Why a property debt fund can deliver outsized returns relative to risk

Our next presenter is Alexander Madono, founding director at Capstone Funds.

Alexander has worked in project finance and construction for over 15 years and managed Madono Capital from inception.

His presentation topic today is why a property debt fund can deliver outsized returns relative to risk.

Welcome to the presentation, Alexander.

Yeah, great.

Thanks, Angelina, for having me.

Yeah, here to talk about why the Property Debt Fund can deliver outsize returns to risk, and also just a little bit of background on our fund and what we do.

So what is, overall, what is a Property Debt Fund?

So we see that it's a simple way to invest in the property or the real estate market.

but instead getting consistent returns and also not volatile returns.

So a debt fund tends to have not much volatility in the returns that they offer.

There's also liquidity aspect where a debt fund is easier to get into and out of compared to a real estate, physical investment in real estate.

So what we do as a fund, we're a managed investment scheme, we operate under an A4Sell.

And what we do is we pull funds from our investors.

And then we invest into, we lend out as a non-bank lender, we lend out our funds to debt assets that have Australian property as the security for each of our lines, typically as a first mortgage.

And then by doing that, we generate

interest from our loans and we're able to then pass that on to our investors with our 10% per annum return that we offer.

So that's it in a nutshell what the fund does.

But then the question is why invest in real estate debt and what advantages does it have to not only real estate investing but also other asset classes?

So a key defining feature of a debt fund or debt investments is that it has assets that back the loan.

So in our case, that's tangible Australian property assets that typically established residences, or we might do residual stock lines, which are completed apartment blocks that developers may have just completed.

And then underneath this is the loan to value ratio.

That's another key feature of debt funds.

So our fund currently has a 60% loan to value ratio, which is relatively conservative.

And it means that for every $60 that we've lent out, we have $100 worth of property that underlies that as security.

And then another feature of debt funds is that we're repaid first.

In the capital stack, debt gets repaid first when there is a sale event or any other event like a refinance.

And that sort of brings us to this kind of a diagram where both the debt and equity might be considered, this top line might be considered the total value of a property.

And it's typically broken up into a debt component and an equity component.

So debt

would typically be a first mortgage and equity.

So if there are changes in the valuation price, which is that top line, equity will be the ones that are taking the full volatility of the value of the property.

Debt is static and it stays at that bottom level and it just receives its interest

So debt investments don't tend to outperform or underperform like equity, that top level might dramatically see a change in the value by outperforming or underperforming.

Debt investments tend to be static and consistent and because of the underlying value of the security, relatively less risk than equity and more sure that the loans, that the investment will be repaid in full.

So then,

How does a debt fund offer greater returns for risk?

So we've put together a few little graphs here, which I think exemplify pretty well.

So here is a term deposit.

Term deposits can be seen as a bit of a proxy for the risk-free rate.

It's a low risk fixed income investment, and you get a relatively low return, but a consistent return that doesn't change over the five-year period in this case.

That's compared to an equity return.

So all-ordinaries is a good proxy for the Australian public company market.

So over the last five years, this asset class or the all-ordinaries in particular has delivered a four and a half percent return.

Typically it's more like a seven percent return in the longer run.

But what

Similar to the equity component in a real estate investment, the equity component in companies has a similar dynamic where the company might have debt underneath it, but equity is the one taking the full volatility of the value of the company.

So you can see that in the return profile here that it is a volatile asset that doesn't have a fixed return and it can go up and down over the cycle.

It can go down 30 or 40% like it did several times in a recession or during COVID.

And in the long run, it should achieve a relatively good return.

Then that's compared to the capstone income fund.

So what we're trying to do is offer the best of both of those worlds, really a higher yielding asset class or investment.

So we're offering a 10% return.

But because we're a debt investment, we can achieve consistent returns that take out the volatility.

And because debt investments don't tend to outperform or underform, we just offer a consistent, stable return over the five-year period in this case.

And other asset classes may even have more volatile returns, for example, venture capital or seed investments, where they may dramatically outperform, but they may

dramatically underperform and have a loss of capital.

So the space that we're playing in is trying to be at the lower end of the risk curve while still offering very attractive returns to investors.

So that's, I guess, the reason why we think that a debt fund can offer an outsized return compared to the risk.

So the risk in finance, a proxy for risk is volatility, and we're taking out that volatility through our 10% consistent fixed return.

So some key facts about our fund, yeah, our 10% return, we have a portfolio line to value ratio at the moment of 60%,

85 or greater than 85% of our fund is currently in first mortgages.

We've done over 75 loans across the two funds that we manage.

We've completed those with no instance of capital loss.

And that's a testament to what I've been talking about earlier that our investments have security, tangible security underlying it with conservative loan to value ratios.

And that's how we can achieve every line that we've ever done has always been repaid.

been repaid its capital in full.

We also have a unique feature where management is invested alongside other investors in our fund.

So between five and 10% of our fund is management units.

And we also act as a first loss investor.

So if there ever was a an issue with any underlying loan in our portfolio, or achieving the 10% return management units would be there standing behind it and would be forfeited if required.

And that means that we generally stand behind the fund and all the investments that we make, not only professionally, but financially through these management units.

And then we're diversified across assets and geography.

So we typically stay in metro areas in the Brisbane, Sydney and Melbourne, East and Seaboard of Australia, but we've got some other assets around the place.

So how to invest in our fund?

We're open to wholesale investors, which has a definition as most of the people watching this will know.

It should be noted that the labour government is talking about increasing the requirements for the wholesale investor cutoff or what qualifies.

So we think now might be a good time to invest in wholesale funds because it's likely those investments will be grandfathered in going forward if those changes are made.

We've got a minimum investment of $100,000.

And yeah, if anyone's interested in looking through our further information memorandum or discussing the fund with myself or one of the other managers at the fund, you're welcome to reach out and we can organise a meeting to discuss further or download our information memorandum off the website.

Thank you for your presentation, Alexander.

Do you have time for a few questions?

Yeah, sure.

How does the fund sustain a 10% return?

Yeah, so a 10% return, so we've worked pretty hard over the last few years of our operation working out what is the right return to pay investors.

So we typically lend out to, our loans typically have about an 11 or 12% interest rate on them.

And we get some additional benefit, sometimes our loans go into default.

All of our loans are less than 12 months, but some of our loans might be six months and they may go into a month or two of going over that period.

But then at the same time, we have constantly undeployed funds where we get repaid a loan and we have to redeploy that out into another loan, which is a drag on our fund return.

So yeah, we've worked out that 10% return is the right return.

Our investors love it because it's double digit.

It's higher than other funds in this space, but also other asset classes.

Why can a non-bank lender achieve greater premium than a traditional bank?

Yeah, sure.

So yeah, we lend out at about 11 or 12%, which is higher than a banquet lender.

And the reason for that is the type of loans that we do.

So as I mentioned before, our loans are typically shorter tenor or maturity.

So banks don't tend to look at loans that are three, four, six months loans.

And the kind of lines that we're doing are these residual residual stock lines, which is left over from a build of a from a developer or bridging lines, which are

a borrower has bought a property and sold the property and they need to just bridge that gap for three or four months.

So we'll continually try and enter and exit out of these loans.

And it's not a place that the banks typically play.

And also borrowers aren't really too concerned or too price sensitive for those short period lines because they're only in it for four or six months.

So by doing this, we can achieve outsized interest rates compared to the banking space.

And it's how that we can continually deploy our fund out at 11 or 12%.

And then by doing that and managing the portfolio and trying to be fully deployed, we can then pay our investors the 10% return that our fund is known for.

Thank you, Alexander.

Great.

Thanks, Angelina.