IN THIS ARTICLE, MERRICKS CAPITAL EXPLAINS HOW THE VACUUM IN BANK LENDING HAS CREATED A UNIQUE INVESTMENT OPPRTUNITY IN HIGH-RETURN. LOW-RISK FIRST MORTGAGES

  • Bank lending practices have changed due to action by the regulatory authorities and the Banking Royal Commission
  • These shift in position has created a void in the commercial property financing market and a risk/return imbalance
  • The resulting market dislocation has created an outstanding investment opportunity

The last few years have seen significant change in the Australian residential property market. A combination of regulatory change, a shift in bank lending practices, increasingly negative sentiment towards property investment and solid underlying fundamentals have created a risk/return imbalance.

This imbalance means the investment returns from senior lending – or first mortgages – are very high due to a lack of lending alternatives, while the risk profile is low due to the security of quality assets with low leverage, creating the ultimate “perfect storm” investment.

There are a couple of factors behind the changes in bank lending practices. Concerned about the financial stability of the banking sector, the Australian Prudential Regulation Authority (APRA) began implementing a variety of measures to address responsible bank lending in late 2014. These included limiting interest-only loans, to limiting excessive growth of investor lending and applying enhanced criteria to ensure the serviceability of loans.

In addition to the regulatory measures, the focus on bank lending practices during the Banking Royal Commission has resulted in a tightening in lending criteria. This includes things such as lower lending limits, increased scrutiny of expenses, enhanced verification of income, more vigorous scenario stress testing, and greater incorporation of credit card limit details and other potential liabilities. In general terms, the loan application process has become more onerous and loans, if approved, are smaller than they once may have been.

The measures have been very successful in improving the quality of new mortgage lending generally and moderating the growth in higher risk investor and interest-only lending, but they have also created a property financing void. Unsurprisingly, those lenders who are in a position to fill this void are also able to generate impressive investment returns.

But attractive investment returns are just part of the story. The risk profile of senior lending is also constrained due to the priority ranking of senior debt and the prudent investment criteria applied. Merricks Capital further mitigates individual loan risk through a combination of moderate loan-to-valuation ratios (LVRs), adequate presale coverage, and high levels of borrower security, along with a rigorous property section process.

The outlook for housing prices remains a key area of economic uncertainty and national dwelling prices were down 6.3% over the year to February, led by falls in Sydney (-10.4%) and Melbourne (-9.1%). While the falls have so far fitted with the “orderly adjustment” description offered – and in fact engineered – by the Reserve Bank of Australia and other regulators, there is still no strong indication that the market has bottomed. Sentiment around housing is mixed – consumers expect to see further falls in housing prices but they are becoming more positive about the timing to buy. And while unemployment and interest rates remain low, serviceability of mortgages should remain resilient, providing key support for the market.

Merricks Capital supports the outlook for an orderly rebalancing in housing prices, but by applying conservative LVRs to the loans in the portfolio (the average LVR in the Merricks Capital Partners fund is 58%), it would require a significant collapse in the underlying value of the property to have an investment impact. Similarly, Merricks avoids projects in areas subject to oversupply and bubble-like conditions and instead focuses on financing properties in areas with strong organic or underlying demand.

Even in a soft housing market environment. the economics of financing construction and development projects makes a lot of sense. Low interest rates, population growth/high levels of immigration, a prior lack of housing supply and significant pent-up or “unmet” demand will ensure continued demand for housing stock. And while the short term impact of regulator action and the bank lending changes has been a healthy moderation in house price growth, the medium to long term effect will be increased health and stability of the housing market.

In the meantime, the market dislocation that has resulted from the vacuum in bank financing has provided a unique and compelling investment opportunity and Merricks Capital has been pursuing these senior lending opportunities through its Partners Fund.

ABOUT MERRICKS CAPITAL AND THE MERRICKS CAPITAL PARTNERS FUND

Merricks Capital has a 12-year track record across global investment markets, investing across the capital structure where there is the best risk-adjusted returns. We believe that one of the best opportunities in the world currently is in first mortgage lending against Australian commercial real estate.

The Merricks Capital Partners Fund invests in a range of senior loans, diversified across type (residential construction, land purchase and subdivision, hotel and agricultural assets) and geography. It has generated 12.7% p.a. since inception with low volatility of returns and a modest risk profile.