MARKET REVIEW

Implications of COVID-19 for retail sales and financing of retail real estate.

Over the last few months we have reported increased opportunity to finance retail backed property. These comments have led to a number of questions about the viability of retail real estate and our confidence in funding these opportunities.

Up until COVID-19 these financing opportunities where the core domain of the major banks.  In these times traditional financiers seem reluctant to commit to new clients in the space which is leaving a chasm for groups such as Merricks Capital. As a business which is primarily an asset focused lender as opposed to serviceability focused we have different lenses to the banks. Banks need to know their borrower will unquestionably service interest so they can in turn service their own highly leverage balance sheet. We, on the contrary have no debt on our Fund’s balance sheet and are primarily concerned about the value of the real estate holding so our borrowers can refinance our loan in 18-24mths.  When you lend equity, as we do on behalf of our institutional and wholesale clients, we have more flexibility to structure the interest payments and cashflow of loans to accommodate borrowers in difficult times. In return for this flexibility we achieve much high returns on the basis that our assessment of asset values will hold and our funds and interest can be recovered in one form or another.

In regards to lending against the retail property sector our perspective is no different to other sectors – “will the value hold or grow in the underlying real estate so our senior secured loans will be repaid”.  The Australian Bureau of Statistics (ABS) reported its preliminary retail trade figures this week, with turnover rising 2.4% in June, and 8.2% when compared with June 2019.  In its most simple assessment retail as a whole is not imploding and there are some sectors of retail such as consumer staple that are thriving. If possible we are attempting to increase our exposure to property leased to supermarkets and other staples whilst the banks are slow to provide certainty. Other sectors of traditional bricks and mortar retail are suffering temporarily as shoppers stay at home and in other sectors are more terminal as buyers go online permanently. Delineating between permanent decline and temporary decline requires much deeper due diligence and the next month or two is going to be very telling in states outside Victoria which are returning to more normalised shopping patterns.

The components of retail spending have been quite varied, and also volatile, as consumers have moved through panic buying of staples, to household goods such as fitness/office/entertainment equipment and, more recently, to cafes, restaurants and takeaways as venues began to open. Likewise, spending on clothing, footwear and personal accessories saw a significant improvement in June as shops reopened. The ABS data this week also reveals that spending in supermarkets and grocery stores remained elevated, reflecting a continuation of increased home food preparation and consumption due to social distancing.

Unsurprisingly, the impact on the retail real estate sector has been variable as consumer spending patterns have transformed. Reflecting this, the share prices of larger regional shopping centre owners Scentre Group and Vicinity Centres fell significantly (-44% and -42% respectively) over FY20, while sub-regional centres (discount department store as major anchor tenant) and neighbourhood (supermarket-based) centres such as SCA Property Group (+8.8%) fared better. SCA Property Group’s recent trading update confirmed that within its investment portfolio, neighbourhood centre valuations fell just 2.1% from December last year to June.

Going forward, price risk for retail real estate assets will be a function of income stability, the level of operational significance, and occupational density. On these measures, neighbourhood shopping centres and urban supermarkets should demonstrate greater resilience compared to larger regional and sub-regional centres.

On this basis, Merricks Capital has recently funded supermarket anchored urban and regional opportunities. As we pick our way through the other sectors of retail we are definitively hunting more staple backed retail properties to finance into construction or support borrowers purchasing these type of assets from bigger institutions who appear to be strategic or forced sellers.

Merricks Capital Activity

We issued two terms sheets this week. One of these is to finance the additional stages of a land subdivision in Queensland and the other is to provide funding for an industrial warehouse and office development in West Melbourne.

After a period of consistently strong enquiries during April and May, the fund is now more fully invested and we are actively seeking more investors to support the lending against opportunities coming out of due diligence.

Strategy

Our strategy continues to focus on the following key principles:

  • Continue lending against assets at conservative LVRs, as fiscal and monetary stimulus has averted major declines in real estate prices which underpin our first mortgage strategy
  • Maintain higher interest rates to take advantage of the limited competition in private markets
  • Maintain a resilience in our fund via portfolio insurance to manage our way through any potential delayed or defaulting repayments
  • Maintain a preference for financing existing buildings/assets versus construction loans, along with commercial office opportunities

The Partners Fund strategy of senior lending against real assets offers an attractive risk-return trade-off during volatile market conditions. Limited competition in the lending space provides superior investment returns, while the downside risk of the portfolio is limited due to the conservative nature of our investment process and the high quality of our loan assets. Further protection is given by the portfolio insurance. The pipeline of high yielding lending opportunities currently under review, which represents a diverse range of assets and sectors, will underpin the continued advantages of the strategy.