pulled back from that market while that is resetting. 

I think there’s been the Royal Commission, there’s been increasing capital requirements on banks which is extensive for them. Banks have generally pulled back out of lending into real estate markets and that’s presented the opportunity for the non-bank sector to participate in that market. At the moment there’s quite a paradigm shift of non-banks participating in the market and taking market share away from the banks. The banks really provide the majority of capital and debt into the real estate market, it’s something like 85-90 per cent, and that’s a $300 billion dollar market, so a very significant contribution by the banking sector. 

You’ll see non-banks and alternate lenders gradually take some of that market share away from the banking sector, which is really reflective of what’s happening and what exists in our overseas markets, particularly in North America and Europe where the non-bank sector is a much larger participant in the debt markets than they are in Australia, so it’s really just following what’s happened in those very sort of deep and global markets overseas. Also, I think as it relates to residential, I think the question was around recalibrating that market as well and yes, as I said earlier, it’s come off a strong period of growth and that can’t continue on that level of momentum. So a break in that sort of growth and just a flattening out and in some cases a small decline in values is appropriate. 

It just makes sure that the market is growing in a sustainable fashion as opposed to growing very strongly and falling sharply, as these sort of pullbacks in the market are healthy. As I said, they reset the values for the next cycle and help readjust and make sure the participants that are in the market both at a lender level and a developer level are appropriate for the next cycle. 

Like you said, the banks control about 85-95 per cent potentially of the market here for commercial real estate. Do you have a view on how much of the slack, so to speak, so say if they drop their market share by 10 per cent over the next few years, how much of that would be picked up by non-bank lenders versus family offices?  Or even, I’m thinking if non-bank lenders do emerge as market leaders, do you think there’ll be concentration among them or we’ll see more players with less market share between them?

I think definitely my view is that you’ll see the banks lose some of that market share. It’s a bit under $300 billion dollars, so 10 per cent of that is obviously around $30 billion dollars. That could be passed across, if you like, or taken up by non-bank sector over the next 3-5 years, and look, nobody knows the answer to that. But I think at the moment you’re seeing some very significant transactions being undertaken by the non-bank sector, so it’s not hard actually to forecast that you would see quite a significant amount of debt capital moving to the non-bank sector.

That’s not going to disrupt the banks. The banks are always going to be the major participants in the market. They have lots of capital and they provide very attractive rates, so it’s not really disruptive to their businesses. And the non-bank sector is not looking to replace the bank sector, it’s really complementary to the banking sector. It’s giving optionality to developers and borrowers that they can talk to their banks and their relationships, but they can also talk to a non-bank participant to look for finance and financing alternatives. I think if what you’ve seen happen over the last 10 years coming out of the GFC is you’ve seen groups establish themselves, credible groups such as Qualitas who have been operating for 10 or 11 years and have got proper business practices in place, and policies and procedures, and actually operating very bank-like in terms of how they go about their business but they do take on a little bit more risk, maybe do a little bit more higher gearing on transactions to provide a better outcome to a borrower. 

But they’re, as I said, very much bank-like in terms of the quality of transactions and the quality of counterparts they deal with. I think largely you’ve got a market that’s emerging and being created through groups like that. I think in cycles you also have groups that emerge or come into the market looking to make money on a short-term basis. I don’t think smaller groups like that will exist. They will come in and do a few transactions and then leave the market but you’ve got other groups who are here for the long-term and when you look back in the market in five or ten years you’ll see that the market consists, of course, of the banking market, but then you’ll see the establishment and some very strong non-bank groups doing great deals with good borrowers and often in partnership with the banks. 

And like you said, you’re relatively complementary to the banking sector in some ways. I did note earlier this year that you lent $250 million in senior debt to a private developer for Trenerry’s West End complex near Docklands in Melbourne (pictured below). I don’t know whether these deals are becoming more the norm for you, but going more granular, how much of your business is being generated by these senior debt deals like that one, which the banks traditionally used to fund more of, say, as opposed to 12-18 months ago?

Definitely, that’s the trend, is for us to participate in significant transactions like that. That particular transaction, as an example, offered us a very compelling business case to provide that loan. It was a very strong development of nearly 400 apartments, very strong presales in place, very credible developer group and builder who was very experienced in this sort of type of development and size. All of the risk attributes of that deal sort of made sense to us. And then when you marry that with the return that you can achieve on that, relative to size and where it fits into your fund platform, that makes sense for us to do that.

I expect you’ll see us do many deals in our market both across the construction and development sector and also across the more passive style investment deals, whether it’s an office still in transaction or industrial property for instance. That will become more commonplace than what it is now. You’re seeing a few more of them but it’s a little bit rare to see those big deals done by a non-bank sector that, I think, in 3 years or so, it’ll be fairly commonplace for non-banks to be doing those type of deals. 

So, essentially moving up the capital stack to mitigate risk and seizing the lost opportunities of the banks?

Yeah, as I said earlier, the banks are really good at what they do in terms of providing large amounts of capital at very attractive prices. I think the banks, to be really honest, I don’t think they’re best at looking at transactions or taking in heightened or higher risk in some of these transactions. I think they do what they do really well, but when the transaction’s a little bit more heavily structured or you do need to take on a little bit more risk, I think it’s really important that those deals that are done by groups who have strong expertise in real estate, have been doing it for a long period of time and can get their head around the risk in that transaction, and also match up the risk of that transaction with the risk tolerance of the investor, if you like, or the ultimate investor in that platform. 

I think that’s very important consideration of those deals, where they do present a little bit higher risk than an average sort of bank-style deal that the investors who are in that deal ultimately through a fund platform are happy to take on that risk and the return that comes with it. 

And if there is higher gearing on these deals than bank deals, what kind of LVRs are we talking for them on average?

Just generally, I suppose, banks may be sitting at a 55-60 per cent LVR. I think you can take that up on certain transactions with certain clients or borrower groups, maybe another 10-15 per cent, and still have a sensible deal that makes sense from a risk point of view. And for that extra risk that you take on, then you are able to choose reasonable pricing, and often the pricing may be disproportionate actually to the extra risk you’re taking in or taking on.  That is, you may only provide a loan that’s a little bit higher than the banks but the return that you can achieve for that in the current market is pretty generous, and because the scarcity of capital to take that type of risk on, it can be very attractive lending.

I’m sure your stress testing for this kind of thing would be very rigorous given the market environment. What does it look like for these kind of deals? Do you, say, apply losses of ‘X’ per cent across the board for residential markets or does it vary?

Yeah, we do a lot of stress testing and lots of sensitivities and we do it transaction by transaction. So we run multiple sensitivities on any one deal to try to break that deal and see what the extreme risk points are, so when we sit down through our investment committee process we can talk about all the various scenarios of what-if’s and what can go wrong on that transaction. On a typical sort of development transaction in the residential market, we would like to see most of the debt covered by presales to credible purchases and then obviously having a good borrower, a good builder, the site dynamics and location attributes are strong. 

But then once we’ve done all that work through a due diligence process, then we pull the deal apart and try to break it, as I said. One of those scenarios we may look at is we will assume maybe 20-30 per cent of presales default and also assume maybe the value of that property reduces in value maybe 20-30 per cent as well. Now, that’s sort of an Armageddon situation. If that Armageddon situation happened then we would still be whole in our capital, that is, we wouldn’t have lost any money, then that’s a very good sensitivity that we do.  Often our sensitivities around those sort of levels of pullback and then we make sure our capital is still intact and our return is still intact. If that’s the outcome of one of our sensitivities, then that enables us to sort of consider that transaction but then there’s a whole bunch of other things that we’d look at as well, but that’s just one example.

I’d like to also drill into the Qualitas Real Estate Income fund which, I know it listed in November last year, it was probably a tricky time to list so it hasn’t done a lot since then, but what kind of returns are investors seeing there or what is the composition of the fund, as well?

The reason for that fund was that there isn’t really a 100 per cent focus real estate debt fund on the stock exchange listed. We thought given these types of lending transactions are generally sort of for the exclusive domain of wholesale investors, we thought retail investors might be interested in the debt side of real estate lending. And so we did a whole bunch of work around testing that thesis and we decided that we would trade a listed vehicle that would house real estate loans and that was the genesis of listing that, the QRI vehicle.  That’s approximately 6 months old today and in terms of from when we listed, we set out to achieve an 8 per cent target return, we set out to deploy our capital over the first sort of 6 months or so of that fund listing and we’re on track with those targets that we set out to achieve. 

That houses some nice and very broad sort of risk characteristics across various types of loans whether it’s a construction deal, or investment deal for an industrial property, or an investment deal for a retail or office building. The investments that that vehicle’s made today are very broad, both by asset class and by geographic and we’re very pleased with the formation of that portfolio.

Like you said, you’re diversifying out of residential and you are focusing on different growth thematics. I’ve noted that you have a food fund and also a new retirement living venture, so I’m wondering if you can tell us a little bit more about these kinds of opportunities, or what the driving force is behind this? 

I think we look for opportunities all the time that suits our sort of thesis, if you like, around certain markets, but also trying to match up what our investors are looking for, remembering that Qualitas is a real estate investment manager. We manage capital on behalf of very significant global institutions, whether they’re pension plans or insurance companies, superannuation funds, sovereign funds, and also, we have some very significant family offices both from overseas and domestically that invest through our fund platform. So, we’re obviously about looking for risk characteristics in asset classes in real estate that suit that theme and the risk appetite and tolerance of that investor client base. 

We have been very strong on residential for a very long period of time from our formation, actually, and we continue to be significantly invested in residential and we like the sector.  But, sectors do move around and you need to diversify your business and diversify what your investors are invested into. Certainly, over time, we’ve expanded our business with our funds growth and that includes doing a lot more senior debt. We continue to invest in equity as well, so we do invest across the whole capital stack. But being in the market and active in the market you come across opportunities that make sense, and part of that is us expanding and growing into other traditional asset classes within real estate such as office, industrial and retail etcetera. 

But also, we’ve had the opportunity to look at the seniors’ housing market, so we quite like the thematics around that in terms of the ageing population in Australia. A transaction came to us that was very compelling and we were able to close a transaction recently that enabled us to enter into that market and that was our first sort of investment into that seniors’ housing market.

You’re actively looking for more countercyclical opportunities like that, would you say?

Yeah, when we take on an investment opportunity, we like to grow into that sector, so I think we will add to that seniors’ housing portfolio through some strategic acquisitions and investments in that sector.

Similarly, another example would be in the build-to-rent sector. We really like that sector in Australia, it’s a new asset class but we’re very strong and have high conviction that it’ll be a significant and active growth area in our market. 

We did a lot of work looking at the market particularly in the USA and looked at that, what’s called multi-family over there and through those studies and research, we came across a very compelling transaction in New York that we invested into from an equity point of view and that was – one, it was a good investment for us and our investors, but also it gave us an opportunity to experience first-hand, that multi-family asset class in the US and many of those attributes and skills and learning from that transaction can be applied to the local market. 

We’re looking at the local market on the back of that interest in the US and certainly looking at debt transactions in Australia for build-to-rent, and also from an equity point of view as well. It’s one of the emerging asset classes and we are hoping to be the forefront of that growth of that asset class. 

Could you maybe put a little bit more context around build-to-rent?  I was looking into this earlier, actually this week, and like you said, it is popular in the US and UK but there seems to be an issue with new laws that might be coming in Australia from July 1 where it might put the brakes on the build-to-rent sector because of the tax implications for foreign investors. What’s your view around all of this and do you think that will restrict growth in the sector? 

Yeah, I think the Government does need to look at this sector. Nearly 30 per cent of Australians rent, so it’s a very significant number, and vacancy rates are low in Australia, particularly in our capital cities and more particularly in Melbourne and Sydney. I think build-to-rent is an asset class that has to exist in Australia. I think the Government needs to recognise that and understand that they’d need to help the market commence, and I think. when the UK market commenced not that long ago, the government helped out in terms of tax concessions, etcetera, so I think the Government here has to. 

I know the Labor Government pre-election was promising that they would reduce the withholding tax for managed investment schemes from 30 per cent to 15 per cent, which enabled overseas investors to be more compelled to invest in that asset class in Australia. 

The Liberal Party hasn’t as yet signalled that they will match that or look at the concessions around tax on build-to-rent, but I’m hoping they will. And I think hopefully through lobbying by the Property Council of Australia and others, they will look at this sector and realise to help it commence in a large fashion and to promote the industry to get it going, I think the Government does need to look at some of those tax implications that apply to that sector and just free it up a little bit to make the transactions more economic and also to encourage developers to participate more strongly in that market and hopefully it creates an asset class that moves or commences quicker than it otherwise would. 

All very interesting, that’s really good food for thought. We might leave it there today, thank you so much, Tim, for the chat.

That’s fine, happy to help. Thank you very much.

That was Tim Johansen, Managing Director of Capital & Debt at Qualitas.