The private credit market in Australia has grown exponentially over recent years, with some estimates putting the total value of allocations to that asset class domestically at close to $200 billion. Globally, the figure could be about $1.5 trillion.
As an asset class, private credit has a long history, but it has only been in more recent times it has been somewhat ‘democratised’ to provide easier access for retail and self-directed investors, including SMSFs.
The attractiveness of private credit is easy to understand: solid risk-adjusted returns, liquidity, diversity and access to previously inaccessible markets. For many investors, private credit offerings, like our CFMG Capital Monthly Income Fund (MIF), have become an attractive alternative to investing directly in property.
But it is worth considering the differences between the two property investment avenues to understand how they can fit in your portfolio.
Structure
Direct property is a relatively well-understood investment. You use equity and debt (from a bank) to buy a property that is rented out to a tenant, with the rent used to cover your loan repayments and costs (levies, insurance, management fees, tax rates, utilities and the like).
If there is any left over at the end of the month, you get a distribution. If the investment costs exceed the rental income, you will have access to some tax benefits (negative gearing), but generally won’t receive a distribution. When you decide to sell the property, you will get a capital gain or a capital loss. After you have paid taxes, your total return can be calculated as a mix of yield and capital growth.
Private credit is a bit different. As an investor in private credit you have an interest in a loan made to another party to undertake investment or development activities, mainly in the property sector. While CFMG Capital’s MIF is unique in that its underlying investments are focused on land development, the structure is not unusual. It is an open-ended pooled managed investment scheme, which means investors will have an interest in the benefit of construction loans made to the developer of individual new residential communities.
Once the land has been developed and sold to buyers, the loan to the developer is repaid to MIF investors. The loans are secured by first mortgage securities over real property, so MIF investors have priority over all claims on a property if the project is not completed and the loan defaults.
Returns
In Australia, the average long-term growth rate of residential property is about 6 per cent a year, with poor-performing investments probably closer to 4 per cent and good investments probably closer to 9 per cent. There are, of course, outliers to these numbers with capital growth, rental returns, changing tax environments and other variables impacting the overall return. The return from a direct property is made up of the rental yield and the capital growth.
One of the key benefits of private credit is the returns on offer. The nature of the lending and the associated risks mean borrowers are often willing to pay higher interest rates.
CFMG Capital’s MIF commenced with a targeted annual return of 8.25 per cent (net of all fees). Across the private credit universe, there are funds with higher targeted returns and funds with lower targeted returns. MIF’s target return is reviewed monthly and may increase or decrease depending on the performance of the underlying loans and the requirements of the borrower.
Liquidity
Liquidity provides one of the key differences between direct property investment and private credit investment.
Once you buy a property, you are pretty well locked into the entire investment for the life of the investment. You buy and sell the whole property depending on your rental agreements; the period for liquidating your investment could be 60 to 90 days by the time you vacate the tenant, market the property and wait for settlement. This assumes your tenant’s lease is up. If they have a long-term lease, you will have to wait until that expires before starting the selling process.
Private credit is generally a much more liquid investment. The MIF allows unitholders to request a partial or complete withdrawal of their investment at any time after an initial 12-month investment period.
MIF withdrawal requests lodged seven business days before the end of each month will be paid 20 business days into the following calendar month (subject to meeting the withdrawal terms contained within the constitution and the product disclosure statement). This means investors can access the cash in about 27 business days.
Fees
The costs and fees of managing a direct investment include borrowing costs (if leveraged), direct costs to third parties and your own personal exertion. As a direct investment property owner, you will generally manage the investment yourself. You will need to find and manage the real estate agent to oversee the property, including finding a tenant, undertaking lease negotiations, doing regular inspections and managing maintenance. As the owner, you will also need to keep track of loan repayments, rates, levies, taxes, insurance and many other responsibilities.
Private credit investors pay the manager a fee to manage the investment in its entirety, which is a much more ‘hassle-free’ investment. For the MIF, CFMG Capital is paid a yearly management fee of 1.1 per cent of the funds invested, while administration costs are expected to be around 0.55 per cent a year of the funds invested in the trust.
CFMG Capital also charges an asset identification, fundraising and structuring fee of up to 4.4 per cent of the funds raised by the issue of units, which is payable to the responsible entity from the trust assets upon the issue of units.
Interest rates
As we have learned over the past few years, interest rates change and they can go up and down. These changes can impact the overall return of an investment, particularly if it is heavily geared.
For a direct property investment, the investor will have to make higher repayments as interest rates go up. They may be able to cover some of this rise by increasing the rent. If rates go down, they will get the benefit of lower repayments.
For private credit investors, the impact is a bit more complex. Investors are essentially providing credit to other parties. But credit is a competitive market. If interest rates fall, borrowers will seek to source finance at the lowest possible rate. In this case, investors will have to lower their expectations about the targeted return to ensure they remain competitive.
Risk
Risk is always a critical component of any investment.
For direct property investment, the key risks are associated with changing interest rates, changing tax environments, as many Victorian property investors have learned recently, and tenancy risks, including damage and vacancy and capital risks if markets fall.
For private credit, the key risks are associated with borrower default, which MIF mitigates by only lending when a first mortgage secures the loan, market risks related to changing market conditions that impact the borrower, distribution changes when interest rates change and liquidity risk.
As you can see, each type of investment has pros and cons, and it is important to consider which is best for your investment goals.
Andrew Thomson is general manager of CFMG Capital.