Every balanced portfolio should include CRE Debt

Our next speaker in the property and income perspective is Craig Bannister from Palace Capital.

His presentation topic is every balance portfolio should include CRE debt.

Palace Capital is an institutional debt and equity fund manager specialising in the finance of Australian and New Zealand commercial real estate.

Since the inception, they have written over $3.4 billion of total investments in debt and equity, covering a wide range of real estate sectors.

Craig is an executive director for distribution.

Previously, he worked extensively across Asian financial markets whilst based in Singapore for over 20 years, held a variety of strategic roles with major international financial services firms.

Welcome, Craig.

Over to you.

Thanks very much.

Well, the presentation today is I believe every balanced portfolio should include commercial real estate debt.

And when we look at the key asset classes in Australia, obviously the largest being the residential home mortgages market over $9 trillion, we're talking about commercial real estate debt and at $0.5 trillion or half a billion dollars there.

When we look into that market, the returns that we can provide for our wholesale investors can be the 8 to 12% range for single asset SPV investing.

And that compares very favourably with certainly ASX listed equities.

And what I've seen over when we started the business in 2016 is the lack of volatility within this sector when compared to equities or bond markets.

And certainly we've seen that play out in the last 18 months, where

we've had a portfolio now of about 1.7 1.8 billion dollars and there's no impairments we've had no losses on any of those 470 transactions debt transactions that we've done and they've been through pretty challenging times so certainly it's a great asset class that's growing in awareness

The returns are very stable and it's considered the lack of volatility when compared to equities and the traditional bond markets.

This slide really talks about some of the implied volatility within listed equities and bond markets.

And as I said, the returns under the first mortgage debt investments that we offer

which generally have a 65 LVR against valuation, are running about 10% per annum.

And that's been unchanged through these volatile times.

When we get into what is a commercial real estate debt investment,

Really, commercial real estate refers to the use of funds, really.

It must be for a business purpose, so we're not lending to mums and dads.

Residential mortgages covers that.

We don't do that.

The security property that we lend against, it may be a residential, it could be commercial, retail, industrial, or vacant land.

And the loan types that we generally lend to are one of four different types, pre-development, where we lend on an as-is valuation.

A borrower is coming to us to help settle on a block of land.

It could be a $10 million block of land.

We all agree it's worth $10 million, and so we're loaning $6.5 million against that asset.

We have first mortgage security against the site, and we also have company guarantees and personal guarantees against the borrower.

Moving on from that, after 12 months or so, that borrower may get approval.

That could then mean that we're lending against a construction loan, which would be for the project coming onto the land.

And then at the back end of a residential construction, there may be unsold stock.

And so we could then do a residual stock loan.

So we could effectively do three loans to one borrower over maybe a three-year period.

We also do investment loans, which would be against an existing asset that may have

income stream, and they're looking for a repurpose of that asset.

Most of the commercial real estate debt is registered by first mortgage, and as I said, maximum LVR at 65%.

The other 35% is the equity buffer.

So for us to lose a dollar on these loans that we're making, that property would have to fall in value more than 35% from their previous valuation.

So we tend to be lending into areas that are inner city, Sydney, Melbourne, Brisbane and Adelaide.

So we're not lending into country areas, we're not lending into holiday hotspots, which volatility would be greater.

And generally the loans are short term, they're sort of 12 to 18 months, maximum 24 months in duration.

Importantly, when we start off, the whole premise of the market is built on valuations.

If the valuations are correct on day one, then we know we're lending against that.

And we use tier one value as a palace capital.

That's key to it.

If your valuation's out from day one, then so is all your LVRs.

Typically, we're lending the groups that we're lending to anywhere from $10 million asset valuations to $100 million.

So they're well capitalised groups.

Part of our due diligence is to weed out the good borrowers from the bad, you might say.

Digging into balance sheets is important, understanding their business, understanding what they're trying to do with the loan and what assets they're ultimately trying to build.

When we look at some of the returns and how the investors are compensated, they're now part, we've moved, if you like, from a fixed rate to a borrower to a fixed rate return to an investor.

And now they're generally variable plus BBSW rates.

So a lot of our loans are 6% or 7% plus BBSW.

So BBSW is currently running at four, just a little bit over 4%.

So a 6% plus BBSW loan is returning a 10% per annum.

On the flip side, we probably lent that money out to the borrower at seven or 8% plus BBSW.

So our business is very simple in terms of

Money lent to the borrower versus rate to the investor.

It's simply a margin that the borrower pays.

We have warehouses or single asset SPV opportunities.

That means that people can invest into a single asset if they understand the area they might like to live near the actual project.

They may invest into an SPV or through warehouses that give a broad investment criteria.

Generally, those funds are open-ended and some of them may be listed or unlisted.

And often there's a first loss capital protection in the warehouse fund.

So as Palace Capital as a manager, we have 5% first loss capital protection in a lot of the managed funds, not the single assets, but the managed funds definitely have first loss capital protection.

My experience sort of over the 2016 since we started is many of the non-bank lenders, not just Palace Capital, have zero or near zero loss rate for the investors, which is fantastic to hear.

Certainly the credit teams within a lot of the non-bank lenders, we have a 25-man credit team within Palace Capital.

It's deep, it's big.

There's a lot of due diligence that goes on.

A lot of those people have come from the traditional banking world where the big banks used to dominate this market.

Now it's the non-bank lenders that are gaining market share from what was the domain of the big four banks.

But when we look into our actual loan book, I've said there we've written 419 loans, 91 construction loans.

Across all of that, the default rate has been very low, 0.6% in early 22, and it's risen to about 1.1% through last year, which is still a very low number.

Even in those defaulted loans where we've had to take possession and sell the asset, we've never actually lost a dollar on our loan amount.

A default might mean that we have to step in, take possession of the asset and then sell it, but we've always recovered our full amount.

You know, there is a case study there that we've got some detail around three failed builders, certainly in the last 12 or 18 months.

That's been the most common form of failure in these loans, builders going under.

We've all heard about it in the press.

We've got some good case studies there.

Suffice to say, in all of those three loans, we fully recovered the loan amount, but that's been the biggest challenge over the last 18 months with builders going under.

And how, as a lender, do you compensate for that or try not to be in industries or sectors where there's been a lot of failures?

When we look at the big picture of the market here, this is a slide that comes from APRA, and it's talking about the market growing from in commercial real estate debt loans, 375 billion to 475 billion added to 2025.

And a large percentage of that market share will be dominated by the traditional non-bank lenders, not the traditional banks.

So people like Palace Capital are gaining a lot of market share from the banks.

And part of the reasons why that occurs, there's some of the advantages from a borrower's perspective on dealing with the non-bank lenders.

On this slide here, we talk about turnaround times.

We could be up and down with credit approval within three to four weeks, where the banks would be a lot longer.

Traditionally, traditional banks require a lot of presale coverage.

Bank lenders, we could be a lot lower on presale.

So we are relatively flexible around loan terms to borrowers.

So the borrowers are coming back more and more to the non-banks.

So with a little bit of a wrap up here, until recently the commercial real estate debt had been fairly closed off to a lot of institute to wholesale investors and it was more at an institutional level.

That's changing now.

There's a lot of ways that wholesale and even retail investors can access the asset class now.

And certainly the attractive risk adjusted returns around that 10% per annum with good diversification away from the equities and bonds where volatility has hit those asset classes has been certainly something that we've benefited from in this asset class.

So just in brief, I think we offer a great attractive risk reward to investors.

Some of these non-bank lenders in the space now are certainly best in class.

We have best in class credit and origination teams.

And as we've talked about, it's a very weak correlation to some of these other asset classes with high volatility.

So thank you very much for your time today.

And any further questions?

We would love to speak directly to you at Palace Capital.

So thank you.

Thank you, Craig.

Thank you for the presentation.

Now we do have two questions for you.

The first one being, what security underpins a typical commercial real estate debt investment?

All of our loans are secured by registered mortgage.

So that's probably first mortgage up to a 65, maybe a stretch senior loan to a 70 or 75% valuation.

So registered mortgage on title.

We then have company guarantees over the borrowing entity and the directors are also liable under personal guarantees.

So those three forms of security are on every loan that we make.

Right.

And the second question is, what is the return portfolio or profile that investors can expect to receive, such as in the percentage terms for CRV debt investments?

Well, first mortgage debt investments now with 65% LVR are running at 10% to 11%.

Second mortgage investments, which run up to an LVR at 75%, are generally returning anywhere from 14 to 16%.

And then through Palace Capital, we have opportunities to invest in preferred equity and ordinary equity, where some developments, we open up to the investors and they can come in at the higher risk level, higher up the capital stack,

they're getting sort of 18% to 20% returns under preferred equity and targeting 20% to 25% returns under ordinary equity.

And we have a time for the third question.

So how is the CIE asset class diversified from traditional listed equities and bonds?

It's the unlisted nature of these debt instruments.

and the mark to market where traditional equities and bonds are obviously marked to market on a daily basis and emotions play out into those markets and markets will get driven by fear and greed and so there's movements in those markets.

the asset class here, we're talking about a term debt facility, a loan.

It's a 12 month, it's an 18 month loan term.

And so with that, you know, comes the, the, the, the break that it's not correlated.

So we're not marked to market marketing these investments on a daily basis.

Now we saw this through the, the recent COVID crisis.

Some of the ARITs,

enlisted REITs plunged in value where the underlying assets in those REITs were still performing and you know on the face of it really probably should have been valued at 100 cents in the dollar but they weren't they were trading at 90 or 80 cents in the dollar and that was just a function of people in the market having to sell other than the need for capital rather than the underlying assets being impaired and so the same thing happened with us we had

mortgages, loans that are backed by these mortgages and they had a 12 month timeframe or an 18 month timeframe.

So people may have said, can I get money out of them?

No, you can't.

They're, you know, you're locked in for a period of time, but over that time, the development continued.

The underlying security remains liquid and you know, it was being developed or there was no impairment to the actual underlying asset.

And so that's really the key to it.

Thank you, Craig, for the presentation and the Q&A.

Good to see you and take care.

Thank you very much.

Thank you.