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The refinancing cliff

BY   |  WEDNESDAY, 14 FEB 2024    9:48AM

We call it the commercial real estate loan refinancing cliff, offering a once-in-a-decade investing opportunity for real estate credit.

Soaring interest rates have hit office and retail landlords hard, prompting a wave of write-downs across the commercial property sector, with Dexus, Mirvac and Vicinity Centres all booking portfolio losses in their recent annual financial results and with further devaluations likely. Indeed, values have dropped so substantially because of the rising cost of capital, that from an interest cover perspective, many borrowers will find it difficult to get their loans renewed upon maturity. This is about to create a massive refinancing gap that the major banks are unlikely to accommodate at the same leverage levels and borrowers will be forced to find other means to achieve a refinancing of that existing asset albeit with a much lower interest cover ratio.

That will mean the pricing for alternative private lenders on these refinancings is likely to be very attractive, with the RBA Cash Rate having increased 13 times over the past 18 months and overall pricing for non-bank loans increased from the low-to-mid single digits to the low double digits.

The Australian private credit market contains a variety of different loan structures and instruments that provide bespoke solutions to accommodate many different risk and return objectives for institutional investors.

Obviously, the higher the risk, the higher the premium received for that risk.

This can range from investment grade to non-investment grade debt, non-leveraged to leveraged debt, and senior secured debt to subordinated or mezzanine debt (which earns a higher coupon for sitting behind senior debt). In terms of maturities, a variety of different tenors are available, but most are within five years. There is also a small but growing proportion of opportunities beyond five years, particularly in the infrastructure sector.

Australia's private financing structures are bank-like and low-risk, which, when combined with premium pricing and below-trend currency rates, makes us a comparatively appealing investment destination in comparison to many other developed nations. We've also seen international credit investors pivot away from China in recent years, and with few developed market alternatives to Japan in APAC, the relative returns on offer in Australian real estate private credit are appealing to Sovereign Wealth Funds, global Pension Funds, and insurance company investors.  Portfolio diversification and rising interest rates are also fuelling growth in offshore institutional investors' real estate private credit investment in Australia - it has become much more attractive. Our relative economic and political stability, as well as our regulatory systems - including insolvency laws - all entice inbound investment.

The number of senior secured private debt managers is small but expanding. Lower competition provides for more appealing relative value, as seen by typically greater spreads when compared to similarly rated term loans. Australian real estate private debt typically has a floating rate and therefore provides a level of inflation protection, while the senior position in the capital structure provides defensive characteristics in the current market environment.

It is also common for Australian transactions to have more conservative initial leverage and maintenance covenants that are assessed on a regular basis throughout the loan's term.

At Wingate, we currently see significant opportunities in residential real estate private credit, especially construction lending in the major capital cities, consistent with the macro-thematics of structural under-supply and higher than-trend net migration levels. There is a strong demand to develop built-form medium and high-rise apartments. This is because there is still huge pent-up demand for residential property. The average capital city vacancy rate is sitting at approximately 1%, and according to both Housing Australia and the National Housing Finance and Investment Corporation (NHFIC), there will be a shortfall of over 100,000 properties over the next five years. Developers and financiers want to build, but approvals and high costs can make this challenging. With the right mix of due diligence and quality developers, we are able to make good decisions and achieve the right risk-adjusted returns.

Hotel construction lending in the major capital cities, with returning inbound travel (both offshore and interstate), also provides an ongoing investment opportunity. The stock of existing hotels in the nation's CBDs is largely dated, and the level of amenities in them is limited and poor, yet the returns hoteliers are currently making are extraordinary.

We see a great opportunity for fringe CBD hotel development - Surry Hills in Sydney is a good case in point.

We also see significant potential for attractively priced stretch senior loans (including junior tranches) to meet the $10bn bank refinancing gap at maturity facing borrowers across office, retail and industrial sectors. Wingate's approach to optimising results during periods of dislocation is to stay true to our thematic convictions, focus on strong sponsors and quality real estate, invest at an attractive basis or attachment point, and emphasise conservative capital structures, focusing on duration and durability.

Rather than attempting to time the market, we believe that this strategy, along with measured capital deployment over the next two years, offers the best odds of delivering good risk-adjusted returns. We believe the disproportionate risk-reward in real estate private credit will likely last several years. Some of the best real estate vintages have occurred following a market disruption. I believe we are in the midst of a very appealing one.