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In an uncertain inflationary environment, is private credit to be preferred? -Andrew Schwartz

For most of the past decade, as global interest rates approached zero and inflation was described as benign, investors relentlessly chased yield. And as savvy investors know, one of the best places to find a decent return has been the Australian property sector.

This investor demand has been reflected in the steady compression of yields over the past decade, from mid-to-high across all real estate sectors in the early 2010s to mid-to-low today.

This is still healthy, with yield spreads over 10-year bonds still maintaining a positive spread in favor of property yields. There are also parts of the market where yields have recently risen, such as the retail sector, which is now beginning to recover as some of the most significant impacts of the COVID-19 pandemic abate.

But as we find ourselves at the start of a cycle of rising interest rates and inflation expectations push to 5% due to a number of demand and supply factors that do not show no signs of easing anytime soon, smarter real estate investors are now looking beyond just ‘a search for yield’.

Simply put, at this point in the cycle, it’s not enough to earn an income. If your fund is offering you less than 3-5%, you may be fooling yourself into thinking you are doing well when you will be falling in real terms. With the steep steepening of the yield curve, you can now find bank deposits offering 3.5% if you are willing to commit to a fixed term of three years. Compared to deposit rates just a few weeks ago, this was a very large and potentially attractive increase for some. However, if inflation forecasts to stay above 5% turn out to be correct, these seemingly attractive interest rates will actually send you back.

What investors need now is inflation shelter – and that means returns or total returns of more than 5% as protection against rising prices in the economy. Property – both equity and especially debt – can offer these returns and protection if you know where and what to look for.

We believe that certain sectors of the real estate market will resist rising inflation, such as residential assets (including rental construction) and assets that depend on footfall, such as retail, accommodation and l hotel industry, as expenses rise in line with wage increases. These are good options for equity investors looking for an inflation hedge.

However, the real winner in this environment is likely to be private credit – an area in which Qualitas has deep experience, significant exposure and a wealth of opportunity.

It is well known that debt is seen as a safe haven in uncertain environments, especially senior debt, which is why we have seen credit spreads widening in recent months. But it’s a particularly good time for private debt funds, which are able to reprice both base rates and risk margins to the benefit of the funds and their investors.

In terms of base rates, a significant portion of Qualitas’ debt portfolio is based on floating rates which will increase based on official rates. So, contrary to the cliché that higher rates are bad for real estate, they can significantly increase returns for our funds and investors.

The best news is that these rate increases are implemented immediately, whereas a landlord can usually only raise rents once a year. This means the lender is entitled to a greater share of a property’s cash flow until rent increases compensate the landlord. In these circumstances, it is probably better to be the lender.

Currently, variable loans make up a significant portion of our unlisted funds, providing investors with protection against the effects of rising interest rates.

Risk premiums, represented as spreads over base rates, are already increasing in line with market uncertainty. As the flow of funds between the RBA and the banks is withdrawn, the cost of capital rises and liquidity exits the system.

As a result, those with cash demand higher risk premia to compensate (see chart). And among those with liquidity in today’s market are alternative non-bank lenders.

5-year bond spreads to be traded over RBA cash rate1

Source: Bloomberg, May 2022

The commercial real estate debt (CRE) market has doubled in size over the past 10 years and is expected to continue to grow strongly, helped by inflation. If real estate swells due to inflation, debt levels will swell with it.

Alternative lenders like Qualitas have captured a growing share of the banking market and now account for around 10% of all CRE loans, with forecasts that this proportion will double in the coming years.

In fact, we could see an even faster withdrawal from the market by banks which, in times of uncertainty, tend not to increase their portfolios. As alternative lenders step in to meet market demand, they will be able to demand higher risk premiums, which again translates into higher returns for lenders and their investors – returns that are expected to outpace inflation.

The other benefit of debt, of course, is that if economic conditions deteriorate markedly, the additional security provided by debt (versus direct equity) is where you want to be. Experienced managers will keep a close eye on loan-to-value ratios throughout this period of economic uncertainty.

For the first time in a decade, we are faced with both inflation and rising interest rates. Fortunately, and somewhat surprisingly after the challenges of COVID-19, we are doing this against the backdrop of strong confidence in the economy, businesses and the real estate sector.

But investors will need to adopt a different strategy in their decade-long quest for yield. In the real estate sector, there are opportunities to shelter from, and even benefit from, inflation. Investors will just have to look a little harder – and private credit is a great place to start.

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