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Mind the gap between independent valuations and a mark-to-market assessment

  • The Reserve Bank of Australia’s 25 bps interest rate rise on Tuesday was the sixth consecutive rate rise since May and took the cash rate above 2.5% for the first time since July 2013. The Reserve Bank of New Zealand followed suit on Wednesday, with a 50 bps rise, bringing the New Zealand cash rate to 3.5%.
  • Many investors may be surprised that independent valuers don’t mark their valuations to interest rate markets but rather rely on comparative asset sales over the previous 1-2 years.
  • In July, we highlighted our view of a dislocation between capitalisation rates (‘cap rates’) in commercial real estate and Australia’s 10-year bond yields.
  • Consequently, we have been taking a more conservative approach to loan-to-value (‘LVR’) covenants where we expect to see valuations contract as long-term interest rates stabilise in both Australia and New Zealand.
  • Our base case assumption has been that cap rates should come under pressure as Australian 10-year bonds revert to more normalised yields of 3% – 4% p.a., regardless of recent asset price inflation that appears to be driven by COVID stimulus.
  • We assessed the direct impact of this base case as real estate valuations softened by 10-20% from their peaks, depending on sector asset class and geography.

To date, we have not observed property sales transact meaningfully below their valuations but have noted that the time to transact and the number of interested parties to complete asset purchases is softer than 12 months ago, which we consider to be a typical precursor to valuations pulling back.

We have proactively taken the following key actions over the past 12 months to reduce valuation risk in our portfolios:

  • Reduced weighted average LVRs across the Merricks Capital Partners Fund and Merricks Capital Agriculture Credit Fund (to <63% and <56% respectively);
  • Re-tested valuations for higher LVR loans or where a particular loan’s exit strategy has changed. We obtain independent valuations for all new and existing loans and rotate valuation firms periodically over time to maintain the objectivity of valuers’ assessments; and
  • Tracked data on our loan exit strategies to ensure that we monitor real-time indicators of asset prices or refinance potential. We believe that maintaining current market data is critical to our investment monitoring since asset valuations usually rely on backward-looking data points.

This week, two new loans settled – an income producing commercial real estate portfolio in New Zealand and an acquisition of cattle breeding farmland in New South Wales. These investments have a weighted LVR of 62% and are forecast to generate an investor IRR of 11.6% (net of fees and costs). Due diligence is progressing on $820m of new loans that are forecast to close in Q4 2022 with a weighted average LVR of 63% and estimated average investor returns of 12.1% (net fees and costs).