Property funds set themselves apart

Summary: Opportunities for investors to lend capital to unlisted commercial property funds and receive high returns are abundant. Technically a form of shadow banking, investors are filling a lending gap left by the major banks.

Key take-out: Interested need to do their own due diligence, on the primary lender, the project, and the terms of the transaction. 

Achieving double-digit returns from commercial property funds sounds like a scary proposition to those with fresh memories, but the risk is now a little different to 10 years ago. 

Non-bank commercial property lenders are turning heads with their opportunities for sophisticated investors. Commercial property fund yields aren't as high as they used to be – returns exceeding 15 per cent were the norm in the few years leading up to 2007 – but they are still high compared to bank interest rates. Yields of more than 7 per cent are quite common.

In many cases, these opportunities are fully subscribed within days of launching. Others within the hour. One of the commercial property funds Eureka Report has been tracking recently launched a multimillion-dollar investment targeting a 10.5 per cent return per annum: the fund was fully invested within 15 minutes.

Unlike pooled mortgage schemes, investors lending money to these types of commercial property funds know exactly what asset they are backing, and its profile. With some parts of the sector still reeling from the fallout of the global financial crisis, ‘opening the books' has become a proven way to build trust with investors and borrowers alike.  

At the same time, the Australian Prudential Regulation Authority is tightening the taps on Australia's Big Four banks, which are having to re-weight their lending portfolios and reduce commercial property exposures. This is playing into the hands of many non-bank financiers, including peer-to-peer lenders, which Eureka Report explored last week.

A different scheme

Pallas Capital and Balmain Private are non-bank commercial property lenders that would prefer if their names weren't mentioned in the same breath as pooled mortgage schemes.

Pallas Capital says its investors are putting an average amount of $250,000 towards an individual property from a minimum allowable investment of $100,000. Asset values are in the $2-15 million range, loans typically range between 6-12 months, and investors are earning net returns of 9-12 per cent per annum.

Balmain Private isn't too different. It's loaning out money for a little longer on average, targeting slightly lower returns right now, but allowing for smaller minimum investments.

Like many of their peers, they only take sophisticated investors and deal with credentialed borrowers. Their borrowers and investors are largely cut from the same cloth and most comfortable with blue-chip investments in major capital cities – places they know well.  

Pooled mortgage schemes hold several investments with typically longer maturity dates, but they can also let investors withdraw within much shorter periods, which created an asset/liability mismatch during the GFC. Investors came for their money, funds couldn't facilitate withdrawals and, at the extreme end, they were forced to freeze.

“Investors have control over the loan term, location, asset class and loan size. They have control over their money. We found coming out of 2008-09, this was the only way a lot of investors, coming out of very opaque funds, were going to part with their money,” says Pallas Capital director Dan Gallen.

“Each loan is discrete and completely segregated from the other in an individual unit trust structure – it's not a pooled fund.”

A case study

Lowly leveraged loans (at loan-to-valuation ratios of 50-60 per cent) for well-located development sites present the best opportunities for these firms. Most of their deals are first mortgages.  

Pallas Capital uses the example of a 6-12-month bridging loan for a developer that needs a little more time to sell down apartments so they can drip-feed them into the market or move onto another project.

“It's a fix for the developers to sell the property or refinance the property loan and make their way back into the bank sector,” says Pallas Capital partner Craig Bannister.

“If we lend the money on a short-term basis at around 12-13 per cent, we could then potentially offer our investors between 9-10 per cent. The spread is Pallas Capital doing due diligence on the asset and the borrower, and managing the loan throughout its duration. That's how we get paid. The investor sees the net return paid monthly into their bank account.”

Skin in the game

Despite the neighbourly nature of their investors and borrowers, these financiers aren't actively matching borrowers to investors – a common practice for non-bank lenders pre-GFC, which didn't foot any funds themselves.

Balmain Private debunks the likelihood of a GFC-type event happening in its part of the sector based on participations usually only offered after loans have been settled by the fund first.

“We appoint independent valuers and conduct due diligence, and if that ticks the boxes then it goes to the investment credit committee,” explains Balmain Private's head of sales, Tom Sherston.

“There are four members on the committee who must be unanimous. If they decide to proceed, we put skin in the game instead of waiting for lenders. All loans are fully funded by Balmain in the first instance, and then investors are offered the opportunity to purchase part or all the loan. From there each loan is held in an individual sub-trust and held by the custodian.”

Risks to the system

After combing through product disclosure statements, the value of an individual property on a non-bank lender's books would need to fall between 30-50 per cent on average before investor funds are compromised. That's happened before in some regional markets, but never within the boundaries of financiers operating in Australia's major capital cities.

Back in 2007, when the average term deposit rate was above 6 per cent, pooled mortgage schemes were paying yields north of 15 per cent. Now, term deposits are paying around 2 per cent and it's common for commercial property funds to offer returns above 6 per cent. Spreads could be indicative of risk. Eureka Report explored other risks in Property investors line up for high returns a few months back. 

The Reserve Bank knows on a large enough scale non-bank lending “could damage financial system resilience” because of scant regulatory oversight. However, based on data from five different sources, the RBA inferred last week that non-bank lenders make up only 7 per cent of the Australian financial system – about half that of 2007.

Singling out non-bank lending for property development isn't easy though, and there's limited data on this particular area.

“Liaison suggests that this type of lending has increased relatively strongly over the past year or so, but has not fully offset the pullback by large banks,” added the RBA in its quarterly Financial Stability Review.

When banks provide senior debt to these deals, essentially working with the non-bank lender, there could be extra cushioning because then APRA's bank regulation enters the fold. However, the RBA notes “some growth” in the provision of senior debt by non-bank lenders.

Proposed Government legislation for non-banks to register under the Financial Sector (Collection of Data) Act will make it easier for APRA to monitor shadow bank activity.

Overall, it's an area that financial regulators are closely watching. Shadow banking isn't necessarily shady, but everyone, especially the investor, will benefit if more light is cast on the area.