The Qualitas Real Estate Income Fund (ASX:QRI)

Commercial real estate (CRE) credit refers to loans provided to borrowers to finance real estate for investment and development 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 can be used to purchase land that is vacant, developable or can be improved upon (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 completed buildings that can be occupied and generate income from tenancies.

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 returns^{^}. 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 one of Australia’s leading real estate investment managers, with a long history in managing CRE credit. As a property specialist, Qualitas on behalf of investors sources lending opportunities in the CRE credit market, undertakes credit assessment of the loan and actively manages the loan performance and risks.

How CRE credit generates regular income^{^}

^ 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.

An alternative financier 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 financier will raise equity capital from investors.  Qualitas is an alternative financier that provides CRE loans to commercial borrowers such as property developers.

The opportunity for alternative lenders is underpinned by the following:

• 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.

As an experienced manager of CRE credit, Qualitas is well positioned in the Australian market with 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.

CRE credit is attractive to investors seeking regular income with the potential for capital preservation. Additionally, CRE credit provides exposure to the property market without the need to actually own property. Its benefits include:

Predictable and regular income^{^}

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

The potential for capital preservation and portfolio diversification

• The loan value does not fluctuate like property values.
• CRE credit ranks ahead of equity, meaning it is repaid first.
• CRE credit 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 credit is a relatively new asset class for retail investors in Australia, it has been available to wholesale and institutional investors for decades. As banks continue to reduce their exposure to CRE loans, alternative financiers such as Qualitas have increased their market share and made this asset class accessible to retail investors.

^ 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 relatively inflexible set of lending parameters for assessing CRE loans, which excludes a number of quality borrowers.

These borrowers look to alternative financiers because they need flexibility and are willing to pay a premium 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, with regard to market pricing at the time.

CRE loans provide exposure to the property market without the downside risk of owning the property.

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

CRE credit 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 credit ranks ahead of equity and will always be paid first from sale proceeds.

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

The providers of CRE credit (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 credit 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 and the interest rate are generally agreed at the outset , which in practice makes the income is relatively predictable compared to property ownership. The income generated from the CRE loans (i.e. borrowers paying fees and regular interest payments on the loan) in the QRI portfolio can provide a regular income source which  may vary from month to month.  However, QRI has consistently delivered monthly distributions since IPO at attractive returns^{^}.

^ The payment of 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 indicative of future performance.

Protecting investors’ capital is our highest priority and our investment processes have institutional-grade governance and a structure similar to that of a bank. 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 credit lending

Two primary CRE credit risks are a loss of loan principal and a loss of loan income. The loss of loan principal is the risk that a borrower cannot repay the loan and the security property value declines and is insufficient to meet the full repayment of the loan. The loss of loan income is the risk that cash flow from property or other borrower sources will be insufficient to pay loan interest and fees that are due to the lender. These risks can be managed through prudent loan-to-value ratio (LVR) levels, a strong focus on senior debt, robust covenants, geographic diversification, sector diversification, short loan tenor, and a solid asset management model.

Please refer to the PDS section 8 on risks related to QRI.