Kathryn House
Private credit. It's been making media headlines this year as one of the market's hottest asset classes. But it's also been generating ongoing debate with both supporters and critics. So what is private credit? Why has it become such a force in the Australian real estate sector? What's been sparking the public debate about private credit? And what should investors be watching out for?
Drew Bowie
Having people who fundamentally understand the underlying assets is critical. And who are they responsible. Creating enduring value, long term thinking will protect investor capital.
Kathryn House
That's Drew Bowie, the head of real estate credit for MA Financial Group, a top 300 Australian listed company with in excess of 750 staff involved in investing, lending and advice, with $12 billion in assets under management.
Andrew McCasker
The banks generally want to provide a solution for their client. The solution is not, we can't help you, you need to go away. And that proactive engagement from the banks with private credit groups like Drew's allows them to provide that solution to the client. Well, we can support you up to this level, but here's two or three other groups that will help you get from A to B and allow you to still participate in the market.
Kathryn House
And that's Andrew MaCasker, the managing director of CBRE's Pacific Debt & Structured Finance business. I hope you enjoy our conversation. So, Drew, thanks for joining me today in CBRE's new podcast studio.
Drew Bowie
What a fabulous space. Good morning, Kathryn.
Kathryn House
And Andrew, good to have you on the show as always.
Andrew McCasker
Always good to be asked. Kathryn, good to see you again.
Kathryn House
Now I have to say this is an exciting one for me because it's the first time we've had all of our guests in the podcast studio to record. To kick us off, Drew, CBRE recently produced a private credit research report, and I must admit, it was the first time I'd really focused in on this sector in any great detail. The numbers were pretty extraordinary. CBRE is forecasting that the amount of private credit funding Australian real estate could grow by 80% to $90 billion in the next five years. So, I really wanted to get under the hood and find out what is private credit? Take us back to basics.
Drew Bowie
Well, it's actually been around for a long, long time, Kathryn. So I've been in real estate private credit for in excess of 35 years and we've seen extraordinary growth. So the numbers and the forecasts, you know, are correct. It is an exciting space that really fundamentally is giving access to wholesale, retail and in these institutional markets to a place that has typically been the domain of the banking system in Australia. Now globally private credit has been a large sector for many decades. The US accounts for about 60% of the market in private credit. UK/Europe 55%. In Australia it's more in its infancy, 10, 15%. So really, fundamentally the assets, the type of structuring is the same as the banking sector.
Kathryn House
Yes. So, Andrew, give us your thoughts. CBRE's report tipped that residential development lending was a key growth driver, but that commercial lending's also coming into focus.
Andrew McCasker
Yeah, definitely. Look, I think just picking up on Drew's point about the private credit space, I think if we look back 10 years ago, there was definitely in Australia a stigma around what private credit was. And as private credit has evolved and become certainly institutionalised and much more professional, that stigma has dropped away and has allowed groups that would traditionally solely participate with domestic banks start to use the advantage that we see in private credit, which is slightly higher leverage, slightly lower pre sales and that's been allowing them to get into the market a lot quicker and deliver the product more quickly than what they would through traditional bank funding. So that residential build to sell space has certainly built the basis of private credit. And as private credit's evolved and the returns they're looking for change based on the type of capital they're getting, then they're starting to move into that commercial office space, industrial space, and filling the gaps that we're starting to see in the domestic banking space.
Kathryn House
So are you seeing similar trends globally, Drew?
Drew Bowie
Yeah, we are certainly. Globally it is a much more mature market and so the secondaries market is a very active space there compared to in the Australian context. But certainly we think about the global context, there's a lot of money pushing from the Americas, from Europe into Asia and if you think about the APAC region, Australia holds itself up very well from a risk adjusted return basis, from a legal construct basis, from a mature market basis, predictability and defensive. So I think we can continue to see that interest in Australian private credit.
Andrew McCasker
And I think too just to add to that, I think the transparency of our legal system. So the investors are trusting the manager that they have on the ground like MA, but also understanding that if there is an issue or a problem, the legal system supports both sides so it can come to a negotiation and a conclusion and they can be confident about what that's going to look like in the process they need to follow.
Kathryn House
Yes. So we've got the next RBA rate decision coming August 12th. Everyone was a little bit back footed I think last month, expecting a cut that didn't come. What's your expectation for rates and will a rate cut further fuel this private credit market?
Drew Bowie
The best thing about being in private credit and being senior secured is you don't have to worry too much about interest rates because fundamentally it's going to affect equity a lot quicker than what it will affect credit. So it's a bit of, who knows, you know, I'm no expert in that space but what we do recognise is falling rates is good for property. CBRE would absolutely be able to identify with that, I'm sure. But what we have seen with the falling of the rates, a lot more confidence coming back into the market. We're seeing deals becoming more viable. So we are seeing an increase in activity for a whole range of reasons. But one of those reasons is around monetary policy.
Andrew McCasker
Falling interest rates are great for the property market for everything you've just said. But if you put your other hat on where you're managing your investor's relationship, obviously they're looking to drive certain returns. Does that make it harder for you?
Drew Bowie
Well, the margin to a risk free rate doesn't change substantially. In fact if the cash rate drops dramatically then the margin typically is increased because it's not 100% of that is usually passed on to borrowers. That said, the gross return will favour the equity markets. I think we will see a shift of some money back into the equity markets. That's a good thing when you think about the equity markets themselves. We knew that there was going to be a point in time where it was not the right time to buy a commercial office building. And so you shift into private credit, they're going to be very complementary to each other. I think having a diversified business makes a big difference for this sector actually being able to leverage when's a good time to be in equity? When you need to pull back a little bit in credit, that's a healthy thing. But if you think about last year, probably was the hardest deployment year I've ever seen when interest rates are still pretty high. So and yet now we're seeing greater deployment when interest rates are lower and we're still seeing a continuation of investor interest in the sector.
Kathryn House
So, if we shift back to the residential market, there's obviously been a huge focus on Australia's housing undersupply. CBRE's recent credit report highlighted that private credit already provides funding for over a quarter of all residential construction in Australia. And it's clearly an area of focus for MA Financial Group. You announced a $1 billion-plus real estate credit vehicle with Pincus Warburg to originate and manage credit facilities for high quality real estate developers and projects. So what role do you see private credit playing in addressing that housing imbalance?
Drew Bowie
I think it will be substantial. Traditionally, the private credit real estate credit market has been very attractive to residential developers. More so because it's not an interest servicing, passive type of investment product. And so it has lent itself towards residential development. It will continue to do so. You know, we've seen substantial growth in the skill base within private credit into that sector as well. It's been a bit slow on the uptake. You know, I think the credit market has grown quicker than the skills base operating within this sector, which has been challenging, but it is skilling up. But I think the understanding that private credit markets, the level of support that we can offer developers knowing that the development business is very, very hard, you know, you have to commit your capital for very long periods of time. There's a lot of risk associated with that capital and the ability to roll into the next project is very difficult. And that means they've got to spread their equity across multiple projects. And that's where the higher leverage that the credit market has been able to offer has been very attractive. Now when I say higher leverage, it's only high relative to what the banks are currently doing. It's not as though the private credit markets have created a new product. The sort of leverage that the private credit markets are operating in now is the same as was what the banks were operating to under a previous regime. And so I think that will continue to play out. The private credit market is essential to if we can get anywhere close to solving the supply crisis.
Andrew McCasker
Yes, I think a couple of points there, Drew, and I think you're underselling the private credit space a little bit too because our head of research, Sameer Chopra, is very passionate on the Australian residential market and the numbers that he states about what we need to deliver into the market to just meet the current demand curve, we're well and truly under that. And without the engagement and the use of the private credit space, we'd be so far behind those goals and key numbers we need to deliver on, we'll never catch up. And I think the private credit market that's supporting the quality developers delivering products that are well accepted into the market has enabled that residential market to continue to push along. And yes, we are starting to see the banks move leverage up a bit and move pre-sales down. And I think that's driven both by competition but also by their need to be able to attract those quality sponsors into that residential development space.
Drew Bowie
Yeah, indeed. Many of our sponsors also borrow from the major banks, you know, so it's not as though we're just supporting an industry that the banks don't want. It's filling the gap to what they are unable to support, typically through pre-sales, et cetera. But if we think about pre-sales in particular, and this is often debated around governments, et cetera, around taxes and the like, if you do not have investors buying off the plan, then you don't end up with any stock whatsoever. And so reducing the level of pre-sales is really important to getting actually boots on the ground and projects underway. If you don't have an attractive product for investors, they're not going to come, in which case you don't have the pre-sales, you don't get any stock whatsoever.
Kathryn House
So are there partnership opportunities for banks and private credit? Are you seeing that at all?
Andrew McCasker
100%. We have the fortune of working very closely with domestic and offshore banks and funds and working very closely in the private credit space. And we're regularly talking about the complementary nature of private credit, working with the banks or filling that gap or void that the domestic banks don't want to push into. Having private credit, being able to deliver product into that space is very important. So we see the private credit working hand in hand with the domestic banks, certainly in the commercial lending space and more recently in that residential space, allowing a more blended cost of funds, but also a more structured facility for them to deliver more complicated construction programs. Just to illustrate how it works is that we've got a commercial office building which has some vacancy. It needs to be repositioned, there needs to be some tenant incentive payments and there needs to be some refurbs done to it. The domestic bank that's in there that's supporting the borrower at the moment can only go up to a certain limit. So we've brought in a private credit provider that has provided the facility for tenant incentives and for repositioning the asset. That'll give the borrower about 18 months to execute on their leasing strategy and reposition the asset. And the plan will be new tenants will come in, the valuation of the building will go up, the revenue will get to a point where it's able to meet its interest cover, and then a refinance will happen and the asset will be repositioned for another three to five years back into the domestic banking space.
Kathryn House
And are you involved in any interesting examples?
Drew Bowie
We have a live partnership with SMBC, but we're talking to the major banks here in Australia all the time. We're supporting their own clients in similar situations where it just doesn't fit their narrow requirements at the moment. And so we're supporting their clients. The bank is happy for that, knowing that we're not going to try and hoard that client or steal from them or, you know, do anything like that.
Andrew McCasker
Or be predatory.
Drew Bowie
Or be predatory. In fact, that's a very good point. Right. Because as I said, the power lies with the lender. And so it is so critically important to have a lender who doesn't abuse that and take advantage of any default that could happen through the changing of time and circumstances. So I think that the major banks like dealing with groups like MA Financial, where we are fully transparent. They know our board structures, our governance structures, our compliance processes, and they're very alike in terms of that. So we'll continue to see tremendous growth in partnerships with not just the majors, but the banking sector generally throughout Australia.
Andrew McCasker
And I think too, Drew, and you mentioned it before, is that the banks genuinely want to provide a solution for their client. The solution is not, we can't help you. You need to go away. And that proactive engagement from the banks with private credit and groups like Drew's allows them to provide that solution to the client. Well, we can support you up to this level, but here's two or three other groups that will help you get from A to B and allow you to still participate in the market.
Kathryn House
We've talked a lot about the positives, but there has been rising regulatory interest in the private credit sector because there's been this proliferation of new funds and a raft of new players coming into the market. So, Drew, is more regulatory focus a good thing?
Drew Bowie
Well, yes, it is. I think, you know, what we're probably talking about is, is the market transparent enough? You know, if you think about the regulator, ASIC, they're probably thinking, do they know everything that they need to know to ensure that the consumer, the investor, particularly in the retail markets, are protected? And the level of transparency does differ from manager to manager. For instance, within our real estate credit funds, we report every month and we report on deals that are in our watch list. Now, our view there is, if you don't have a watch list, you're not watching, or if you're not reporting on your watch list, you don't want to tell your investors. And neither of those is acceptable. So we've been reporting on that since day one. Being on a watch list does not necessarily mean you're going to lose money. It's just telling investors, informing them how your manager is spending their time. So we think a greater level of transparency is a good thing. It can only ever be a good thing for a market. But I think it goes beyond just regulation in terms of what's a good manager or what's maybe not so good. It goes to the skill set of that manager. Do they have the ability to work out situations? Do they have the ability to value correctly? Do they have a passion for the underlying asset? So particularly in real estate credit, you know, I sort of see this as a bottom-up approach. You know, you really understanding the real estate. It's not a job at a desk. You've got to be out there on sites, touching, feeling, smelling, hearing, really knowing what good design is, what enduring value is in real estate. Because the markets can shift tomorrow. If you don't really understand the underlying real estate then you're on the back foot. It's not something that is a desk bound, computer type assessment. It's very much bricks and mortar. Understanding the real estate.
Kathryn House
So what are your thoughts on the regulatory front, Andrew?
Andrew McCasker
Look, I think it's definitely something that's needed and transparency is absolute. I think the other part which is missing in that private credit space is data, like truly understanding the size of the market and the type of transactions that are being done. And ASIC can easily do that for regulated banks because the banks need to report each week, effectively, on what their commercial real estate exposure is. I think the biggest concern I have, putting aside the retail money because retail investors should have that high level of support and scrutiny around investors and managers. I think as long as ASIC don't come in and decide to overreach and try to take on the role of the compliance and the management of what the manager does, then I don't see a problem in ASIC certainly being involved. And as I said, that data collection I think would be very important.
Drew Bowie
I don't think that is really a problem in terms of an overreach. You know, if they want information then the better managers already have that information. Right. So it's just a transfer of that data. If you have to go and do the analysis yourself because they're sick of asking for it, you're behind the eight ball.
Andrew McCasker
Yeah, I think the overreach I'm thinking of is if they turn around and start saying, well your maximum LVR in residential construction can't be higher than 75% for example, or you can't lend more than X dollars to a certain counterparty. I think those type of decisions and policy makings need to sit with the managers and the quality managers. And similar to the superannuation funds we're seeing at the moment, perhaps if there's a manager that's underperforming, maybe ASIC then have the right to be able to say, well look, you either find someone to sell yourself to or hand all your money back.
Kathryn House
Well, it's an interesting point because I was going to ask as my next question, is there scope for consolidation in the private credit sector? CBRE's report highlighted that the top 10 providers currently have an 85% market share. What are your thoughts on the consolidation front?
Drew Bowie
Well, I think it will continue to evolve. There has been some consolidation or at least a lot of M&A activity. It hasn't been so much consolidation of local players. But there's been a lot of M&A activity of offshore investors coming into the market. But I think it probably does continue to evolve. We sort of think about, we're quite an active business in that regard. You know, we bought mortgage aggregator, the second largest in the country, Finsure, which gives US data on 1 in 12 home loans in the country. So when you consolidate like that and gain data, it's tremendously powerful. I think it will evolve. But fundamentally it comes down to what are you buying? If you're buying just the people, then sometimes there's a better way of going about it.
Kathryn House
So Drew, in MA's recent investment outlook report, something that stood out to me was the conversation around avoiding the losers, not picking the winners. What does that philosophy mean?
Drew Bowie
Well, when you think about credit, you're not buying upside. Okay, so really you're assessing the downside risk. Our returns are very transparent. It's an interest rate or a line fee or margin of some sort, but not profit sharing. When you think about certainly senior secured credit, you know, some managers have pushed into equity spaces as well. But when you're in credit, you're thinking about what is my downside risk. That's what I'm focused on. I don't need upside. So yes, we think about where forward look markets and try and think of what is the downside risk to that. And we hope there's upside for our borrowers because that's what they're going in it for and we want them to be incredibly successful. But we're not relying upon any of that value accretion for our credit assessment
Kathryn House
Right. So, when we were doing a planning call before the podcast today, we were talking about the adviser network and how that plays in the private credit space. Can you tell me a little bit about how you view the adviser network?
Drew Bowie
With increasing importance. We spoke about how the strong growth in this sector, and this sector evolves very quickly and lenders' appetite changes very quickly as well. So if I'm a borrower, if I'm a developer, I've got relationships out there, sure, but the advisers, certainly the better advisers will have deep relationships and know exactly who's doing what and be able to extract those best terms. And the best terms are not always what is the cheapest rate. The best terms can be who actually understands your product, who's going to be there to support you when Covid happens. Things like this, you know, we've seen a whole range of different behaviours when times get tough. And the legal process of what we do in private credit is very favourable to the lender, right. If something goes wrong, it's the lender that has the power. And so having a lender who does not abuse that power is there to be a compassionate, supportive, understanding lender off the back of very good foundational knowledge themselves is valuable to a borrower. So if you're a borrower, you don't know who to go to, you don't know how to interpret all the feedback that the lending market is giving you that's really challenging and mistakes or errors of judgment in that process can be exceptionally costly and can break businesses, I think. So understanding all that, I think the adviser network will become increasingly important and I think too.
Andrew McCasker
Just picking up on Drew's point about as the network continues to grow, we've seen the private credit space build out similar to the evolution of the industry in the US and the UK. Advisers in the US very heavily led and more so now in the UK and we're starting to see that in Australia as the market deepens with domestic banks, offshore banks, the fund and the private credit space, and then finding the groups like ourselves that have the market knowledge and the intellectual property across a number of those credit providers to make the process a little bit easier for the borrower is the path we're going down. And the point Drew made about pricing, 100%, like the number of transactions we do where our recommendation is not the cheapest one, but more around the relationship and the style of people they're dealing with in their private credit space versus well, this one's 50 basis points cheaper. 50 basis points cheaper becomes a lot more expensive when something goes a little bit off the rails, I can imagine.
Drew Bowie
Which ultimately will be the cheap one anyway, correct?
Andrew McCasker
Yeah, correct.
Drew Bowie
You are, you're just getting to the cheaper by a better route.
Andrew McCasker
That's right.
Kathryn House
So how important is it, Drew, for managers to have skin in the game? I was really surprised to read that something like 40% of private credit managers have no material co-investment.
Drew Bowie
Well, I think most listeners will think that, if other people have money on the line, then it's a more comfortable position to back. So I think it's very important. The essential thing is that the skin in the game is aligned. You know, some people say we're investing, but they might be ranking behind you, which might sound okay, but then you think about what their processes and procedures will be to protect their own interest. So skin in the game, we like it. We have a lot of staff co-investment in the things that we do. And you can't invest in everything. The businesses get bigger. Your money only goes so far. So I think it is important. One of the things that I suggest to investors is actually consider who is managing the manager, right. So look beyond just the individual people, the fund manager, and you think who are they responsible for? For instance, I'm responsible to CEOs and to a board, a senior management team. I've got plenty of bosses. Investment committees, external compliance committees, a whole range of different processes. And these are things, even though I run the team, these are factors that are imposed upon me. You know, we've got a board that are challenging all of our teams around our compliance, our processes, our thoughts on the market, whether our product is still market fit and appropriate in changing environments. All these things means that you're being watched, you know, and you're thinking longer term, you're making longer term decisions for the health of your investors and ultimately therefore your business as well. So it removes that short term thinking. So skin in the game, I like it. It's important. It's not the be all to end all, I would say, but the alignment can be measured in a whole range of different ways.
Kathryn House
So, are we seeing any changes in the way in which investors can access this asset class? In addition to unlisted fund structures, are we expecting to see more interest in listed market structures that provide access to diversified private credit portfolios?
Drew Bowie
Yes, we launched one a few months ago and that's been incredibly well received. Daily liquidity, or liquidity full stop, is really important. Many wholesale funds, including ones that I manage, and retail funds have monthly liquidity. But having daily liquidity through these list ed vehicles is really popular and of course unit pricing as well. So it will continue to evolve as the market gets bigger, continues to mature, you know. But retail investors, wholesale investors, have had access to this market for quite a while now. They understand it, particularly in first mortgage real estate. Most people, most investors understand what a mortgage is. They've had one, they've aspired to pay it back. They're trying to, you know, support their children obtaining one. And they probably think that, you know, if they borrowed 70% of their house value from Westpac, then Westpac's body doesn't have a problem, you know.
Kathryn House
Yes.
Drew Bowie
So they get the sector and so that's made it easy, a very accessible sector for the retail investor in particular.
Kathryn House
So what are you seeing, Andrew, in terms of an evolution? Any thoughts on what you're observing overseas as well?
Andrew McCasker
Certainly the listed funds make it easier for people to invest and not only understand the mortgage, but people understand the ASX. We'll also start to see funds like Drew and some of the other larger groups that have got listed stock to become part of the pool that superannuation funds will need to invest into. And that'll happen as the market continues to grow. The offshore investors, we're seeing every sovereign wealth fund with three initials looking to Australia to invest money. And that comes back to the really early statement that Drew made around our transparency, our legal system and the quality of the transactions that we have in the market attracting that capital into the Australian private credit space.
Kathryn House
So maybe if I was going to ask one last question of you both, what would be your advice to anyone looking to invest in private credit. Drew?
Drew Bowie
Who is managing the manager, what do you know about them? What information is available about them? Can we see remuneration policies? Can we see who the board is? Can we see who's making, ultimately, the decisions? What is their skill set in the underlying asset? That's really critical. You know, I think where, if I was to think about our world of real estate credit, where it goes wrong, 101 is the initial value due diligence was incorrect. You know, people think that going into a loan to value ratio, 70% is a very strong defensive position to be in. It is as long as your 70% was actually 70% and your starting position wasn't 80% because your valuation was wrong. So having people who fundamentally understand the underlying assets is critical and who are they responsible to. Creating enduring value, long term thinking will protect investor capital.
Kathryn House
What's your best piece of advice?
Andrew McCasker
So everything Drew said yes. And my other bit on that would be if you've got $500,000 and you're investing at the bank and you're getting 4% or you can give that $500,000 to private credit and they're saying, we'll give you 18%, the risk that you need to take to get from 4 to 18 is commensurate with the return. So you don't get 18% for free, you get 18% with a whole heap of risk.
Kathryn House
Yes.
Andrew McCasker
And then that all then flows back into who's the manager and who's managing the manager. So if they're a good manager that's got a process and policies and a good investment committee, then maybe 18%'s achievable. If you're just purely chasing the dollar value, you're probably going to end up not getting 18% back.
Kathryn House
Yes. Well, thank you so much for joining Talking Property, Drew. It's certainly given me a much deeper understanding of the private credit space.
Drew Bowie
Wonderful Kathryn, enjoyed it.
Kathryn House
And Andrew, always love having you on Talking Property. So you're going to have to come back again soon.
Andrew McCasker
I look forward to the invitation. Thanks Kathryn.
Kathryn House
To our listeners. Thanks for tuning in. And if you want to read CBRE's private credit research report, you can find a link in our episode notes. Also, make sure to subscribe to Talking Property so you don't miss our upcoming episodes. And if you get a chance, we'd love it if you could rate or review Talking Property to help others find us. Until next time.
