Property: Debt vs Equity | Conviction Capital | Episode 3

Two leading money managers, two different strategies.

With thanks to InvestmentMarkets, this is Conviction Capital.

Welcome to Conviction Capital, I'm Juliette Saly.

Well property investors are facing a very different market to the one we saw a few years ago.

interest rates tighter financing conditions changing valuations and a huge amount of capital chasing private credit are reshaping the opportunity set.

So today we're taking a deep dive into property but from two very different perspectives one looking at the equity side of the capital stack buying and actively managing property assets and the other looking at the debt side lending against property and earning a return through interest.

So let's welcome Alex Abel, Managing Partner at ASA Real Estate and David Dix, Head of Asset Management at Think Tank.

Great to have you with me, both of you.

Alex, I might start with you.

From the equity side, what are you actually seeing in the property market right now?

It's a really interesting question, Julie, because the market, in terms of generalising in the market, because it's such a broad opportunity set, the real estate market itself, whether you're investing in retail assets, which we own a bunch of, predominantly in the essential services space, all the way to office, which is a bit of a dirty word at the moment.

Industrial's had a bit of a journey as well, and then there's all the other alternative parts of the market as well, whether it's self-storage, parts of healthcare,

And generalising in all of those we think is somewhat dangerous because real estate is really local game and that's where we think investing with a manager who really gets into the detail, has decades of experience, is the best way for investors to get exposure.

And are you seeing sort of the same amount maybe of caution David from the lending side or what's the outlook there?

Yeah I think probably the way I'd answer the question is to first kind of understand what property market we're looking at and if you think about the residential market across Australia and that's a space we play in as well as commercial as well.

But the residential market represents around $12 trillion of assets, about three to four times the size of the superannuation market.

So they're very big markets.

And I think to Alex's point, there's plenty going on across many of those markets, but it's also important to distinguish between the small scale operators and also the large scale operators.

We'll probably get to the large scale operators in this interview a little bit later on.

and it's also important to distinguish between the development side as well as a pre-existing asset.

So depending on which part of the market you're talking about will define kind of how you respond as a lender, as a debt provider into that market.

So going back to you Alex, how much do you think what is dictating the property market at the moment and what people are doing is about interest rates and the potentially higher for longer aspect?

There's interest rates and then there's growth.

Where can you access growth?

And that's where people today are looking at particularly convenience and essential services retail and they can see that the consumer needs to spend in that space.

They can see traffic volumes at shopping centres, for example, and turnover in the retailers in that essential space.

That continues to perform quite well and so they can buy into that growth story on the income side and that gives them comfort as well on the capital value side.

In terms of capital values themselves, they've obviously been moving around a lot.

Interest rates have played a role, and obviously risk-free rates play a big role, particularly in liquid markets.

But direct markets do perform differently, and although you can look at the ARITs on the stock market, you can also look at direct transactions, and there's recent transactions that have taken place over the last six weeks where

Assets have been sold at very close to book value, whereas the listed stock is trading considerably down on book value.

So the direct market is alive, it is trading, but sometimes you've just got to be patient and you've got to be earning the right assets with the right attributes, which is typically income with some growth.

And what does the interest rate environment mean for borrowers, particularly if we are going to see more rate hikes, some economists suggesting there could be two, three more in this cycle?

No, you're exactly right, Juliet.

So, again, pivot back to the residential market.

The residential market across Australia, so I'll talk generally, obviously there's pockets, we've seen around three and a half percent falls from the, I think it was the March 26 peak according to totality.

I would say that this is more of an affordability kind of lead downturn rather than necessarily an economic downturn, albeit we've seen tighter market conditions with, as you point out, the interest rate rises.

So actually three interest rate rises in 2026.

We saw in, I think it was February, March and May of this year.

So you've got a cash rate sitting at around 4.35%.

And putting that into context, you're actually looking at about $7,000 of additional mortgage repayments for the average $1 million loan.

So all of those things start to impact on, I guess, the consumer and the borrower.

But in saying that, the Reserve Bank has actually pointed out the resilience of borrowers and resilience of, I guess, mortgage holders across

across the market, so according to the RBA, fewer than 1% of mortgage holders are behind on repayment, so it probably gives you a sense of the resilience.

Whilst there's weakness coming through in the property market and many headlines around that, I think as the RBA point out, Australia and Australian borrowers are in an okay position at this point in the cycle.

Let's talk about where you are in terms of an investor as well.

So if you're a self-directed investor there's different ways obviously of getting exposure to property.

So how does that I guess compare with property debt?

What exactly is an investor being paid for?

Okay so I thought you might ask this question so what I thought about is kind of an analogy because debt is essentially you know we're happy to provide lending, provide finance to someone provided obviously they can repay the capital and pay the interest along the way they're the two essential components so

really an asset owner, a borrower, they get all the upside, they get all the equity as we call it, all the benefits of growth across the market and we've seen, back to the residential property market, we've seen 46% growth since COVID, since around 2020, so even though I talked about those falls, they need to be held into context but

If we unpack the debt side of things, so without getting too complex, I think of it like a sponge cake.

So essentially you've got the sponge itself, which is the predominant amount, maybe 75 to 80%.

I would class that as the senior debt.

So that's the one that is the really important one and needs to be protected, needs to be protected against some of those other layers.

So we might be talking the cream and the icing, and then obviously the cherries on top.

So the more cherries, the more equity there is.

What's really important is that in each of those components,

we understand how much risk has been taken and what reward we want to achieve.

So crude, maybe a crude example, but one way of unpacking it.

All right, let's talk about the equity proposition, Alex.

So if I invest in property equity, where is my return coming from?

Well, as David said, using the sponge cake analogy, and this does go to the risk profile in terms of the equity that you're investing.

So the fund that we run, for example, it has gearing of 43% and as opposed to David's example of 75 to 80, which is I suspect lives in the residential space.

The higher the gearing you take on, the more risk you're taking both on the up to the upside risk and also the downside risk.

So over the last four years, equity has been a tough place to be because there's been downside that's played out through various parts of the market and fixed interest or private credit has largely outperformed.

But we've seen some of those risks start to unfold now that there were

some larger risks being taken that perhaps people had envisaged in that space.

And certainly the way we think about debt is that it's a component of our return profile, but we really do not want to be in a position whereby we're over leveraged and we lose control of the situation, which is where your covenants come into position.

And, you know, we've been through a number of different cycles.

I spent four and a half years in the UK between 2006 and 2007, and it was a wild ride over there.

you really could see some serious equity erosion take place over there and we've seen it take place here as well and I think it will continue to take place over the next six to twelve months.

So obviously everybody wants more upside rather than downside but how do investors look at that trade-off do you think?

Yes, well, I mean, so when we're looking at buying an asset, we're looking at the fundamentals of the asset in terms of the location and the businesses that do occupy it or are likely to occupy it.

And then we also look one step further in terms of what are the businesses that they actually run?

What is, what are the services they sell or what are the goods that they sell?

And so we're looking at right through the covenants of those businesses and their ability to survive a downturn perhaps, which then means that they can continue to pay the rent, which can continue to fund the debt provider, for example, and indeed our distribution.

So in our fund, we haven't missed the distribution in over 20 years.

And that's because we've looked through to that part.

The other part of the, so we can pass through those income returns, obviously.

The other part of owning an asset is you benefit from tax depreciation, which can be quite beneficial in the form of tax deferred distributions, which you don't get in debt.

And then obviously you get the benefits as markets go through the cycle.

And it was a wonderful cycle from 2010 till 2022.

And that cycle's really been playing back out the other way now.

And often this is what happens at the bottom of the cycle.

It goes on for a while.

you're in there you're in the trenches and it's a grind but then you wake up one day and you look back and you go wow that that's over and the return has already been made and that's why we're looking at the market right now thinking this is a great time to buy because when it turns it's too late.

What about the risks from the debt side David because you're sitting higher in the capital stat that doesn't mean there's no risk.

Once again, it depends on the asset class and we're in the asset class, so maybe a little bit about think tanking that we operate in the very small loan or lending part of the market, so across both residential and commercial property.

We have many, many good borrowers with very strong balance sheets, and that's probably the most important thing.

You want to understand, obviously, the asset itself have very strong valuation procedures around valuing assets.

You also want to ensure you have proper and appropriate credit controls in place, so understanding the capacity of the borrower's ability to repay over a period of time.

You also need to understand, I guess, where the line sits or the line value ratio sits and how that sits across that market.

So we want to ensure that there's plenty of room and buffer there if the values were to come down and that we will continue to be repaid.

So across our book, we see arrears at very, very low levels.

So we're probably talking about the two to 4% and that's probably industry-wide across the non-bank space, some more, some less.

But for us, we're not talking about defaults every day, we're talking about borrowers that generally speaking will be able to meet their commitments and we work with them if they can't so that we ensure that there's not a fire sale of assets as well.

So you put all those things together, for us it provides us with confidence that

As we've been doing also for 20 years, we've never missed an interest payment over that period of time to our investors.

Probably gives you a sense of the more conservative end of the market that we like to play.

We need to talk about private credit and the amount of capital flowing into the sector as well.

Is there potentially too much money chasing too few opportunities?

Yeah, I think it may well be the case.

Maybe the jury's out and we're going through a structural cyclical change, I should say.

I mean, it's a $230 billion market.

Now, to put that in context, it's still a fraction of what we see over in the US, where there's, you know, multitudes of, you know, debt across many different parts of the market.

What I would say is that there has been a lot of money going into high yielding assets.

It is a little bit of buyer beware when investors are looking at different providers.

Part of that is that many are chasing a yield.

So where a sophisticated investor is looking at a product provider, they need to understand exactly what risk they're taking on and whether they're appropriately being compensated for that.

So, yeah, there has been a lot more capital going into this part of the market and perhaps we're seeing kind of a natural play out of that at the moment where some of the more marginal players are perhaps being exposed.

We've also seen a lot of commentary, Alex, around property developers and the risk, I guess, of the Baffler collapse as well.

I don't want to get into a specific case necessarily, but what does that tell us about the risks in the current environment?

Development's been very difficult for four years now.

Cost escalation since COVID has been over 40% and developers model is pretty simple.

They take a cost base, which is land, construction costs and other costs, including holding costs and interest.

and then they sell it for a margin.

And if that margin doesn't exist, which is really where we're at now, because the costs have inflated so much, and that is they've either come down or they've flatlined.

And so it's been a very tough place, and I don't think there's any developers who would deny it's been a really tough place to be a developer, and that's why

Owning high quality existing assets for the last few years has been quite a good ride.

You've gotten your income along the way and the income has probably supported your valuation as well.

But moving through this next phase of the cycle, it's very interesting because there will be very limited supply across most parts of the market and that includes Resi for that matter.

And so where there's pockets of oversupply or a high vacancy, they will get soaked up.

Older buildings will lose relevance in the market.

And in four years time, three years time, we think rents will really start to rise potentially very aggressively and there will be a lot of return to be made at that point in time.

With the risks though from a lender's perspective, David, what are some of the warning signs or red flags that you might look for?

Well, again, we don't operate in that space, so I can't talk to specifics, but I guess, you know, the cost blowouts have been, you know, have been sizeable over the past few years since COVID, as we've seen that.

Many of the developments that are, you know, in place now are probably marginal from a profit perspective for the developer.

And it's a real conundrum because the government, as we know, has mandated targets around the supply that needs to come on.

So, you know, it's a very difficult time.

And I guess back to your earlier point, there's been a wall of money that's been coming into the space.

And perhaps that's what's happened here, whereas it's extended to some of these marginal players.

I think at the end of the day you've got probably 40 or so lenders into that structure, many of them on different arrangements, some would be focused on land, some would be focused on the construction, some would be focused on residual stock.

So they'll each have their own needs and requirements.

I would say they'll be clamouring over the documents and the situation as it stands to ensure that they can not only recover their assets but also e-car to return on top of that.

So interesting, interesting situation to watch.

All right, well let's talk about opportunities.

So Alex, where do you see the most compelling opportunities at the moment?

It's a very good question because sometimes it's just, it's darkest before dawn and rarely do people ring the bell at the bottom and they get in.

It's very sporadic and you'll only know a few years after whether you've actually got the bottom or not.

We're not necessarily focused on getting the bottom.

We're focused on buying high quality assets that generate a good income stream.

And whilst I do think replacement cost is a commonly an overused term in real estate,

When you're buying assets that are relatively modern, that does really reflect quite well on replacement cost because you know that it might cost $14,000 a metre, for example, to build a certain type of building.

And if you can buy that building at $7,000 a metre, there's a lot of capacity there for your value to grow before potentially new supply gets delivered.

And supply may get delivered in due course, but it's because the value's grown, the value grows because rents grow.

or the market changes and people paying more for the same level of risk as they've paid in the past.

We've also seen convenience, retail, specialised assets holding up better than perhaps many had expected.

What do you think is behind that?

It's really that safety, the perception of safety that you get out of owning essential services, retail or convenience retail, or specialised assets for that matter.

The risk that you take on by owning a specialised asset is that you're probably taking a larger bet than you would otherwise on the operator of that space.

We have seen in the past and even during COVID, for example, I know there was a few abattoirs that are quite a specialised space, not everyone invests in that space, but you have an abattoir that falls over and goes bankrupt.

An abattoir is not worth much at all.

In fact, it's not even worth land value because of all the mediation that has to take place in an abattoir.

Specialised assets used to get quite a big premium.

That premium got bid right down when all that liquidity came through COVID and assets were getting bid right up.

And some of the assets have been repriced.

Healthcare is another one which has

got bid very tight into about four and a half percent yields that's now moved back out again so that's been a tough place to be in healthcare but certainly convenience and essential services retail has performed the best but people shouldn't forget the Amazon effect and the challenges of COVID that happened from 2015 to probably

2021-22 when retail was a tough place to be.

So things go in cycles and our view is that you have to be looking across all of the markets and be quite specific on the equity you're allocating and be really purposeful around why you're investing and where you're investing.

Is there anything that you think is specifically mispriced at the moment?

Well, I mean, we bought an office building in Melbourne back in May, which we bought at $7,000 a metre and an 8% yield.

We thought that was mispriced.

We thought that was fantastic buying.

And we also sold a shopping centre in WA at a 5.7% yield, which we took a view that it had too much exposure to discretionary retail.

and we were very concerned at that point in time around where discretionary was heading and you only need to look at JB HiFi's share price over the last 12 months to see where that market's gone and JB themselves are a fantastic operator so that's not a criticism on them at all it's just really the consumers doing it tough particularly in that discretionary space.

And David what makes a good property loan in this environment do you think?

The asset itself, I should say, is obviously important from a valuation perspective, but it's the combination of both the asset and the borrower's ability to repay that is the ultimate thing that we look at.

For us, I mean, when it comes to opportunities, we've seen, I guess, an emergence of construction, sorry, I shouldn't say construction, it's commercial-based lending.

So what is that in our space?

It's probably your small medical suites.

It could be self-storage, it could be

you know, for example, a business owner that wants to bring in, wants to actually purchase an asset that they can actually work out of, that their business can come into and obviously at arm's length pay the appropriate amount of rental lease.

So for us, it's the smaller ticket items that we like.

It's been an area that we've specialised in over the, certainly the past 15 years.

And there's continued demand in that space.

We see a lot of demand from mortgage brokers, so they're the predominant, I guess, pathway of a loan coming into our business.

And we've seen the emergence of the mortgage-broking community as well, where you see around 22,000 mortgage brokers operating

across the market and they take about 80% of the market so they become a very important avenue for business and distribution.

So for us, less perhaps interested in the opportunity around the assets themselves, it's more about the themes in the market and where we can perhaps take some market share and where we can conservatively lend into that market.

So what makes a good private credit opportunity as well where I guess separating one that investors might be paying a high interest rate because they just simply think the underlying risk might be too high?

Yeah, it ultimately comes down to risk-reward.

So, you know, the question that needs to be asked is for the risk that I'm taking, what reward should I expect?

And we've seen, you know, very high yields being offered and perhaps returns being paid to investors over the past five years in particular.

I guess there's a question of how sustainable that is.

For us, I think the sustainability of the income that you're delivering to your clients is the most important thing, and obviously repaying the capital.

So for us, we like to operate in our lane, which is conservative-based lending, where we have very strong confidence of the repayment cycle and the capital return.

and then ultimately we can provide that in the form of a distribution to clients.

I think one of the market themes that's come about more recently is the concept of gating around some fund structures.

So what is a gating?

A gating is essentially where liquidity was being offered up to a certain level, perhaps 5%,

the number of redemptions come in more than 5% and the asset manager needs to halt redemptions doesn't necessarily mean that there's a problem behind the asset base or the loans themselves but I guess that's a theme that's playing out in the market that we

have some concerns around.

I think if providers are offering liquidity in a certain form, then they should be true to label and be able to deliver that.

I understand the issues around the asset base being illiquid, and that's really the, I guess, the conundrum that we've got at the moment.

You know, illiquid asset classes or assets being offered in a more liquid form and finding that right balance is another part of the equation.

So for equity investors, what should investors be looking for, I guess, past or beyond the headline yield and expected growth?

Our view is when investors are looking at investing, they should look at the manager that they're investing with, look at the track record that they've got, how long they've been in the market, and also how much of their skin's in the game.

We think this is a really important part of investing alongside a manager who has a material amount of their own wealth invested alongside investors.

So if you also look at a self-directed investor assessing property equity investment, what are sort of maybe the top three things they should be looking for?

The top three things, well probably the first thing is the manager you're investing with and being comfortable that you can trust them to invest your money.

The second thing is understand the risk profile of how they operate and the portfolio that they manage or they intend to manage if you're investing into a blind fund for example.

And then the third part is really just the risk profile overall, which goes to gearing and capital management in particular, which to a certain extent sits in David's lane as well.

But we never want to be putting our investors' capital at risk by gearing too far up the risk curve.

And so they're probably the three components I'd encourage investors to think about.

And from the debt side, top three?

Top three.

in terms of three things that matter most.

First and foremost being repaid capital at the end of the day so I think you know perhaps to reiterate some of the points you know the confidence in a manager is really important and track record is at the forefront of that so you know for us a 20-year track record of never missing interest payments and never having not paid our investors is something we

we, you know, we're very proud of, but also we don't, you know, rest on our laurels around that.

But at the end of the day, I think that's the first one.

Second one I think is true to label around liquidity.

So as I pointed out, you know, if you're offering a certain liquidity profile, then being true to label around that,

I think the third thing to assess is probably just around the governance and the experience of the practitioners that sit behind the provider.

So for us that's very important, ASIC, their report 820 focusing on governance and for us it's particularly important, we've picked up a lot of that.

and just gone back and looked at our processes and made sure that we have everything set up correctly and we're confident that we are in the right place and it probably goes to some of the things that people can look at when they're assessing a provider.

What do you think about some of the biggest misconceptions people might have about taking on property debt?

Okay, so having spent 25 to 30 years in multi-asset, I joined Think Tank about 15 months ago and I would agree that there are a bunch of misconceptions.

I would say the misconception is, first of all, is that it's a predominantly risky space.

It certainly doesn't need to be.

I'm sure there's risk being involved in offering credit in certain funding structures.

but I think risk reward it's you know I think investors can be confident provided they understand what they're investing in back to my earlier point so that's probably one of the biggest misconceptions that it's just naturally a risky market I don't think it needs to be seen as that.

And speaking of risky markets Alex particularly when there's so much nervousness at the moment what do you think investors are most likely to get caught out on in the property market at the moment?

Well, I mean, David's point on liquidity is a very interesting one.

I think that liquidity in secondary assets, it doesn't matter what kind of asset they are, secondary assets I think will be challenged for the next 12 months or so.

And I think they need to reprice.

So I think that's where people might get caught out if they're already invested in that space.

And if they're not, perhaps there's some really good opportunities there.

And I think that's perhaps what sometimes the media miss is that whilst times are really challenged, that also means there's fantastic opportunities.

And that's what we're really looking forward to executing on.

And you mentioned before that we may not know the bottom until a couple of years, right?

Hindsight is a wonderful thing.

But with that in mind, do you sort of be viable where or do you take a risk if you believe in something because you might miss out on that opportunity?

Well, it's why we really focus hard on the income and hard on the asset quality, which then also leans on typically how much capex you need to put into a building.

We don't think now is the time in the cycle to be taking a lot of capex risk.

That means buying buildings that are potentially secondary, that need a lot of capital to be tipped into them, because frankly, you don't need to take those kinds of risks.

You can buy an asset that's relatively modern, that's got a really good income profile,

and historically speaking they're really good value.

So we're looking forward to finding a few more of those.

All right Alex and David thank you very much for your time.

So whether you're investing in the bricks and mortar itself or lending against those bricks and mortar the message is the same.

Understand where you sit in the capital stack, understand what you're being paid for and most importantly understand what can go wrong.

With thanks to Alex Abel from ASA Real Estate and David Dix from Think Tank.

Thanks for joining us on Conviction Capital.

Conviction Capital was brought to you by Investment Markets.

To find and compare Australian investments, visit investmentmarkets.com.au