In Australia, debt investing is the new black – except for commercial real estate. Risk aversion has been pushing investors to increase their allocations to fixed-income securities with clear preferences for safer sovereign, semi-sovereign and high quality corporate debt. Yields on Australian sovereign debt securities are at all-time lows –around 3.1% (10-years).
When it comes to Commercial real estate, the retreat of foreign banks, 2nd tier lenders, securitized debt (CMBS) as well as non-bank lenders through the financial crisis has left a noticeable gap in the lending market. This dislocation of lending markets and reduced competition has left the four major tier 1 commercial banks with a large share of the commercial real estate lending market in Australia. Furthermore, the appetite of these banks to expand their credit books on commercial real estate is limited with flat (or slightly negative) credit growth in the sector over the past few years.
Surprisingly, foreign investors who have shown persistent demand for commercial real estate on the equity side have displayed less interest in the Australian debt markets. Perhaps foreign banks requirements to repatriate capital as a covenant to ensure deposit insurance through the financial crisis was a necessary evil. However, the return foreign investors in Australian fixed-interest investment as a whole have been positive. At present, nearly 80% of all Commonwealth Government Securities on issue are owned by offshore investors.
As a result, an opportunity exists for other sources of debt finance to enter the market and take advantage of both the lack of competition as well as the attractive returns on offer. Benchmark lending rates and longer-dated swap rates in Australia remain high compared to other mature markets and margin spreads remain well above historical averages.
This lack of competition also has lenders on the right side of the negotiating table. Loan covenants remain both flexible and favorable from a lending perspective as do conservative LVRs and market fundamentals. Importantly, the cap rate decompression cycle seen through the financial crisis has improved debt serviceability on new loans. Incomes have steadied and lending margins have improved through the recovery to give further support to interest coverage ratios.
Borrowers for the most part are also looking to diversify their funding sources and extend the maturity profile of their debt. Small and mid-size groups that are unable to obtain a credit rating and access capital markets have limited options. Despite the gap that exists in the market, it’s hard to see a large resurgence of 2nd tier, non-bank and offshore lending in the short-term, given the global economic conditions.
Perhaps it is more a case of limited access to debt, rather than the cost of debt, that is holding cap rates steady. Whilst we don’t forecast any substantial yield compression in the short-term, the current low cost of capital is supportive of a compression cycle if it were maintained over the medium-term. Therefore, improved availability of debt is the key to achieving any substantial downward pressure on cap rates over the medium-term.
