A Primer to the Commercial Real Estate Debt in Australia

There is a lot of focus on private credit right now. In a world struggling with a weaker economic growth, elevated interest rates and inconsistent asset returns, investors are looking more keenly beyond traditional asset classes – like stocks, bonds and real estate – to find more reliable sources of income and diversification.

For many investors, this is leading them broadly to private credit and specifically to commercial real estate debt (CRED). However, the world of CRED may come across as a little opaque and mysterious, particularly for those new to this scene. This article provides an introductory guide to the Australian CRED sector, framed around several commonly asked questions… What is it? How does it work? Why does it work? What is the outlook for lending into each sector? What are the risks and returns? And most importantly, what are the keys to success in this space?

What is Commercial Real Estate Debt? The CRED strategy describes the provision of finance to property buyers and developers, for several different purposes. The funding may be used for buying stabilised, income-producing real estate, for constructing or refurbishing new residential or commercial buildings, or for acquiring land sites for future developments.

In Australia, this market landscape was traditionally dominated by the big banks, which historically accounted for 85% of all CRED lending. The situation has progressively shifted since the Global Financial Crisis. With more stringent capital requirements for banks, and higher capital weights for commercial lending, bank lenders are increasingly shifting to residential mortgages (where the capital weights are the lowest) and retreating from commercial real estate (where the capital weights are the highest).

Amid this structural retreat, there is great demand for more capital to build residential housing. Australia remains a major beneficiary from the global movement of people. These migration flows have accelerated markedly with the post-pandemic reopening of borders. Even with some modest slowing in immigration, we are still looking at a sizeable jump in housing demand. Australia is facing an acute shortage of dwellings, a trend most likely to be with us for the rest of this decade. The most viable solution is increased housing supply – as cutting migration does not resolve the housing shortage already in place in Australia today. The road ahead calls for a big ramp up in housing construction, funded by both equity and debt capital.

How does CRED work? Why does it work? From an investor perspective, there are several compelling features about this market that are worth drawing out, to highlight the structural market features that make CRED investments resilient, to an extent that we do not see in other credit markets, both in Australia and abroad.

There is a world of difference between equity and credit exposures, even for the same underlying piece of real estate asset. From an equity perspective, every cyclical downturn presents an immediate impact on the bottom line, with the direct translation of pricing corrections to capital returns, along with any adverse effects from weaker occupancy and vacancies on rental income returns. From a credit perspective, there are more generous shock absorbers at work. For any given loan-to-value ratio, the credit position is much more resilient to pricing corrections, with lenders only exposed only after a sizeable price fall that wipes out the equity contribution.

Importantly, CRED provides a highly effective hedge to interest rates. Compared to other credit market segments, lenders and managers can nimbly pivot from fixed- to floating-rate exposures in line with the interest rate cycle. Where fixed income returns are sharply eroded by high inflation and high interest rates, there is much greater resilience in commercial real estate lending, which can sustain returns with fixed-rate loans when cash rates are low or supercharge returns with floating-rate loans when cash rates are elevated, as we are seeing right now.

Meanwhile, it is worth mentioning that lending to commercial real estate is very different from corporate lending, with exposures to markedly different set of market conditions and investment risks. In this current sluggish economy, we have already moved past the peak in construction cost inflation in 2022, with a flatter trend for builder distress and insolvencies in 2024. In the broader economy, high mortgage rates continue to pose marked distress for many operating business – particularly in the restaurant and hospitality spaces – where insolvencies continue to rise at a concerning pace. Altogether, we are seeing a very different risk profile for corporate lending more reliant on operating cash flows, as more corporate lenders suddenly becoming restaurant owners. In comparison, there is more substantial real asset backing on commercial real estate lending, where there is a cleaner path to realise value, by selling repossessed real assets, in the event of borrower default.

What is the outlook across different sectors? Down at the real estate level, there are very divergent market trends across different local markets and different sectors, which will drive very distinct risk profiles and exposure preferences, for both asset owners and lenders alike.
For the next several years, the residential sector is likely to be the top focus for investors and developers in Australia, particularly amid the recent population boom driven by high immigration. This surge in residents has created an acute supply-demand imbalance, with new stock additions struggling to keep pace. Local government regulations, including stringent zoning laws and protracted approval processes, continue to constrain the availability of developable land, exacerbating the shortfall in housing stock.

In this environment, dwelling price and rental growth have been robust, particularly in high-demand areas around city centres and the inner rings of each city. While Sydney continues to have the most expensive real estate markets, it is Brisbane and Perth that have emerged as the most upbeat housing markets, with strong price gains fuelled by strong demand growth and relative value (at least compared to Sydney).
This structural imbalance between supply and demand shows little sign of easing and is likely to persist for several years to come. The market remains chronically undersupplied. Indeed, current supplies are running around 70,000 dwellings behind the official designated target set by the government.

Meanwhile, commercial sectors are beginning to show early signs of stabilisation following a cyclical downswing. Over the last two years, cap rates have seen a prolonged softening phase as interest rates and economic uncertainty pushed down on property prices and reduced transaction volumes. In this environment, investors have been cautious about buying in this market, given limited confidence on occupancy and rental growth, especially set against the squeeze from higher borrowing costs.

However, there are clearer turning points are on the horizon for the most underperforming office and retail sectors. As interest rates begin to plateau and consumer confidence slowly recovers, value investors are showing a little more interest in re-entering the market. This is an early indicator of a potential recovery in asset prices as capital looks to flow back into these sectors in 2025.

Overall, there are clear differences in the outlook across various sectors. We continue to be relatively bullish about the prospects of the industrial / logistics sector, given the ongoing shift towards online shopping and more demand for same-day deliveries. At the same time, there are early signs of recovery taking hold in office and retail, which should accelerate with interest rate cuts from 2025 onwards. That said, for both buyers and lenders, there may be good deals in weak sectors and poor deals in strong sectors, and each transaction is being assessed on its individual merits.

Risks and returns in CRED. Ultimately, investors are drawn to CRED strategies by its attractive mix of risks and returns. In a world with low demand growth, high inflation and elevated funding costs, many asset classes have struggled to deliver on their return potential. What was more alarming was the increased degree of correlation between stocks and bonds, leading both to lose value at the same time in 2022. Meanwhile, we continue to see very strong and steady returns coming from CRED strategies, lowly correlated to cyclical economic conditions, the movement of interest rates and the returns of other asset classes.

Some of that resilience comes from the private nature of CRED. While listed asset managers may push back on the lack of daily mark-to-market in private credit, we firmly believe that this absence of public market volatility is a strong feature and not a bug. Indeed, we have seen this very clearly during the Global Financial Crisis, when listed REITs saw a big collapse in prices (-74% from peak), which massively overstated the price falls in CBD offices (-26% from peak) and regional shopping malls (-8% from peak). What public real estate markets added was dramatic pricing volatility, in part reflecting by contagious market fears about the ongoing viability of the banks. Even now, listed REITs are much more correlated to bank stocks than their underlying real estate asset values.

Meanwhile, for investors keenly focussed on capital preservation, there is much more consistency in CRED returns, compared to anything on offer in public markets. Indeed, traditional asset classes – from shares, bonds, credit to real estate – often reporting negative monthly returns, losing money roughly one month out of three. In simple terms, investors are going backwards one step, for every two steps forward, hoping that the gains in those two positive months are greater than the losses in that one negative month. By comparison, there are good CRED managers who can demonstrate a long track record of consistent returns, without the negative monthly returns that befall other asset classes. This returns resilience has been demonstrated over many years, across multiple cycles.

The keys to success in CRED investment. Altogether, we see a strong and ready case for increasing the portfolio allocation to private credit, and specifically to commercial real estate debt. Whether it is an investor deciding between a front-foot stance to enhance portfolio returns, or a defensive stance to bolster portfolio diversification and resilience, we see an additive role from an increased CRED allocation for many investor portfolios.

At the same time, there is no shortage of new capital moving into private credit, but that may run ahead of the growth in the deal pipeline. Getting good access to a deep and sizeable investment pipeline will be a challenge for many investors. Finding an experienced origination platform will be a vital part of any successful deployment of capital within this strategy.

Meanwhile, there is the vital matter of manager selection. In a hot sector, there is no shortage of copycats, moon-lighters and tourists. Indeed, we are seeing a rapid influx of new private credit managers – copycats looking to mimic established platforms, moonlighters from other sectors dabbling in private credit and tourists from offshore platforms looking to run a fly-in, fly-out operation. Simply, there is no substitute for an experienced CRED platform, with managers who can use their specialised skillset and long-standing relationships to originate loans, manage credit risks and oversee builders to deliver projects in a timely manner.