This article was written and published by Glenn Freeman from LiveWire Markets.
A pragmatic outlook for residential property prices was a key takeaway from my recent chat with MA Financial’s Drew Bowie, which occurred just a day after the Reserve Bank of Australia last hiked the official RBA target cash rate by another 0.50%. A view that persists despite Bowie also presenting a case which supports house prices falling between 25% and 30% over the next 12 to 18 months.
Bowie refers to CoreLogic’s auction clearance rate – the same figures used by the RBA – which currently sits at around 58% when averaged across Australian capital cities.
It is generally understood in the market that an auction clearance rate of below 60% implies a fall in values; and above 70% implies rising values: “given we are below 60%, it would be fair to suggest falls may continue,” he says.
A managing director at MA Financial Group, Bowie heads up the MA Secured Real Estate Income Fund. Having offered the strategy to wholesale and institutional investors for around five years, the Fund was made available to retail investors in April 2021. The Fund's monthly income target is the RBA cash rate plus 5% per annum - excluding fees and costs.
Using Sydney as an example, Bowie says property values are around 28% above the long-term growth trends and that borrowing capacity has reduced by upwards of 25% since the rate increases began. “All that suggests falls of between 25% and 30% are very plausible.”
Though there is a counterargument that suggests Australian house prices could have a softer landing. As Bowie explains, people due to come off fixed mortgage rates – which has already started to happen, with the last of those set to roll onto higher variable rate loans by the end of 2023 – could face a three-fold rise in their regular mortgage repayments.
But he emphasised that most of these borrowers were assessed at an interest rate of about 5.75% and that many have probably seen their property value rise at least 20% since taking out their loan.
“That would mean they’re probably not going to suffer much pain if the values do drop,” said Bowie.
“The real concern is if you bought at the peak and are a forced seller over the next 12 months, as we approach the trough in values. But with low unemployment, you could argue that not many people will face that problem. As long as people keep meeting their mortgage payment obligations, the Banks will not revalue the asset and require an equity top up, as they would on an equity margin loan for instance.”
Bowie opened our interview by explaining exactly what MA Financial Group’s Asset Management division does for its investors.
Having provided non-bank lending services in Australia for five years now, his real estate credit team has completed around $2.5 billion worth of transactions. These are solely first mortgages, a category of loans Bowie described as a “historically tried and tested investment class that is very well understood,” underpinned by a mature legal system.
“And given most people understand what a first mortgage is – either having or aspiring to have a mortgage for themselves and/or their children – we felt it was a suitable investment for retail investors,” Bowie said.
A diverse book of property assets
These assets span the full range of sectors including residential, commercial, industrial, and retail. A key consideration for the MA Financial team is the depth of the potential pool of buyers for each type of asset.
Bowie said a combination of factors meant loan default rates were very low and there were few challenges facing the sector.
“This non-bank sector is still relatively new and has been operating and growing in a market that has been relatively easy up until now. Property values have been rising, interest rates have been very low, as has the rate of unemployment,” Bowie said.
“But cycles happen, they always have. And with 25-plus years of experience across real estate, credit, and restructuring, we have the necessary core competencies to assess and manage exposures across these cycles.”
How defensive is private credit in this environment?
Circling back to the point raised at the start of this wire – the latest interest rate hike, which takes the official RBA target cash rate to 2.35%, the highest level since 2014 – I asked Bowie how private credit has fared so far, and his expectations over the next year.
“About a year ago, we started to offer only floating-rate loans, to provide a margin over the cash rate,” he said.
This means the interest rate at which MA Financial lends money is increasing in line with the cash rate rises. The team also only lends at conservative levels, with a maximum loan-to-value ratio on individual assets of 65% and a target average of 60% across the portfolio.
How declining property prices affect MA Financial’s investments
Bowie’s team is mindful that the higher interest rate environment can depress values, as we’re seeing across the residential property markets currently.
“We expect the decreasing values to continue in the short term. But also, when we assess these transactions, we are assessing them for substantial value declines and for interest rate rises,” he said.
“In every transaction, we assess to ensure the investment can withstand these short-term pressures. And they are, in our minds, short-term.”
Why is that? A key point here is that the maximum loan period for the MA Secured Real Estate Income Fund is 24 months, with a target average to maturity of only 12 months across all its portfolios.
“We're constantly making new investments, and all those new investments have new data, new due diligence, and new current market assessments. So, we can largely avoid getting caught in a market that sees that value of any one asset declining for long periods of time” Bowie said.
At what level do rising rates become concerning?
The short-term maturities of the loans the MA Secured Real Estate Income Fund writes mean the portfolio is largely insulated. But at the same time, the team acknowledges there are periods in the market where the risk versus return trade-off doesn’t make sense.
“As a defensive investment strategy, we are prepared to not take new deals if we think property valuations don’t reflect the current market, or have not yet built in the recent interest rate rises, noting that valuations are backward-looking,” Bowie said.
“It’s about challenging valuations, assessing the due diligence – the qualifications, the assumptions, the market data – that the valuer uses. Valuers don’t always get it right, in our opinion. And we’ll often decline transactions because we’re not comfortable with a valuation.”
So, Bowie’s response if the market becomes considerably more difficult would be to sit on the side lines for a while to look after the interests of all existing investors.
“We’ve done that before, when the market got a little hot before COVID we sat out of the market for a couple of months. We have the benefit of being a multi-disciplinary business which means we can be more selective as to when to invest and not lend when the reward for risk is no longer justified” Bowie said.
MA Financial, which is itself a listed entity, hit the boards of the ASX in 2017. The broader group's operations span asset management, lending, corporate advisory, and equities research.
What’s on your mind currently?
The challenges facing the construction sector, as it grapples with higher inflation after having weathered COVID lockdowns, mean builders have been confronted with the perfect storm. These stresses also coincide with the highly competitive environment, where margins were already squeezed, leaving only minimal buffers.
But even given the above difficulties, Bowie remains “cautiously optimistic” about opportunities in the construction sector – which can comprise up to 20% of MA Financial’s real estate credit portfolio.
“We're very active managers of that sort of risk, with a team of highly experienced construction financiers complemented with full-time staff that wear helmets and steel-capped boots for a living who ensure they're being built to the high quality that we expect” Bowie said.
“We also keep a close watch on the risk environment and provide borrowers and builders with support where needed. So, we've been very fortunate so far, with a healthy book of assets right across our construction portfolio.”
Asked about any recent loan assets in which the Fund has invested, Bowie refers in general terms to:
- an industrial project in the suburbs surrounding Sydney Airport, and
- a residential development in Sydney’s affluent eastern suburbs, which targets the downsizer market.
The first of these has seen strong uptake of sales and leases, achieving if not surpassing MA’s expectations of the value of the project. And the residential development has also benefited from the limited supply of similar quality apartment stock in the region.
What's the biggest risk?
“Where I lose sleep is around the fact that the non-bank lending sector is such a broad church of different operators and people,” said Bowie.
“I hope that borrowers make the right choice as to who they deal with in the sector. But I worry about some other non-bank lender making a poor decision and, and hitting the newspapers for the wrong reason, because of the potential unjustified knock-on effects to the reputation of the non-bank lending industry generally.”
In short, the concern here is that not all non-bank lenders are as diligent in their assessment of risks and processes.
“That’s outside of my control, but it concerns me. In terms of what we are doing and how we need to pivot as cycles move, I think our 65% individual asset max LVR is right for this defensive strategy,” said Bowie.
“I’m confident in our process and that the Fund structure and returns are suitable to weather the current volatile markets such that for now we are confident to continue what we’re doing.”