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Higher costs and rising rates trigger a strategy shift in private debt
With interest rates still at relative lows, private debt offers both inflation protection and attractive risk-adjusted returns despite headwinds such as rising costs and program delays.
Financier and multi-strategy alternative investment manager Alceon Group, a leader in the private debt space, gave a quarterly webinar update on real estate private debt with head of real estate funds management, Grant Atchison and head of wholesale capital, Omar Khan.
According to Alceon, the industry is being hit with higher construction costs, program delays and rising lending rates, which is putting pressure on builders and developers.
“In very simple terms, it’s become a lot more expensive to build a house in the market,” Atchison explained. “The clear impact is that there is a compression of margins for builders and developers.
“Building inflation costs have gone up to 15-20 per cent but civil inflation costs are up 10-15 per cent,” he continued. “Cost escalation has partly been offset by revenue escalation but there is less contribution going forward due to margin compression.”
Alceon’s portfolio is heavily weighted towards low density house & land and town house construction.
“We selectively choose what goes in the portfolio,” Khan highlighted. “We have a heavy weighting towards low density house and town house construction where there has been less of an impact in inflation.”
Program delays stemming from weather, unavailability of staff and supply chain issues are all causing intermittent time and cost incursions.
“There hasn’t been any respite from ongoing rain nor is there a way of de-risking a portfolio from it. We just must make sufficient allowances in the portfolio for it,” Atchison said.
“There is a significant concern about rising interest rates, with the expectation that the Fed will go at least an additional 75bps up to 100bps at their next meeting. This creates exchange relativity where an increase in the US, makes our imports expensive and we are a significant importer of goods.”
Alceon notes that from a strategy perspective, when rates go up again, it moves the portfolio to floating rate securities. The average loan is about nine months, which allows a progressive rollover of fixed to floating.
The impact of the rising interest rates
Rate compression is when market prices of investments rise in relation to the income the investment will generate. When cap rate compression occurs, prices increase without a relative increase in rental income.
“Around July 2021 we dropped the target rate for the fund from 7 to 8 per cent down to 5 to 7 per cent,” Khan said.
“That wasn’t just a rate compression story but we also changed the strategy at the time where the fund primarily focused on senior secured first mortgages opportunities, whereas previously you could also invest into media capital.”
Alceon undertook a strategy shift amid an acknowledgement that conservatively positioned real estate private debt will generate somewhere between 5 to 7 per cent pa.
“Due to the increase in the cash rate, we’ve changed the way we structure loans. As the portfolio turns over to newer loans, we’re likely to see an increase in gross return to the fund and an increase in net return to the fund going forward,” Khan highlighted.
Market outlook
Atchison is cognisant of the challenging conditions and rising costs. Despite these being passed on, there is that margin squeeze. The lender is confident going forward with some positive signs starting to show.
“Shipping costs are coming down substantially from the peak. The first signs were primary building materials like concrete, steel, and timber easing,” Atchison said.
“The slowdown in housing demand will also help with labour costs that should free up a number of resources in the business.”
Other positives include a revival in the international student market with migration also coming back. Low vacancy rates will contribute to demand.
“On the negatives, we’re still keeping an eye on political uncertainty in Ukraine,” Atchison continued. “They are a major source of building materials in the industry. Energy costs continue to go only one way and material costs don’t usually come down as quickly as they go up.”
According to Atchison, interest rates aren’t usually taken into account when deploying capital.
“We want to make sure that when we deploy capital to our borrowers, interest rates aren’t a significant factor to them and they are able to weather any increase,” Atchison added. “We want borrowers to take the benefit of any decrease in those rates as a windfall rather than a decision as to whether they continue or go insolvent.”
A key factor here is that Alceon can pass on costs, but it only does this to borrowers who can legitimately take on borrowings, develop a project and repay capital.
