Australian real estate debt, capitalizing on growth: Savills IM

The commercial real estate (CRE) debt market in Australia has grown rapidly over the last decade. According to the Australian Prudential Regulation Authority, the market expanded from A$200 billion in 2012 to A$357 billion by 2022, a circa 6% compound annual growth rate (CAGR).

Going forward, Mordor Intelligence forecasts the market to continue its growth trajectory to reach circa A$470 billion by 2027 at a CAGR of 5.6%.

However, while total CRE debt volumes in Australia have increased, domestic bank loan portfolio weightings to the sector have declined over the same period. The proportion of CRE lending by authorized deposit-taking institutions (ADIs) has dropped from a peak of 87% in 2013 to circa 73% in April 2022.

MAINSTREAM BANKS HUNKER DOWN TO SAFER BETS

The standard response by both domestic and international banks during periods of market uncertainty is to reduce risk.

This typically results in their capital being directed towards lower loan-to-value (LTVs) and better-quality underlying assets and sponsors. Furthermore, banks prefer lending on assets with longer leases to reduce vacancy risks.

Outside of the industrial sector, average lease lengths have reduced over the last five years and are likely to impact banks’ appetite to lend into the CRE sector.

Therefore, the reduction in CRE market share by ADIs over the last decade, the recent market volatility and subsequent bank retrenchment will provide a greater opportunity to non-bank CRE lenders.

Over the last decade, non-bank CRE lenders in Australia have increased their market share from 10% to 15%. Despite this growth, non-bank CRE lenders’ market share in Australia is still below the US and European markets, where non-bank CRE lenders have a market share of circa 50% and 40% respectively, and is heavily focused on the land and residential development markets.

Non-bank CRE lenders in Australia are forecast to grow at a CAGR of circa 17.5% over the next two to five years. At that rate, non-bank CRE lenders will achieve a circa 40% market share by 2032.

While this seems a dramatic growth level over the next decade, it is similar to the level of growth experienced by non-bank CRE lenders in Europe, where market share increased from virtually nothing immediately after the global financial crisis, to circa 40% market share by the end of 2022. 

OPPORTUNITIES FOR NON-BANK CRE LENDERS 

Non-bank CRE lenders are likely to grow into spaces where traditional lenders have been forced to leave a gap in both acquisition and refinance loans.

For example, the majority of banks’ annual debt issuance will be absorbed by refinancing existing maturities, so non-bank lenders will have the opportunity to fund new acquisitions.

That said, whilst financial regulators around the world are universally focused on banks’ real estate exposure, APRA has a distinctive approach to regulated institutions which includes prescriptive expectations around minimum interest coverage ratio levels for CRE lending.

Furthermore, the recent increases in interest rates will typically restrict banks to LTVs below 50% as they move to protect their liquidity positions and capital allocation to this higher-risk sector. This will result in a funding gap that must be filled by an equity injection or refinance with higher LTVs. 

According to CBRE, circa A$75 billion of outstanding CRE debt is refinanced annually. Assuming average initial LTVs at 60% with loan maturities of five years, and assuming average new LTVs at 50%, we can estimate a debt funding gap at circa A$11 billion annually.

This figure takes into account the average all property capital growth over the last five years at 2.13% annualized, provided by MSCI Real Assets.

In addition, there is a gap developing between senior lending and high-yield debt. At the senior lending end of the risk curve, where the ADIs and international banks prefer to operate, competition is high with ample liquidity.

ADIs and senior lenders’ investment strategies typically focus on CRE loans to high-quality investment-grade borrowers which are usually unsecured and non-recourse to the borrowers.

On the other end of the scale is the mature high-yield debt market, with well-capitalized non-bank lenders targeting residential and commercial real estate development loans with maturities below 24 months. These loans are further up the risk scale but also enjoy increased yields.

Investment strategies are aimed towards speculative residential developments, build-to-sell and land subdivisions with loan-to-costs (LTCs) up to 75-80%.

The lending opportunities that occupy the gap between senior and high yield do not generally offer enough yield to satisfy high-yield debt strategies. They are also unattractive to banks due to their stringent regulatory capital requirements.

As a result, potential clients that fall into this gap represent an under-served market that needs finance for transitional and yet-to-be-stabilized assets with LTVs up to 70%. These could be assets that need modernization, retrofitting or bringing up to required environmental, social and governance standards, for example.

This is the segment preferred by institutional private credit, with investment strategies focusing on first mortgage and capital protection while providing attractive returns for investors relative to senior lending.

FOCUS ON "SECOND LIFE" IS KEY

One of the key advantages of CRE debt strategies structured with first mortgages and conservative LTVs is the downside protection provided to investors.

Loans can be structured with circa 30-40% equity cushion and are asset-backed. Given the assets are used as security, those that can be repurposed and put to alternative uses are most attractive, since this versatility provides an extra layer of insurance for the loan security.

In the decade after the global financial crisis, with near-zero interest rates, non-bank lenders specializing in these strategies saw rapid growth in market share in Europe and the US.

However, in the new era of higher inflation, higher sustained interest rates and changing tenant requirements – including shorter lease lengths in the office and retail sectors – underwriting of sustainable rental levels for assets in distress or post-tenant insolvency is key.

While there is increased pressure on businesses in Australia and insolvencies are likely to remain elevated amid the Australian Tax Office clampdown, the absolute levels of companies entering external administration (EXAD) remain below the peaks reached during the global financial crisis.

Nevertheless, regardless of insolvency and EXAD levels, prudent investing in assets with a second life is essential and will play an important role in the lender’s exposure to exit risk at loan maturity if assets cannot be refinanced.

By Mohamed Ali, debt research analyst at Savills IM

Mohamed Ali is the debt research analyst at Savills IM. He is responsible for developing market intelligence and quantitative tools that provide the team with analytical research and insight on market, asset and regional trends.

Prior to joining Savills IM, he was a research associate in the real assets team at Aviva Investors with a particular focus on developing quantitative research. His research expertise spanned all debt strategies across corporate, real estate and infrastructure. He has a doctorate in astrophysics from the University of Leeds.

Jihyun Kim edited this article.