Property, Risk, and Returns: A Deep Dive Into Mortgage Funds

Hello and welcome to the Investment Markets podcast where we discuss investment markets that impact self-directed investors. I'm your host Darren Connolly, CEO at Investment Markets and with me today is Ben O'Hara, Executive Director and Credit Committee Chair at GPS Investment Funds. The wider GPS group has been originating and managing mortgage loans since 1994 and can state that though past performance is not an indicator of future performance, none of their retail investors has ever incurred a capital loss. However, before we delve into that remarkable statement, I need to remind you this is all general advice and general information only and nothing in this podcast should be construed as an investment recommendation. You will need to decide what is right for you. Welcome Ben.

Thank you for having me.

So Ben, let's kick off with some initial thoughts about mortgage funds. For the uninitiated, what is a mortgage fund and what are the benefits of investing in mortgage funds when compared to traditional fixed income or property investments?

So simply a mortgage fund is people investing in the actual mortgage. So that can be either through direct, a contributory mortgage where you actually invest in a single mortgage, or in a pooled one where actually people are then combining their resources and funding commercial real estate loans. So predominantly at the moment, Mortgage funds have grown immensely since the GFC and now they are 26% basically funding property development loans in Australia. So a mortgage fund is people coming together to then go into a mortgage managed by a manager who then lends that money out to a counterparty and in return they get a rate of interest for their investment.

And what are the benefits when compared to fixed income or property investments?

Fixed income I would say is diversification. So it pays you a regular rate of return. Some offer a variable rate depending on what the actual RBA cash rate is doing. And as compared to property investments, I think the best thing for a mortgage fund is you're not equity. So you get repaid first. Loans always get repaid first and equity gets repaid second. liquidity generally in a mortgage fund is more often and more readily available than in a property trust or a real estate transaction.

It can be hard to sell a big multi-million dollar asset when you want some investors want to get out.

Well, that's the thing. And when you're locked in for those, you're generally locked in for a number of years. Whereas in a pooled fund, people do offer redemptions at a regular basis. We offer them every 90 days. And if you're in a contributory or a select, you are generally in for the life of the loan. And depending on that, that could be 12 or 18 months. But you are often able to access your monies at more regular intervals.

So Ben, income generation is obviously front and centre for most investors. The more income, the better, usually for most. But of course, more income means more risk. How do you balance those two competing pressures in your fund?

I think that's where the disclosure needs to come in where people are assessing risk and are they actually being told where they sit in the waterfall and the equity stack and also where is their money being deployed. In a mortgage fund we often cite LVRs, the loan to value ratio. Now people need to disclose is that net of GST or inclusive of GST and also I think the The biggest pressure on mortgage funds is when they offer a rate they have to use it. So their usage rate has to remain high because what will actually dilute a mortgage fund's return is uninvested capital. So the other part I think people need to realise is that good borrowers get good rates. So if a mortgage fund is offering over the top on what they want to pay investors the investor should ask well where are they actually deploying those funds and who's borrowing them, for what, where and what's the LVR. So all of those types of questions will determine where I think the balance between what an investor can expect to receive and also then what the fund manager needs to actually deploy the funds at. So look at usage rates and also look at where the money's going and thirdly there's leverage. Is the actual fund being leveraged? Are they using the investors monies to gear up the fund even more vigorously to then deploy again because that leverage will get repaid ahead of investors and so when we look at it we've coined a phrase called the Goldilocks zone where it's just right. You give the investors enough of a return but you're also not pricing yourself out of the market from using the funds with the borrowers. Because with funds at the moment in mortgages, you have to respect the property cycle. Sometimes it's challenging to use those funds when you have a quiet property cycle.

And generally the higher the rate, the higher the risk and you've got to be careful what you might wish for.

I think so. And property in Australia is a well loved and respected asset class to, to invest in. But I think what we see is you have to look at what the LVR is and what the asset is. Is it a piece of vacant land somewhere that's subject to a council approval in the never never, or is it something that's being developed shovel ready now where you know what the risk parameters are. So always be wary of what, you know, if it looks too good, generally there's a risk, there's a risk associated with it.

Yes. I think that applies for all investing, Ben.

Very true. Very true.

Now what measures does your fund take to manage credit and default borrower risk? How do you protect investors?

Well, the first thing is we treat investors' monies if it's our own. And in fact, we all have our monies invested in our own funds. So we are very conscious of where we put our monies. And you look at the credit risk. We have our credit team that assess the transaction. They look at the transaction and then they look at the sponsor, the borrower itself. And in our old saying, you always back the jockey being the sponsor. A good developer is always going to make trouble time. easier or more manageable than an inexperienced developer. So you look at the experience of the developer or the borrower and you have a look at their credit parameters. So with the retail license that we have, we disclose our LVRs, our liquidities and all that through our IMs and SPSs. And I think that's what you need to understand is who is the quality of the people assessing these from the mortgage fund.

And do you have many relationships with developers? Do they come and approach you?

Yeah, we pride ourselves on having a direct relationship model with developers and I think that's what builds a stable fund where you can actually source 80% of your business from your existing clientele, be that borrowers each time. They finish a project, look for their next one and then roll into the other one. So we mainly focus at GPS on real estate construction development deals in South East Queensland. We know that market. We're quite happy to assess the risk. We know the players, the good, the bad. And we think we've got a good grip on where we can use investors funds wisely.

Ben, diversification is very, very important for investors. How do you manage diversification and protect their interests?

Given that we only lend in South East Queensland, we're very mindful of diversification through borrower. We don't want one borrowing group to have more than 20% of our loan outstanding, so that way if one does ever run into trouble, it's not going to bring down your overall portfolio. Then you also look at geographical risk. We spread from Noosa to Coolangatta, so we have deals spread across that geography. So again, if a market moves in particular direction adversely, we're not hopefully putting all the portfolio at risk in that. And again, the largest risk at present is construction. And so again, making sure that we don't have one builder on too many projects on all of our lists. So we look at diversification of the risk through who we lend to, where we lend to and how it's being delivered. And I think then you can also stagger the timing of projects so that they're all not at the same point in time at any one time. So that's our method of diversification to manage that risk.

I know there are, do you see a lot of differences in those sub-markets between Coolangatta, Brisbane and Noosa?

Each of them has their own nuances. If you're looking for high-end real estate, you're looking on the sunshine coast or down the gold coast, whereas that more first and second home buyer stock may be in between, between Beenleigh, Caboolture and those growth corridors. So we definitely look at what's fit for purpose in those markets and hopefully back the right projects there.

So you're diversifying not just across those sub-markets but also the types of developments that are being done?

We look at basically units and townhouses. We don't look at anything else. That is a lack of diversification in one sense but we see it as a specialisation in another so that we actually know intimately those markets, how much it is to build. how much it is to sell and whether the deals make sense or not.

So intimately knowing those type of developments and what works and what you've seen work over dozens and dozens of years really gives you a bit of a deep insight into whether a project is going to stack up right from the early days. Is that a fair statement?

I think it's fair to say that we've got a niche in that market so we can tell pretty quickly and advise the sponsor as well whether we think that's appropriate what they're wanting to do or not. And so when we can give them a quick turnaround and that's one of the advantages in our market being able to tell someone quickly yes or no.

Yeah, you don't want the money sitting on the sideline for too long.

No, we need it deployed and we need it to earn interest for our investors.

Liquidity, as we were sort of just touching on, we saw this during the GFC, which I'm sure we're both old enough to remember, it's hugely important. So what are the liquidity characteristics for your fund and when an investor is assessing a fund, what should they be looking for?

They should be looking for what are the terms of that liquidity. So we have two funds in a pooled environment where one offers 90 day redemptions and one offers monthly redemptions. And I think redemptions in any fund though, and we say this to all our investors, are on a best endeavors basis. There are times at the moment we're blessed with a robust property market where projects are finishing. settlements are happening very quickly and we're getting those funds in. So depending on where the cycle in your fund is and the usage rate, you will always have projects finish and money's coming back in. And there are times when the property market's slowed. We've given money back to investors because we said we don't want to use them. But liquidity is a big consideration. So you look at can the people meet them? It's very hard depending on where they are with their funding in the property cycle. but I think it's always noted on a best endeavors basis and we always note that we're not committing to people to lock in for five plus years either. So we factor in a redemption of capital with each time we offer a liquidity event and that's part of our treasury management. functions. And so again, in a select loan or a contributory loan, you know you're invested for the length of that loan. And sometimes they get repaid early, sometimes they may stretch on a little longer. But I think that then has a set period for you as well.

So things are sort of going well now. If we dial back a little bit, maybe just to COVID four or five years ago, Were you seeing those stories in the paper about developers not being able to finish projects, not being able to get supplies, costs escalating? Did you see different parameters in that market compared to now?

There was an extension that we needed to extend the loans and keep the investors informed. I think that is the critical element during those periods of uncertainty is communication with your investors. Disclosing with them. Don't try and hide the truth of the matter.

Bad news always comes out.

It always comes out. It always bubbles to the surface. But generally, all our investors are aligned and so they trust us to manage the process through. And even at the moment we're seeing construction timeframes slip because finishing trades are very difficult to come by. So that last five, ten percent of a project is taking two to three times longer than it traditionally did. So again, our developers are understanding that they need our support and our investors are supporting us because we clearly communicate with them what the new timeframes are.

And is it fair to say that once the investors have experienced open communication, the transparency and they understand, do you typically then see investors reinvest into subsequent transactions?

all the time. We have, especially in our contributory mortgages, they love the fact that we can bring them new product and they can roll their funds into that new investment time after time. We see quite proudly little redemptions from the funds. We've grown our funds just organically year after year. Because everyone needs to remember that while building costs go up, that means your lending limits, you could probably still fund the same 24 to 30 transactions a year. But the actual inflationary effect of construction rises and property price inflation means that we have to keep our funds growing organically over time.

Well, if a cup of coffee is nearly $6, I'm a little bit scared to imagine what the construction costs are.

I heard on the radio it could head to 10.

Okay that's gonna maybe spark a few changes of behavior of a few Australians maybe if it's a $10 coffee.

It will.

Although I must say I have paid $9 at Brisbane Airport so that's...

They've got a captured market there.

They do. That's painful enough to be honest. So Ben transparency is a key part of... transparency and good communication is a key part of investor relations. What do you do with GPS to keep your investors informed about what's going on? And what should those investors actually look for if they're considering another mortgage fund?

I think firstly we have regular newsletters and updates on a monthly basis with our investors, go out every month to tell them what the state of the market is and what our thoughts are. And I think when investors are actually looking at a fund, disclosure in their documentation of what the mortgage fund is actually saying. So we had a retail licence, We've got the eight benchmark rules that ASIC put to us and so we fully disclose all that whereas I think a lot of firms may not disclose as readily as they should on the belief that they are talking to sophisticated or wholesale investors. So their documentation is probably a little bit more briefer so people need to ask the right questions when they look at these funds because I think they need to know where their money is being used and at what expense.

So you're voluntarily ascribing to a higher level of transparency and standards through the retail license?

No, not voluntarily. ASIC have put that there for our retail license disclosure and I think a lot of investors may know at the moment that with the growth in private markets globally and especially in Australia, ASIC are having a look at the disclosures for private markets because I think the share market has actually shrunk by listings by 4% over the last decade. So people aren't listing on that private equity side. I think in the private debt side we've seen our industry grow from literally zero to 50 billion over the last 15 years and CBRE predicted in their report, it'll go to 90 billion by the next six, seven years. So I think that's massive growth. And so with that, there's a lot of participants at the moment as well. I think if you look at that, the actual number of participants in the private debt arena has grown, which means will they all survive over the long course or will there be mergers and consolidations? And that's the challenge because I think, you know, it's easy to lend money. It's another skill to get it back.

So does that mean there's that many more people with capital chasing the deals? Like in your opinion is a sufficient deal flow to meet some of those capital flows?

No and that's what's concerning us as a business at the moment is that you have people with money to deploy and basically driving pricing down to what they'll offer the money for but also doing deals that probably

Shouldn't be done

Shouldn't be done and extending their LVR positions as well so you know lending more and I suppose putting their risk profile askew to actually where the property state of the market is but a lot of these private debt funds too are being supplied with hundreds of millions of dollars which means if you have that sitting there and you need to use it

You don't want it in cash.

It is putting pressure on your utilisation rate and your cash flow. So that's where I think there is a danger at the moment of people overextending these funds and looking at what their commitment levels are.

So what should investors look for when they're considering their own risk tolerance and investment goals and they're looking at the product providers? What should they be looking for?

I suppose who is underwriting the bulk of the investment fund? Is it normal investors or is it a large sovereign wealth fund or is it a larger fund? because they will, at the end of the day, have sway with the fund manager to say this is where we want the funds used and how they are used. So I think equity amongst the investors is a good thing to have a pool of investors there where all interests are treated equal and no one is favoured over anything else. What is hard to get from some funds is their utilization, right? And, you know, are they under pressure to actually use those funds? Because on one hand, when you see a fund that's worth one and a half billion dollars, it sounds very glamorous, but that means they have to do a lot of lending as well.

Well, they've got to deploy all of that capital into many different deals.

That's right. And in many different geographies whose property markets may be different cycles and with sponsors out there that may not be willing to pay that price.

And maybe they don't have teams on the ground. That's the, going back to your earlier point around understanding your geographical markets and sub-markets, even if they are all different just between the Sunshine Coast and Gold Coast, maybe that understanding isn't there.

No, and look the Cairns market is completely different to the Brisbane market at times which is completely different to Sydney and Melbourne and so all of them have their different characteristics at any point in time and I think the risk profiles need to be assessed as and where they lie at that point in time.

So there is a, just generally there's a lot of economic and market uncertainty around. Tariffs are up, tariffs are down, property market, interest rates, so there's a lot of uncertainty. How does this uncertainty impact your funds and maybe the market in general? Do you take it into consideration? Do you react to it? What do you do when you see the latest headlines that are in the news or in the newspapers?

I think first things you'll always have large sensational headlines but ultimately at the end of the day the Australian economy has seemed to be fairly robust to those headlines and it just meanders along at a relatively smooth pace.

Is meander a good thing?

No, no. Unfortunately, I think our structural settings mean that we cannot change our investment structure any time soon. And so it will keep me meandering. Productivity is a massive challenge at the moment. We're down in productivity in the building industry and we've got an Olympics to get ready for here in South East Queensland.

Yeah. Time is ticking.

Time's ticking. It's taking longer to build things. Our biggest challenges are, I suppose, structural challenges and that's led predominantly by government. We've got three different levels of government all with a different responsibility in the property sector for achieving different things. And at the moment, our labour participation rate is changing. There'll be a lot more people retiring out of the trades industries over the next decade and we're not replacing those. There's a big threat, I think everyone's realising from artificial intelligence coming through to different sectors. In construction though, at this stage, we still need boots and hard hats and trades to actually deliver these, the accommodation. And so whilst at a macro level, the economy with interest rates may influence first home buyer participation or I think a greater structural challenge that we will see in the property market is the ageing population downsizing. Where does that then transition through to the second and third home buyers? all of those demographic changes over the next decade or two that we'll undergo are pretty independent of what I think markets will do and economic influences because domestically we've got a two-party system of government that doesn't change that much. Notionally their first job is to get re-elected. So when it comes to changing anything with taxation or There's very few you know degrees of separation between the two and very very few levers that can be pulled regrettably at this stage You know there's since the GST came in that was the last bold Courageous decision.

25 years ago now.

Yeah, and and you know even talk about amending the GST rate gets gets held down and so we're I think we're we're We're going to get to a point though at some stage someone will need to do something and until then we'll just keep meandering along.

So I think what you're saying is we can we could ignore Mr Trump and his headlines.

I think the tragedy and the great strength of Australia is our isolation. We will continue to just be the masters of our destiny to an extent, but I think we need to be forward thinking as well. We once rode off the sheep's back and now we're digging our way out of any economic recession, but our mining boom can't last forever and can't carry the country forever. So we need to think through where we head from after that.

So there's probably two points in there I'd like to pull out. One is Southeast Queensland, which is obviously your geography of focus, is going to see hopefully an Olympics, as long as it doesn't get given to someone else. And then also the number of people entering, taking up a trade, the boots on the ground, sort of on the work site, so to speak. How are those two things, and maybe they're sort of at odds with each other, but How are those things going to impact property development, mortgage funds? How are they going to impact your world? They're a bit more immediate.

The short answer is that we will not be able to meet our supply needs in residential construction in South East Queensland probably for the next decade. Whilst the labour is absorbed by delivering that Olympic infrastructure, unless there is real courageous action taken by state and local government to actually provide greater supply of redevelopment land, we won't be able to meet that. So even if they did do that, then we need to encourage people to take up a trade, encourage the school leavers and overseas immigration to actually recognise their qualifications as well. But we need to increase those trades because for the next decade, I can see a large shortage of capacity to actually supply in the construction industry in South East Queensland.

And is that going to drive up costs? Is it going to reduce the number of new bills?

Well, I can say it certainly won't reduce costs.

Costs never come down. That coffee is never getting cheaper.

No, nothing very rarely comes back. But what that means is hopefully there'll be a plateauing, of course. Because if a project in the private sector doesn't stack up financially, it won't proceed. Whereas in the public sector, We've all seen infrastructure projects that start at $1 and end up at $4. And so the public purse will keep funding those due to the need. Whereas in the private sector, their assessment for their stakeholders is that no, if it doesn't make financial sense, we won't proceed. So potentially what that means is with population growth, the one definite out of the federal election is that we're going to have a big Australia, so population growth will continue and we need to find those dwellings for those people to live in. In South East Queensland last year, I think we had about a 25% success rate of putting dwellings on the ground of what our target goal is. And so if that continues and property prices, they'll continue to escalate. But then the question is, who can afford to buy them?

Very true. I think a lot of people have been priced out of that market, particularly first home buyers already. If you had a clean slate, let's say you were the three levels of government all encompassed into one individual, what would you be doing to meet some of these needs and facilitate a sort of a better outcome for all the different parties involved.

Look, I think as a society we have to accept one of two things. We either have higher density living or we keep the urban sprawl going. And so if it was keeping the urban sprawl going it's going to take years to run infrastructure, water, sewer, power to all of these areas. So to me we have to, I suppose, not listen as loudly, regrettably, to the nimbyism, not in my backyard, but the dream of, a strange dream of a quarter acre block with a house on it.

That's gone already, isn't it?

That's gone, but we have to admit to the fact, I think, that right, we do have all this capacity within five, ten kilometres of our CBDs. We've got other major areas, Gatton, Beenleigh, all these regional centres that could be further developed and enhanced as well. So I think there has to be a holistic approach, so we need greater density around those existing infrastructure points.

So a better infill strategy?

A better infill strategy.

Finally, turning back to you Ben, you've been in this game for a long period of time. What are maybe two or three of the most valuable lessons that you've learnt that you think will be relevant for investors?

I think the first one is Once you're in the market, stay in the market. You only have a crystalliser loss when you leave the market. We've seen through the GFC, prices in shares, equities and property did decline but they came back fairly quickly and very robustly and I think over time what you learn is that markets will generally move in a positive direction and so I think patience and not having the fear of the current situation drive you to make a decision that you know may not be in the long-term best interest so I think Patience in the market is the best thing. Getting in the market to start with is the most vital thing. You just need to get in and then how you get in is either in a little way or a big way, depending on how you can, but get in the market, be patient, stay in there and stay well informed. I think that's the better thing there is that if you are informed and you do your research, you can make better decisions.

Yep. I think they call it climbing the wall of worry. Start small, get in and stay in.

Yeah, that's it. I was at a conference, you know, 15 years ago and the GFC was just first starting and Larry Summers, the ex Obama treasury official said, you know, that's it, just stay in there. Everyone was thinking the sky was falling during the GFC and it was hard to see through that. at the time, but when you look back now you go, geez, I wish I'd bought a lot more.

Perspective is great.

It is, it is.

But maybe perspective only comes with a bit of experience and a few of those grey hairs on the head.

Yeah, and unfortunately receding grey hairs.

Okay, lovely. Thanks for your time and insights and contribution today Ben. It was illuminating and I think our audience will benefit from some of your decades of experience in mortgage funds.

Thank you. It was a pleasure, thanks.

Thank you also to everyone for listening. For more insights like this, and to search, find and compare hundreds of investment products, all in the one place, for free, including GPS's range of mortgage funds, go to www.investmentmarkets.com.au