The Merricks Capital Outlook for 2024
22nd December 2023Agriculture Capital Partners Commercial Real Estate Infrastructure Investors Market Review Thought Piece
The outlook for 2024
- After a roller coaster ride, 10-year bond yields ended the year where they started (USA 3.8%, Australia 4% and New Zealand 4.4%). The 10-year bond yields are the key drivers of valuation for long-duration assets such as real estate.
- The market-implied view that reserve banks worldwide will aggressively cut rates over the coming two years appear to be pricing the best-case scenario. We expect a slower path to rate cuts as real yields in Australia still remain negative.
- However, the dramatic rally in bonds and the easing of rates and inflation expectations suggest run away interest rates are unlikely to be a major forward risk for a first mortgage portfolio.
- Market confidence in more stable macro environment should lead to a major uptick in hard asset transactions in 2024.
- At 60% Loan to Value (LVR) across our portfolios, the more benign rate outlook will underpin a solid collateral position.
- Valuations were fiercely debated in the face of rising bond yields for the first 10 months of 2023.
- Valuers relied on limited evidence of historical transactions to support values. This meant we often had to reduce leverage covenants to compensate for the risk of rising inflation and rates and the potential decline in property prices, with the weighted average LVR of the portfolio reducing from 63% at 31 December 2022.
- The taming of inflation and a more subdued rate backdrop gives us a high degree of confidence that the collateral pool in our portfolios is in a very strong position.
- Private debt and equity in the hard asset classes are slow-moving in repricing relative to the rapid pace of public markets’ daily moves. With the fear of rapidly rising rates, we did have some trepidation that the illiquidity premium we were required to deploy into private markets was tightening too much. However, the rally in bond yields has seen this paradigm shift quickly.
- 70%+ of our portfolio is floating interest rates and benefitted from rising rates. As the portfolio rolled into new vintages of loans, we felt it unwise to chase higher rate loans to get investors net returns of 7% over risk free (ie +12% return).
- The commercial real estate hard assets that back our loans didn’t see rental incomes rise fast enough to offset the looming higher interest rates. As such, we have positioned our portfolio with lower risk and a more modest risk premium (10-11% forward return).
- With base rates falling rapidly in the last month, a 6-7% return over risk free is again achievable, capturing equity risk premium from a more modest risk investment.
- Many measures of risk aversion, such as credit spreads, equity market valuations and the VIX index have ended the year close to peak risk on levels, highlighting that public market valuations are fairly and we sit comfortably in the capital stack with our dedication to first mortgage senior secured private debt.
- A higher degree of certainty around the macro backdrop in Q1 2024 will likely see a more vibrant market. According to JLL, transactions for commercial real estate have been at the lowest dollar volume for 15 years in Australia. Given asset prices have increased significantly during this time, the decline in actual numbers of trades is even more dramatic.
- With bond yields receding, and listed markets showing clear signs of optimism, we believe Q1 2024 will see a major uptick in transaction volume as the bid/ask spread between buyers and sellers is bridged.
- The level of potential buyers requesting finance from Merricks Capital for potential acquisitions is also a healthy indicator that activity will stabilise in coming months.
- Recent surveys by JLL also suggested near record dry powder in Asia Pacific real estate funds for deals, however much of this is characterised as opportunistic allocations. We believe some sellers are running out of time and will need to meet the market, but the deep discounts wanted by the various opportunistic funds are less likely to appear with the current money market dynamics supporting valuations.
- Given this macro environment, we’ve been pleased to see the sale of part of the security pool for our largest agricultural loan. This transacted in December and halved our exposure and dramatically reduced the LVR. Additionally, an agreement was signed this week by the borrower on our largest real estate loan in the Merricks Capital Partners Fund to sell part of their North Auckland asset base with settlement in 1H 2024.
- The clearing price of these transactions were at the lower end of our borrowers’ expectations. However, the asset was purchased by core real estate owners and well above the opportunistic bids from distressed funds that participated in the expressions of interest.
- In the calendar year of 2023, Merricks Capital wrote $1.4bn of new loan facilities which was at the lower end of expectations. With the up-turn in borrower demand and good risk premium over risk free rates on new loans, we anticipate writing in excess of $2bn of loans in 2024.
Key Investment Thematics
Downstream supply chain lending to lead increase allocation to Agricultural Credit
- At 17%, the Merricks Capital Partners Fund is currently underweight traditional agriculture exposure, providing dry powder for our allocation to increase. 2022 and early 2023 was a highly competitive lending environment driven by the banking sector and we reduced exposure accordingly.
- With banks now seemingly at capacity limits the need for non-bank lending and higher spreads has remerged.
- The Agricultural Credit Portfolio LVR decreased from 62% to 56% over recent years as asset values increased. The past six months saw farm value growth of 0.1% compared to the prior two years generating 15% growth.
- Our expectations of more variable weather conditions and mid cycle commodities prices has also led us to shift subsector allocation to downstream food processing and farm infrastructure assets with secure water supply.
Residential Sector: An extremely tight supply/ demand dynamics is leading to a consensus view from debt funds that multi-residential stock and developments is one of the best sectors to allocate, however the terms need to be attractive.
- With 1% home vacancy across Australian and New Zealand the downside risk in this sector is well contained, however some sub-sectors of this asset class are too competitive and a poor return in our opinion.
- The Merricks Capital Partners Fund is underweight allocations to very large $300m+ residential developments. Currently, this is a highly competitive lending environment with international institutions and sovereign wealth capital leading to weaker covenants and lower investor returns.
- Our focus has been on a strong pipeline of loans against assets with values between $75 – $125m. This is in Residual Stock Facilities (RSF), apartment construction and retirement village sectors, where capital is more scarce.
- Housing supply shortage and offshore buyer demand for construction of higher end apartments are supporting increasing revenue in feasibilities of new projects despite the cost pressure still being driven by building sector wages.
- The good news is wage increases are highly predictable and material supply disruptions that were erratic have dissipated leading to certainty of development costs.
- The biggest unknown is how much pressure development land will experience in 2024 as developers are forced sellers. We are seeing lots of requests for finance to purchase discounted sites but are cautious unless the borrower has a clear pathway to development.
Refinance of 20% of the Merricks Capital Partners Fund’s fund capital in Q1 is leading to opportunistic investing with dry powder into premium office construction and strategically located office refurbishment.
- No new office deliveries are expected over 2025 & 2026 in Sydney (JLL) the first time in 50 years and single digit has created the opportunity to invest in this capital-scarce investment sector despite solid tenant demand.
- Recycling of refinanced loans will keep the funds allocation at sub-25%.
- Mixed-use assets have also created a new subsector of office investment opportunities, creating further repayment pathways with the multi-use assets, including Hotels, Apartments, Retail and Office.
- The non-consensus allocation to this sub-sector has proved to be high returning and stable over the past 3yrs despite much of the market rumblings. With such high demand for finance in this sector we can remain selective.
Sector Diversification and hedging remains a key focus to combat any unforeseen macro risk
Any individual loan has limited risk to overall investor returns. The unforeseen contagion or problems within subsector or systematic freezing of refinance markets is always the biggest fear. We continue to manage this risk through ever expanding the hard asset sectors we lend against and hedging a lock up in money market with credit default swaps.
- The Merricks Capital Partners Fund invests across 15 sub sectors within our three core investment sectors, Commercial Real Estate, Natural Resources and Industrial & Infrastructure.
- Port infrastructure, Natural Resources, Renewable Energy Storage and Medical/Healthcare facilities and aged care/lifestyle loans have led this year’s investment diversification and 2024 pipeline.
- We have grown the team 20% over the last year and continue to add industry experts and service partners to find and manage loans in an expanding range of real property.
We would like to thank our investors and capital partners for your support over the past 12 months. Our mission, in partnership with our investors, is to continue to deliver consistent returns by providing innovative capital solutions across a range of hard asset sectors.
As we enter a new year, I’m reminded of a Buddhist quote: A young student calls out to his teacher across the banks of a river “Oh wise one, can you tell me how to get to the other side of this river”? The teacher pauses and responds assuredly “My student, you are on the other side”. It’s been a challenging year for many of our borrowers and they’re looking for some certainty and relief in these economic conditions. Perhaps we’re on the other side of a time that has been dominated by COVID disruptions, rampant inflation, rising rates and uncertainty. With a bit of luck, a little more stability will allow business owners to make decisions with more certainty in 2024.
Merricks Capital Partners Fund Portfolio and Market Update December 2023
The outlook for 2024 Range bound After a roller coaster ride, 10-year bond yields ended the year where they started (USA 3.8%, Australia 4% and New Zealand 4.4%). The 10-year…