Lending against real estate below replacement cost remains our most important line of defence

  • Unlike banks, who have highly leveraged balance sheets which force them to focus on income serviceability to meet their own cashflow needs, our bias is towards the intrinsic value of real estate should we be required to sell an asset for loan recovery.
  • We do not need running yield on all loans to support our portfolio as we have no debt to service. When you lend equity, you can be far more flexible in loan structure in return for higher interest rates.
  • Consequently, one of our key risk criteria in assessing every loan is the expected “replacement cost” of an asset at loan maturity.

Some of our core assumptions over the last decade when thinking about defending our real estate loan portfolio include

  • The “implied cost” of the Partners Fund loans – which is the base cost if we were required to step in on a loan – is generally well below the asset replacement cost due to our conservative loan to value ratios
  • Historically Construction costs have limited downside in Australia due to the inflexible nature of our construction industry and exposure to a weak AUD resulting in higher imported materials prices during times of construction cycle weakness.
  • While assets can temporarily sell below replacement cost, the low implied cost combined with “sticky” construction costs will form a solid base to realise loan values through asset sales if done in a controlled manner

With the first recession in 30yrs we are closely watching key indicators to test some of the above assumption

  • This week we have been re-examining the thesis that replacement costs will continue to rise as the chart below highlights Australian Construction cost inflation is flat year on year for the first time since the end of the mining boom in 2012.
    Our initial expectation as we begun to test cost assumptions was that there should be some slack in the construction industry due to fewer new starts.
  • This view was supported by several of the construction companies we surveyed who do appear to be bidding for work at close to zero margin to keep their workforce fully engaged, however they suggested there was not a lot of room to move down as margins have recently only been in the 3% range.
  • The biggest surprise, however was that Enterprise Bargaining Agreements (EBAs), between builders and the unions appear to have been struck recently with a number of industry sources confirming wages for employees on major commercial real estate sites in Victoria will rise by 4.1% annually over the coming 3 to 5 years.
  • If wages rise by 20%+ over the next 5yrs it is hard to imagine any built form will have a lower replacement cost. This only leaves downside risk in the imputed land price in commercial real estate values should we see a persistent weak economic cycle.
  • As a result, we are increasingly focussing on making sure our construction loans are covered by the replacement cost of the physical building and the land is excess collateral.

Merricks Capital Activity

This week we signed a term sheet for a new 25 level A grade office building in Melbourne’s CBD comprising 10,000m2 of office space. The loan will fund the land settlement in November this year, with construction expected to start early next year (subject to leasing milestones). Our core view is that A-grade office will hold its place as a staple part of institutional CRE portfolios. We are excited to add as much of this sub-sector to the portfolio before the banks return in earnest to dominate the space once again.