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Managing a well-diversified portfolio with commercial real estate debt

May 24, 2021
Managing a well-diversified portfolio with commercial real estate debt

Author: Mark Eggleton, The Australian Financial Review

Australia’s nascent commercial real estate debt (CRED) investment market has developed a track record of consistently strong outperformance not often seen in defensive investment strategies, according to a white paper recently released by MaxCap in collaboration with the University of Technology Sydney (UTS).

Commissioned by leading non-bank lender MaxCap, the research underscores the strength of CRED as an asset class and examines its performance in a diversified investment portfolio.

According to the co-founder and managing director of MaxCap, Wayne Lasky, the results clearly identify that the inclusion of CRED in an investor’s portfolio delivers enhanced returns, provides downside protection and reduces volatility and “therefore increases risk-adjusted returns, the alpha or active return premium”.

“There are very few asset classes that can lay claim to such impressive performance,” Lasky says.

As for what constitutes CRED, it is a fixed income instrument, or loan, secured by commercial real estate where the primary purpose of the loan concerns the use and/or improvement of that asset. The underlying commercial real estate covers a broad cross section of property from industrial land, office buildings, high and low density residential development, non-discretionary retail, etc. Investors are in effect the “bank” and have the benefit of the strongest possible security.

The research analysed a typical diversified investment portfolio and looked at how adding a 10 per cent allocation to commercial real estate debt would affect the portfolio overall. Looking back over the past two decades of CRED returns, the research found portfolios exposed to the asset class not only enjoyed higher returns but reduced volatility.

And in times of uncertainty, as the global economy has experienced over the past decade with the fallout from the global financial crisis and the COVID-19 pandemic, the research found CRED appears to be a highly effective portfolio diversifier as it tends to perform relatively well during such periods of strain in the economy and financial markets.

“Put simply, CRED returns improve relative to other asset classes during periods of crisis and therefore act as a critical stabilising force in an investment portfolio,” Lasky explains.

It would appear that capital markets are validating this research. Lasky says MaxCap has witnessed a marked increase in capital inflows from investors to CRED in the last year. In fact the company recently rated number one in Australia and second overall in the Asia-Pacific region, as compiled by PERE’s research and analytics team, in their assessment of the top 50 ranking of global private real estate fund managers.

CRED allocations still remain relatively small in comparison to many other asset classes. This presents a great opportunity for well-informed investors, according to Lasky, who is of the view that by the end of this decade CRED will become a key part of most sophisticated investors portfolios.

Many private investors are still to experience the benefits of CRED, largely because Australia was relatively slow in coming to the party. The big four banks dominated the space until the local regulatory environment began to change substantially in 2017. Australia’s regulatory reform came many years after the US, UK and continental European moved to reflect the Basel Guidelines.

Today the major banks are still responsible for more than 70 per cent of all CRED lending, compared to less than 50 per cent in the US and the UK. Furthermore, the market is still relatively opaque in nature although the research found entrenched local managers such as MaxCap consistently extract “an attractive return premium for its investors”.

A key reason experienced local managers are consistently delivering solid returns is they understand the idiosyncratic nature of commercial real estate and can take advantage of the asymmetry of information in this private market.

“By its nature, it requires specialised, local market expertise on an asset by asset basis,” Lasky says.

Moreover, at present the best opportunities are sourced through private markets “so it’s really only managers with very long track records and deep relationships that are able to access the highest quality opportunities and deliver those portfolio benefits”.

As for how investors can access CRED, Lasky says MaxCap manages unlisted funds with two funds currently open to sophisticated investors. He states that these vehicles provide investors with the manager’s best deals in a diversified portfolio. Additional benefits include higher returns with a lower fee base compared to investing on a deal-by-deal basis and a higher money multiple for investors as the onus is on the manager to keep the investors’ capital working for the life of the fund.

Fundamentally, CRED’s major role is to perform as a defensive asset in a diversified portfolio – its primary objective is to preserve the principle investment, even under highly adverse scenarios.

Like the bond market, it has a role to play especially at a time when interest rates are historically low. Moreover, it also plays an important role in the overall economy by helping to fund the property sector’s growth.

For Lasky, CRED over the next decade will continue to grow as a defensive asset class not only because it’s designed to preserve capital but it also delivers outsized returns relative to risk and “acts as a stabilizing force in an investment portfolio”.

“The world’s savers have been punished through this period of time because typically most asset classes will ask you as an investor to take on more risk to achieve a similar or perhaps even lower return. In stark contrast, that is not a feature of commercial real estate debt.

“It presents a highly relevant strategic allocation opportunity because it can achieve very important objectives in a well-diversified portfolio,” Lasky says.

“At MaxCap, it’s not only our privilege but our great responsibility to preserve and enhance the returns of the many domestic, but also offshore investors whose capital we’re looking after,” he concludes.

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