Investors are taking a fresh look at private credit and it’s easy to see the appeal

The benefits of buying an investment property have shifted quickly as anti-investor taxes take hold but no such issues exist in private credit funds. Here’s what you need to know.

The private property investment narrative ‘has shifted materially’.

The narrative surrounding owning an investment property, particularly an apartment, has shifted materially this year even in the absence of plunging prices.

While anti-investor taxes from the Victorian government are a significant element to the story, it is only one part.

A confluence of rising construction costs, development red tape and higher interest rates are significantly impeding the delivery of new housing supply, which is responsible for an ongoing surge in property and rental prices. This has inspired the RBA to warn home buyers that conditions aren’t likely to improve “anytime soon”.

Despite all these challenges, there’s another issue: the numbers don’t stack up.

A friend who had recently celebrated the full repayment of his mortgage asked me whether it made sense to borrow against his house again to buy an apartment as an investment (“you know…to help the kids”).

Looking at the arithmetic of apartment ownership on its own, I could easily estimate his return, establish how long it would take to pay the mortgage off, and with a few assumptions, tell him the year he’d start making a gross profit.

But what if I compared the strategy to an investment in the emerging private credit asset class?

Would comparing the well-trodden path of investing in an apartment to investing in a high-quality private credit fund - one with a long track record of earning nine or ten per cent per annum - reveal anything else worth discussing? I fear the outlook for apartment investing might be even bleaker.

Here’s an example

Let’s assume my friend wants to outlay $1.05m on a brand-new two-bedder on Sydney’s upper north shore.

It’s a shop-top apartment above a Coles supermarket on a site owned by the heir of one of the Westfield founders. Stamp duty will be just over $42,000 so the total acquisition costs are just under $1.1m.

We’ll compare investing $1.1m in the apartment and the same amount in a high-quality private credit fund, which has a near seven-year track record of delivering an almost 9.6 per cent per annum compounded return.

The fund has also generated monthly income and no negative months since inception almost seven years ago, even through Covid.

One downside of this fund is that you can’t see, touch, or move into it.

One advantage, however, is that you can redeem a little of it at any time if you need some money.

In contrast, you can’t sell a bedroom off the apartment if you need a little cash.

Each investment is geared 100 per cent (this a hypothetical exercise, clearly) and funded with a loan against the hitherto mortgage-free home, at 6.98 per cent per year. The apartment is rented 365 days per year at $950 per week and is never vacant (unrealistic).

The apartment will produce a much lower gross yield of 4.52 per cent versus the assumed 9.60 per cent return from the private credit fund.

Despite the popularity of real estate investing (which is in no small part due to the amount of leverage banks will extend for that asset class), there are much better gross yields available elsewhere.

The apartment’s gross income of $49,400 doesn’t come anywhere near meeting the interest expense on the loan of $75,260.50, which means the investor is losing money. The result reveals ‘negative gearing’ to be little more than ‘losing money to get a little of the losses back on tax’.

Because the private credit fund offers a much higher yield than the interest rate on the loan and, in this example, pays interest distributions monthly, the arrangement produces monthly free cash flow.

It represents a way to produce additional positive income from leveraging the equity of one’s own home. Of course, there are risks with leveraging your home, which an adviser can help you fully understand.

The gross income of the apartment however doesn’t include maintenance costs such as these:

• Real estate management fees ($3,500);

• Strata levies in NSW of approximately 0.8 per cent of the value of the property ($8,400);

• NSW Land Tax (we have assumed a land valuation of $300,000 requiring a payment to Revenue NSW of $975);

• Landlord insurance, which in NSW averages $400 per annum according to Australia’s largest comparison platform, Canstar;

• Council rates ($1,042);

• Water supply, which the landlord is responsible for ($900).

Extra costs

These additional costs don’t represent all the possible expenses a landlord will incur. I haven’t, for example, included anything for preparing a depreciation schedule, accounting fees, or property repairs and maintenance, which will inevitably arise.

And as I noted earlier, I haven’t weighed the rental income for the possibility of the apartment being untenanted.

After including the additional outgoings, the net income from owning the property in the first year has fallen to $34,225, producing a net yield of 3.13 per cent. That is substantially less than the $104,862 produced by the private credit fund.

Outlaying $1.05m on a brand-new two-bedder on Sydney’s upper north shore might not be as lucrative as you think.

The private credit fund’s gross and net yields are equal at 9.6 per cent because there aren’t any maintenance expenses.

Next, we have to subtract the interest on the loan from the net income received from both investments. After subtracting interest on the loan of $75,260.50 the private credit fund investment produces an annual pre-tax return $29,601.74. This represents additional positive income from leveraging the equity in the investor’s home.

The apartment investment however, produces a loss of $41,035, which the investor must pay for and fund throughout the year as interest payments and maintenance-related bills come due.

What about interest rates?

Another consideration for both investors is the impact of an increase in interest rates.

The property investor will have a larger loss as the cost of servicing the loan will rise.

Interest rate increases may also have a negative impact on demand for apartments and therefore their market value.

For the private credit investor, the impact is also nuanced.

In the first instance, the cost of servicing the loan would rise as the bank passes through the official rate rise to borrowers. However, there is also a potential positive outcome from an increase in official interest rates for the private credit investor. If the investor has chosen a private credit fund with a book of loans predominantly on floating rate terms, the returns from the private credit fund could also rise when official interest rates do so.

The difference in the net pre-tax yield of two investments in the first year is 6.47 per cent at a pre-tax level. It doesn’t seem much, but in dollar terms, the private credit investor receives a pre-tax positive return of circa $29,600, which is also $70,637.24 superior to the property investor return.

That circa $70,000 inferior cash return from the property needs to be viewed with the possibility of a capital gain from the property. Given the losses, often referred to a ‘carrying costs’ apartment investors make, in the early years, while owning the property, the capital gain is a necessary as well as hoped-for offset.

To claw back the 6.47 per cent difference after the first year, the property needs a capital gain of $70,637.24 on its original $1,050,000 market value. If the stamp duty is also recouped, the gain is $112,952.24, equating to a 10.75 per cent required capital gain. In the last decade, the only time national apartment prices rose, in aggregate, by 10 per cent or more on an annualised basis was during the Covid-19 pandemic. And as can be seen, they have more frequently fallen in value than risen by 10 per cent or more.

Final consideration

The final element to consider is liquidity.

The investor in the private credit fund can access any portion of their cash by notifying the administrator of the fund. It’s common that investors can access their cash within one-month. If the private credit fund investor needs $50,000 or $250,000 from their original $1.09 million investment, the cash may be just a call and a redemption form away. The property investor, however, cannot sell a bedroom or a kitchen to access a portion of the funds. Liquidity is a big advantage of the private credit investment on top of those already highlighted.

If my friend, who wants to re-leverage his home to make an investment, were to compare these two hypothetical options, I wonder which one he would pick. Hopefully, he reads this column.

Disclosure: Montgomery Investment Management distributes a private equity fund in the local market andRoger Montgomery is founder and chief investment officer at Montgomery Investment Management.