Commercial real estate (CRE) debt refers to loans made to commercial borrowers who require funding for real estate purposes. All CRE loans are secured by real property mortgages.

The borrowers are typically property developers, private corporations or high net worth individuals. CRE loans are distinct from home loans made to individuals.

CRE loans can be used to purchase land that is vacant, developable or improved (with buildings, utilities or other services), or property (buildings that are complete or under construction). The land or property is the mortgage collateral (or security) for the loan, and investors earn income from the ongoing loan interest and fees.

Types of loans include:

• Land (pre-development) loans: Used to fund land that has been approved for development
• Construction loans: Used to fund property development and construction costs
• Investment loans: Used to fund real estate assets (buildings that can be occupied) that generate income

Loans across the real estate life cycle

CRE loans may provide an alternative way to earn income, especially for those investors looking for predicable income though attractive risk-adjusted returns¹. The ongoing interest payments from CRE loans – which have agreed interest rates and fees – underpin this regular income, which is typically paid to QRI investors in the form of distributions.

Qualitas is a leading Australian-based manager of CRE debt. As a property specialist, Qualitas – on behalf of investors – sources lending opportunities in the CRE debt market, undertakes credit assessment of the loan and actively manages the loan performance and risks for the loan term.

How CRE debt generates regular income

Qualitas is an alternative lender that provides CRE loans to commercial borrowers such as property developers. An alternative lender is not a traditional bank, with the main difference being how they raise capital to fund their lending activities. While a bank will raise capital from deposits and wholesale funding, an alternative lender will raise equity capital from investors.

According to APRA, 90% of the Australian CRE debt market (worth $403 billion) is provided by banks¹. The remaining gap of 10% (worth around $45 billion) is provided by alternative lenders². Senior loans represent the majority of opportunities in the market.

The opportunity for alternative lenders is underpinned by the following:

• Every year the CRE debt market has grown between 2-5%, due to supportive macroeconomics in recent times.
• Bank withdrawal from CRE lending due to APRA and government regulation has widened the gap for alternative lenders.
• Borrowers are willing to pay a premium for more flexible and bespoke forms of finance e.g. mezzanine lending is typically only provided by alternative lenders.

Qualitas, as an experienced manager of CRE debt, is well positioned in the Australian market due to our long-standing local presence and deep borrower relationships built on trust and repeat lending.

Qualitas is a “through-the-cycle” investor. We are sector agnostic and always seek to invest in the best risk-adjusted return opportunities having regard to the timing within the cycle of the market.

1. APRA Quarterly Authorised Deposit-taking Property Exposures March 2022; 2. RBA Financial Stability Review October 2021.

 *Manager estimates

Australian CRE debt market opportunity*

CRE debt is attractive to investors seeking predictable income and capital stability, and provides exposure to the property market without the need to actually own property. Its benefits include:

Predictable and regular income⁵

• The loan interest and fees are agreed upfront, to provide fixed income for the loan term.
• Can provide cash flow from regular interest payments.

Capital preservation and portfolio diversification

• The loan value does not fluctuate like property values.
• CRE debt ranks ahead of equity, meaning it is repaid first.
• CRE debt has the benefit of security i.e. mortgages over property, which can be sold to meet loan repayment.
• The equity buffer provides downside protection – depending on the loan-to-value (LVR) ratio, property values will need to fall to a certain level before the loan is at risk of not being fully repaid.

While CRE debt is a relatively new asset class for retail investors in Australia, it has been available to wholesale investors for decades. As banks have reduced their exposure to CRE loans, alternative lenders such as Qualitas have increased their market share and brought this asset class to retail investors.

5 The payment of regular monthly cash income is a goal of the Trust only and neither the Manager nor the Responsible Entity provide any representation or warranty (whether express or implied) in relation to the payment of any monthly cash income. Past performance is not a reliable indicator of future performance.

• Banks have a fairly inflexible set of lending parameters for assessing CRE loans, which excludes a number of quality borrowers.
• These borrowers look to alternative lenders because they need flexibility and are willing to pay a premium for it in order to do business. Examples include:
  • Lending for properties or land that may be outside the bank’s risk appetite due to caps on CRE lending generally or restrictions on certain areas or property sectors.
  • Providing additional leverage or more relaxed terms than banks are willing to provide.
  • Mezzanine lending (i.e. second mortgages), which is typically only provided by alternative lenders.
  • Speed and certainty of funding.

Qualitas will always assess a CRE loan to determine an acceptable interest rate (i.e. pricing) that reflects the acceptable risk, having regard to market pricing at the time.

CRE loans provide exposure to the property market without the downside risk of owning the property, including decline in value or loss of rental income from vacancies.

Due to the capital structure, CRE debt capital is more stable than equity as a source of funding.

CRE debt has the security of a real property mortgage, which provides the lender with the right to sell the property to recoup payment of the loan if the borrower defaults. CRE debt ranks ahead of equity and will always be paid first from sale proceeds.

Payment priority within CRE debt means senior debt (first mortgage) is paid first, and mezzanine debt (second mortgage) is paid second.

Providers of CRE debt (i.e. the lender) may also be protected by the equity buffer, which is the difference between the property value and the loan value. The equity buffer will fluctuate with property values, and would need to be eroded completely before the lender is at risk of losing the loan value.

The CRE debt market covers a broad range of loan types including land, investment and construction loans, as well as all property sector asset classes such as residential (multi-dwelling), office, hotel and industrial.

Owning these types of assets directly comes with risks, particularly around valuations, as the capital value of assets can rise and fall in line with market cycles. Income is also variable, based on rental demand and market rates.

On the other hand, the value of a loan is relatively stable and the income is relatively predictable compared to property ownership. The loan amount and interest rate are agreed at the outset, and so the value and income are known in advance.

While the income generated from the CRE loans in the QRI portfolio is relatively stable, the dynamic nature of the portfolio’s composition means the income may change slightly from month to month.

Protecting investors’ capital is our highest priority and our investment processes have institutional-grade governance and structure similar to that of banks. This seeks to provide protection against the risk of capital loss throughout the loan investment life cycle – from origination, investment due diligence and approvals to risk management, active asset management and loan repayment.

Our rigorous due diligence and credit assessment focuses on two areas:

1. The credit worthiness of the borrower – this includes the borrower’s business operations, track record, management team, company owners, financials and property portfolios.
2. The quality of the property – we verify the real property asset including whether it could be resold or leased out, the location and its supporting features and demographics.

Qualitas’ investment processes are different to a bank in the following ways:

1. We have greater flexibility to make decisions based on the merits of each loan with regard to QRI’s current risk/return appetite. A bank will often have rigid lending practices which make them more inflexible.
2. We undertake a much more proactive approach to asset management to ensure loan performance is managed as appropriate for the risk profile.
3. Our equity investment capabilities and in-house property development team allow us to assist the borrower if required to manage difficult loan performance or project issues.
4. We undertake individual loan asset reviews every 6-8 weeks, which is a lot more frequent than banks (who only review loan assets once or twice a year).

The Qualitas investment process for CRE debt lending