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Answering the income call with private debt
This week’s Australian inflation shock of 5.1 per cent (annual rate) has all but confirmed what we’ve been fearing; the cost of living has gone up and that means the RBA will be backed into a corner and forced to raise the cash rate. Leaving rates unchanged when inflation has skyrocketed to 5.1 per cent is not only a risky move, but it could be seen as a political decision.
Futures markets are already pricing in a 0.25 percent rise which has prompted investors allocating to property and construction finance to review and assess their exposures. Omar Khan and Damien Cronin, directors of the Alceon Debt Income Fund, touched base with investors to bring them up-to-speed with the current state of flux and a general market update.
The Debt Income fund invests only in portfolio of high-quality loans secured by registered first-ranking mortgages held over Australian real property. A rising interest rate environment may improve the investment case for Australian private debt. Why? Because the underlying loans are variable or floating rate, meaning they increase with bond yields, while they are predominantly shorter-term, with repayment due around 18 months after establishment. There is little wonder that institutions and high-net-wealth (HNW) individuals have been allocating heavily to the sector in recent years.
Private debt can generate stable and high risk-adjusted returns with less correlation to traditional asset classes such as bonds and equities. Investors are able to “become the bank,” with the Alceon Debt Income fund providing capital to finance a mix of real estate development, construction and ownership of residential or commercial property.
In return, the fund collects the interest paid from borrowers and distributes the net income as distributions to investors on a monthly basis. The Alceon Debt Income Fund currently targets an annualised net return of between 5 – 7% (8.27% a year since inception) and features a conservative weighted average LVR and short weighted average duration of around 12 to 18 months.
According to the company, at 31 December, 80% of the fund’s portfolio was exposed to residential real estate and the remaining 20% exposed to commercial and mixed-use asset. Cronin says: “The residential market had experienced very strong growth over the past 12 months, with price growth in the range of 20% to 25%, providing an additional buffer to the reported portfolio LVR.”
Khan says, “Rates across the real estate space credit sector have compressed due to increased capital allocations from institutions and private investors together with the compression from underlying base interest rates. Rates from 2021-2022 will be more stable, that’s from base rates rising. Overall, the fund is performing strongly with an updated return target of 5-7 percent.”
That said, Khan and Cronin are cautious about what an increasing interest rate environment will bring. According to March 2022 CoreLogic data, a softening of house prices in Sydney and Melbourne is expected, with the view that house prices could see an orderly correction in the range of 5 percent-10 percent.
Economics aside, Alceon has taken all necessary steps to reduce risk where possible. With regard to portfolio construction exposure, the fund has no exposure to high-rise apartments, which run the risk of costly construction cost escalations. High-rise contracts typically offer lower margins compared to the house and land space.
All in all, Alceon is positioning conservatively due to increasing costs and a softening Australian property market. Despite the expected hike(s), rates will remain low, causing more developers to look beyond the big banks for a better deal at a time when international borders are opening, and migration is tipped to rise.
