Why rate cuts aren’t bad news for mortgage funds

With interest rates at a decade-high and the RBA signalling potential rate cuts sometime next year, the current yields on mortgage funds present an attractive opportunity.

Mortgage funds have gained traction as higher interest rates have made lending to the commercial real estate sector increasingly attractive. This shift has occurred while traditional property investments such as real estate investment trusts are facing significant valuation challenges.

According to a recent report by investment firm Zagga, more investors are gravitating toward private real estate debt for property exposure in order to avoid the volatility typically associated with property markets. This trend is fuelled by high current rates and the anticipation of stable returns amid uncertain economic conditions.

Understanding mortgage funds

Mortgage funds are investment vehicles where investors’ capital is used to finance property loans. They are a subset of private real estate debt funds designed to provide attractive monthly income, downside protection, and inflation protection.

These loans are typically secured by mortgages over the properties and fall into two categories: pooled and contributory.

In contributory mortgage funds, investors select specific loans to invest in, giving them greater control over their investment choices.

Alternatively, investors can opt for a pooled mortgage fund, where they invest in a diversified portfolio of loans. This approach reduces investment risk through diversification, as the underlying properties—often a mix of residential, commercial, and industrial assets—are managed by a fund manager.

Attractive risk-adjusted returns

Typically, real estate debt funds target returns between 8% and 12%, significantly higher than traditional fixed-income investments. Additionally, many of these instruments offer floating rates, which can help protect against inflation.

Beyond attractive risk-adjusted returns, another reason for the rising popularity of private debt is the scaling back of lending by local banks due to regulatory pressure to reduce real estate debt exposure.

For example, Trilogy Monthly Income Trust, a pooled mortgage investment vehicle that allows investors to tap into the returns generated from loans secured by registered first mortgages, offers a net distribution rate of 8.1% p.a.

Non-bank lenders like these are projected to drive growth in the broader non-bank commercial real estate debt. By 2028, the CRED market is expected to reach $146 billion, growing at an impressive rate of 35% p.a., according to Foresight.

How rate cuts could impact mortgage funds

First, the bad news. With an RBA rate cut on the horizon next year, any decrease in benchmark rates could make fixed income— which locks in returns—more attractive to investors than variable-rate products such as mortgage funds.

However, a likely decline in yields could also de-risk some of these investments. Since most mortgage fund lending focuses on providing loans to small and mid-sized development projects whose credit risk profiles have risen due to rapid interest rate hikes over the past few years, a sustained decline in interest rates is likely to reduce the risk associated with these projects.

In addition, while the yields on mortgage funds might be impacted by rate cuts, they are likely to remain competitive with traditional fixed-income options since they typically come with an illiquidity premium. Most first mortgage funds currently yield between 8% and 9%.

For example, the Msquared Mortgage Income Fund is a pooled mortgage fund with a maximum loan-to-value ratio of 70% and offers a current return of 8% p.a.

Similarly, the Supra Capital First Mortgage Fund targets a return of 8.8% p.a. It consists of a diversified pool of first mortgage loans used for purchasing, refinancing, or developing real estate and does not include higher-risk loans like mezzanine financing or second mortgages.

Mortgage funds provide stable income returns

So far, the current economic climate—characterised by high interest rates and inflation—has presented a unique opportunity for investment in mortgage debt funds. However, as rates fall and the industry recalibrates its expectations for property valuations and performance, strategies that unlock capital for real estate borrowers are likely to become increasingly relevant.

Investors should be mindful that liquidity and financing costs continue to rank among the top risks in the real estate sector. In this context, mortgage funds can play a crucial role in helping investors navigate these challenges while potentially delivering stable income and attractive risk-adjusted returns.

Disclaimer: This article is prepared by Ankita Rai. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.