• Most apartment developments nearing completion were 50-75% presold prior to construction. Settlements of these presold apartments have been very strong, with very low levels of default allowing for most senior debt to be repaid.
  • However, presales of new or under construction apartment developments since March this year remain very slow, in contrast to house and land developments which are not far off record sales pace.
  • As a result, senior debt is being cleared in most projects, but preference equity and second mortgage finance are not being repaid as residual stock remains in many projects.
  • This is creating the opportunity to refinance completed apartment developments with residual stock facilities, loans which are secured against the unsold apartments and repaid over the next 6-12 months
  • The risk involved with these loans is significantly lower than construction facilities and the interest rates are 3-4% lower as a result.
  • We anticipate 20% of the Partners Fund could be deployed in residual stock facilities.

Residual stock facilities provide several benefits for investors. A key advantage is that there is no construction risk, as the apartments are usually close to completion or already completed. Residual stock facilities also involve reduced price risk as the valuations are fresh and market (COVID-19)-relevant. For quality projects in attractive locations, we are seeing moderate discounts averaging around 5%.

In addition to enjoying a reduced risk profile, residual stock facilities shorter duration, usually 12 months or less, they are fully drawn and less complex, and they provide a running yield rather than capitalised interest.

At the peak of the construction cycle, there were more than 30,000 apartments being completed each quarter in Australia. In 2Q there were 11,048 apartments completed in NSW and 7,099 in Victoria in 2Q2019, of which the majority is within Sydney and Melbourne. Charter Keck Cramer estimates 6,800 apartments were completed in Melbourne in Q32020, moderating to 4,800 through 4Q2020, with further reductions across 2021 down to 2,340 in 2Q2021.In Sydney, completions over the end of 2020 and the beginning of 2021 are projected to be between 4,700 and 5,700 per quarter.

These figures suggest less than a third of the peak supply of apartments will be completed in Melbourne next year, and almost a quarter in Sydney, which will allow the stock of unsold apartments to be absorbed and the residual stock facilities to be repaid within the year.

Construction loans will typically provide investors with returns between 10-15%, while the residual stock facilities provide a running yield of 7-10% due to the lower risk profile. The Partners Fund currently has a small exposure to residual stock facilities and we expect this to increase moderately over the short term to become a small but important part of the portfolio.

As absolute return investors, we are focused on overall risk-adjusted returns of the Partners Fund. The contribution to the risk-adjusted profile that these facilities provide, as well as the diversification benefits, makes the addition of residual stock facilities a compelling strategy .

During October we added the Arthouse residual stock facility to the Partners Fund. This facility had the added benefit of an interest guarantee from the sponsor. Our opportunity pipeline includes a number of further residual stock opportunities and we expect to increase our exposure to the sector due to the positive and beneficial impact they have on the risk-adjusted return profile of the Partners Fund.