Four questions that separate one real estate credit fund from another

Australian private credit has drawn widespread press and regulatory attention over recent months. Clients are asking advisers to form a view on an asset class that looked straightforward while conditions were benign.

The difficulty is that real estate credit, property backed private credit lending, is a label rather than a strategy. Two funds can both describe themselves as first mortgage lenders and report returns within a point of each other. Yet they hold portfolios that behave quite differently when the market turns.

Allocating to the asset class is only the first decision. The more consequential one is which version of it a client ends up holding. In our view, that comes down to four questions.

Where your investment sits in the capital structure

The first question is where your investment sits within the capital structure. A senior loan with a registered first ranking mortgage benefits from the real estate as security. It puts the lender at the front of the queue, fully preferred ahead of any other mezzanine debt or equity behind it.

As you move up the capital structure, you are accepting more risk and therefore should be seeking a higher return. Some funds hold a mix of senior debt, and mezzanine, even structured equity.

This is a legitimate choice, but these blended exposures make it difficult for the adviser to determine their true risk profile. Funds with only first mortgage exposure allow for a simpler assessment of risk across a portfolio.

What the senior loan is secured against

A second distinction, and in our experience the one that accounts for most of the divergence between funds, is what secures the senior loan. Lending against a completed building, benefiting from income, or residual stock selling down, is a vastly different exposure. It differs from a loan the borrower progressively draws to fund the construction of a building.

Over recent years, investors have directed a significant share of the capital entering this market at senior and “stretch senior” construction lending. The weight of it has compressed margins and led some lenders to loosen covenants. They have increased loan-to-value ratios while reducing pre-sale and interest cover requirements.

Two loans can carry the label of a senior loan with a registered first ranking mortgage. One of them invests during the construction phase, with many variables at play. The other invests after the construction phase, with security over existing real estate.

How credit quality is assessed

The third question tends to receive less attention. It is how the lender or manager assesses credit quality when making investment decisions. We have witnessed a period in which some funds have become heavily capitalised in their pursuit of funds under management growth.

This can create significant pressure to deploy capital at scale and within compressed timeframes. It can potentially compromise the rigour of the credit assessment process.

These pressures can encourage a more standardised, or “cookie-cutter”, approach to lending. In that approach, the assessment focuses disproportionately on the more readily quantifiable aspects of the underlying real estate security.

This comes at the expense of the less tangible, but equally important, characteristics of the borrower, including their experience, reputation, financial capacity and alignment of interests.

Our experience has demonstrated that higher overall credit quality is achieved when due diligence begins with the borrower, rather than the property.

Our approach is to first establish that a borrower meets our standards of experience, reputation, financial strength and alignment, before progressing to a detailed assessment of the underlying real estate security. This approach is inherently more time-consuming and results in a higher rejection rate of potential investments.

Consequently, it is not particularly conducive to a strategy focused on rapid growth in funds under management.

However, we believe it produces a higher-quality and more resilient credit portfolio. Importantly, it provides an additional layer of credit protection beyond the underlying real estate security. That protection comes through the borrower’s experience, financial capacity and willingness to contribute to resolving challenges should they arise.

What an adviser can actually see

The last question is the most practical, which is how much of any of this an adviser can actually see. An investor in a credit fund doesn’t have access to visit every secured property, meet every borrower, or read every loan document.

So what the manager chooses to disclose in their reporting is close to the whole of what investors can assess. Investors can examine a fund that publishes its full portfolio properly, while they have to take one that offers a monthly return and a summary of its strategy largely on trust.

Asking for the loan list, the concentration, the weighted average loan-to-value ratio and the maturity profile is a reasonable request, and how a manager responds when investors ask is informative in itself.

How Barwon builds its answers

These four questions are the ones we built our own answers around. The Barwon First Mortgage Fund lends predominantly against completed and existing real estate, particularly residual stock and bridging against existing property. It holds no mezzanine debt and no equity, only loans secured by a registered first-ranking mortgage.

Our credit assessment begins with the borrower, weighing experience, financial capacity, track record and creditworthiness alongside the quality and value of the security.

As at the date of this paper, the Fund has no exposure to built-form construction loans. It carries a weighted average loan-to-value ratio of 59 per cent, all of which investors can see with a breakdown of the entire portfolio each quarter.

This approach comes with trade-offs, and we are open about them. It constrains the pace at which capital can be deployed and ultimately the scale we can reach, because it means declining loans that other lenders in the market will write. Lending against completed property also produces lower headline returns than strategies concentrated in higher-margin construction lending.

An adviser comparing funds on headline return alone will not see the reasons for that difference, and those main reasons are the four answers above.

None of this is an argument against the sector. Through 2022 and 2023 we watched the impact of high inflation and the RBA’s response closely. We moved to floating rate facilities as much of the market did, and concentrated on the loans best positioned to perform through a tougher environment. Our conviction in Australian real estate credit is long held, and the structural tailwinds supporting it remain in place.

Real estate credit has earned its place in client portfolios. The more demanding question for advisers now is which version of it a client is holding, and whether enough of the loan book is visible to answer that with any confidence.