- A core tenant of our lending strategy is ensuring there is a healthy buffer between our loan levels and the sworn independent values of assets securing this financing.
- Valuations reflect what the market is prepared to pay for an asset based on the mosaic of many economic variables that drives market participants at the time.
- Generally, valuations are stable and dependable but in the current environment they can be wide ranging. In contrast replacement cost of a building is a much more tangible base line during uncertain times.
- Our commitment to finance office development has been anchored by our assessment of the “implied cost” at which we would inherit an asset if we were required to step in in on a defaulting loan
- Two recent office construction loans added to the Partners Fund have a significant risk buffer as the implied default cost is well below the construction cost of the completed assets.
- As discussed last week construction costs and the resulting “replacement” costs of assets have limited downside risk, due to the nature of the construction industry and labour cost pressure that is ever present in Australia.
- In the current non-bank lending market, we are finding ongoing opportunities to lend against office buildings at in “implied loan value of” of $3500-4000/sqm vs building replacement costs in excess of $4000/sqm and market values of $7000-8000/sqm
In last week’s update we explained why the running income or measures of loan serviceability were the backbone of bank lending where as “replacement cost” of an asset at loan maturity was instead a key factor in assessing loan risk in our investment process.
This week we are providing some current loan examples to show the practical application of this comparison. Looking specifically at the office sector, we have financed the construction of two Melbourne office developments over the last 12 months and are undertaking due diligence on several new opportunities. These loans have helped to diversify the Partners Fund by increasing the office exposure to ~15% from zero 12 months ago.
According to Rider Levett Bucknall (RLB) the construction cost range for Melbourne non-CBD investment grade office is $2,500-3,250 per square metre, while the range for Melbourne CBD prestige grade is $3,450-3,950/sqm, based on Gross Floor Area (or GFA).
The first project example in our loan book is prestige grade but in a fringe location, so the loan implied cost of ~$3,500/sqm is consistent with these ranges. The cost estimates by RLB don’t include contingency, development, design and other professional costs, however, and for this project the total development costs (excluding the land purchase and finance costs) is ~$4,700/sqm. This is well above our implied loan cost of ~$3,500/sqm, meaning that not only would we “own” the asset at less than replacement cost if we needed to step in, but we have effectively “inherited” the land for free.
The second project has a higher implied purchase cost of ~$4,000/sqm, but this is still in line with the total development cost of this project excluding land. In the event we had to step in on the loan we would potentially hold the asset at replacement cost, again having effectively “inherited” the land for free.
The actual “completed asset” valuation of these assets is much higher again. Valuations are normally priced on a Net Saleable Area (NSA) basis, but we can convert these to a GSA basis for meaningful comparison with the construction and development costs, giving a market value of the completed buildings of ~$7,100-$8,100/sqm. While market valuations may fluctuate, they are unlikely to move below replacement cost for any meaningful length of time.
Our analysis last week concluded that while there will be competitive pricing pressure for contractors and subcontractors in order to rebuild work pipelines and keep businesses operational, any downside in construction pricing will be limited. This is a result of wage increases of ~4.1% pa over the next 3-5 years under the recently negotiated EBA, higher imported material prices, supply chain disruption and lower workforce productivity, and the floor provided by already lean margins.
By increasingly focusing on ensuring our construction loans are covered by the replacement cost of the physical building and the land is excess collateral, we are adding another level of security in our risk management process. Not only are the Partners Fund loans at conservative levels relative to end valuation (traditional LVR measurement), but they are at conservative levels relative to building and replacement cost. With building costs downside likely to be limited, we remain highly confident in the expected performance of these loans.