Investors beware as property credit risks rise while double-digit returns disappear

The returns are dropping and the risks are rising in popular ‘mortgage funds’.

Property markets are doing well but credit is another issue. Picture: Glenn Hampson

Record low interest rates and a strong recovery as the economy moves out of COVID 2020 have seen a lift in the Australian property market.

In turn exceptionally strong demand across residential, commercial and industrial property has kicked up growth in both the supply and demand of property credit.

Many retail investors — often using self-managed super funds — have searched property for yield, typically putting money into secured mortgage funds and related investments.

With record low official interest rates investors have been obsessed with achieving returns but those returns have diminished in recent months.

The result has led investors up the risk curve when considering where and how to invest.

For the first time in almost a decade, I have moved to decrease our property credit sub-asset class weighting by 25 per cent to 6 per cent.

The exposure was cut for two reasons.

First, it’s goodbye to double-digit returns — for seven of the last eight years, returns have been between 10 and 11 per cent. Earlier on they were even in excess of that, up around 12 per cent plus.

Forecast returns are now in the single digits below 8 per cent for high-quality exposure. This is now a story about balancing the return with the risk that you are taking.

Second, there are too many players in the market. At the same time as yields have fallen in a “lower for longer” interest rate marketplace, we have seen an explosion in firms participating in the property finance area. The fact that they exist means the demand from investors is there.

The concern when there is such a pick-up in those wanting to participate is you have to question the level of experience in this specialist area: track record in a market is vital.

While rising yields in bond markets have been the story of this calendar year so far after bond markets experienced their worst start to the year since 2013, the shorter end of the yield curve hasn’t been as affected. Nor have credit markets sold off.

From here when any investor is considering this sub asset class you need to consider some key criteria.

● Investment structure: is the investment in a pooled vehicle — therefore a collection of loans — or is the loan against a single asset or stapled (two or three loans together)?

● Loan security: when looking at an asset the loan is secured against, what is the loan to value ratio (LVR)? This is the amount of the loan, expressed as a percentage of the value of the property or asset. Look at when that value was established, ask whether it is representative. If there are multiple assets stapled, are these assets of a similar quality (beware the good asset stapled with less desirable assets).

● Track record: I believe the most important aspect in considering this asset class is the manager’s experience in workouts. Issues do arise and nothing goes to plan, especially with development loans. So what is the manager’s track record in stepping in and managing all kinds of negative issues? It does concern me when the new players in this market tell me “we have never had a default”.

Then there is mezzanine finance which, while it does provide a higher rate of return, is a form of debt I am avoiding at this stage of the cycle. Mezzanine finance sits between the less risky first mortgage or senior debt and the equity.

Yes, you can receive higher returns in property credit positions but remember to look at what you are investing in and with whom. Ask the questions about where we are in the cycle.

More importantly, the rule of ensuring your portfolio is diversified not just among asset classes but in this case within asset classes is vital. Finally, ensure your return matches the risk you are taking, as in “high return goes with high risk”.

Will Hamilton is the managing partner of Hamilton Wealth Partners.

[e-mail]