Investment Rates in the Non-Bank Sector

More and more borrowers are looking to non-banks for commercial loans in the wake of regulatory changes imposed on banks post the Global Financial Crisis (GFC). The products, pricing and terms of these loans are looking more bank-like as the major non-bank lenders scramble for market share. This shift in sourcing commercial loans has also been fuelled by the resilience of the property market as an underlying asset and the historic low cash rates. Increased competition is typically seen as a good thing, and will certainly help borrowers, but unfortunately it appears the investors might be sliding down the yield curve with lower returns if they want regular income from relatively secure mortgage-backed securities.

Defining Private Debt

Private debt, alternate debt or alternate credit, are terms used interchangeably to describe direct lending from a non-bank to a private or public company. Typically, this type of investment product is characterised by:

• Borrower and lender relationship governed by a contract;
• The term is limited to a short period;
• Investment is usually illiquid;
• The investor’s objective is income yield;
• The investor’s relationship to the borrower is governed by the mortgage manager and is typically indirect, through the purchase of units in a mortgage master trust or sub-trust; and
• Limited, if any, reporting throughout the investment term.

Risk-Return Profiles of Different Investment Strategies

Source: IHS Markit (2017) The Rise of Private Debt

Private debt is typically used to fund working capital, infrastructure or real estate development. Pricing and approval for each loan will be a function of the risk criteria but typically reflective of:

• Loan to value ratio (LVR): percentage of loan amount divided by the value of the property;
• Interest cover: quality and value of income from the asset or other sources that can be directed to loan repayments;
• Sponsor/ borrower: track record and balance sheet;
• Term: short term v long term;
• Repayment: interest only, principal and interest or capitalised;
• Exit: repayment strategy;
• Loan type: investment or construction; and
• Capital: source and availability of capital to fund the loan.

Growth of Private Debt

The private debt market has grown exponentially on the back of changes in the market dynamics between its participants:

• Banks: banks have reduced their commercial lending through the tightening of credit policies in response to regulatory capital requirements post GFC.
• Low bank interest rates: investors looking for stable, (relatively) secure income, diversification, (acceptable) risk adjusted income.
• Global recovery: investors looking to invest capital in an organised and regulated property and finance market.
• Finance brokers: aggregator groups accrediting non-banks on their lender panels giving non-banks greater reach to brokers and borrowers.
• Property market: sudden and sharp bounce back to pre-COVID-19 property values on the back of fiscal stimulus/ support to employees and first homeowners despite borders essentially remaining closed.
• Barriers to entry: relatively low barriers in terms of regulations and oversight for non-banks to set up and operate.

Is Non-Bank Credit Growing Faster Than Borrower Demand?

There are signs that the supply of non-bank capital may be outpacing demand.

• Mortgage bond market: there was a sell off of mortgage bonds early last year as the pandemic hit with spreads ballooning before investors rushed back into the market. As discussed in the TierONE Capital March 2021, article, property values remained resilient throughout 2020 and are almost back to the previous highs experienced in late 2017. Investors remain bullish around property as an underlying asset which has been evident with AUD$15 billion raised in mortgage bonds this year with spreads getting down to 73 basis points between the one month bank bill swap rate and the non-bank Australian residential mortgage backed securities and levels not seen since before the GFC.
• Capital mandates: We have also seen the growth of offshore investment houses recapitalising local non-banks allowing them to offer their clients strong income yielding mortgage investments.
• Recapitalising non-banks: Liberty Financials’ share price has increased by 33% since their successful float in December 2021; Resimac shares more than doubled in the last six months; and the listing of Pepper Money sometime later this year with AUD$15 billion AUM, which is 35% bigger than Liberty Financial, are all signs the market likes the future prospects of the non-bank lending segment.
• Capital raisings: The last six to twelve months have also seen several large non-banks successfully raise funds specifically for investment in areas such as “build-to-rent” that the banks appear less interested in supporting.

It has been recently forecasted that the non-bank lender share of the commercial real estate debt market is expected to surge over the next three years and hit more than AUD$50 billion by 2024. The local bank share of this market has decreased from 85% of the market to 71.60%, the lowest since the GFC and there is further expectation their share will fall to 65% over the coming years.

Yield Compression

Notwithstanding the characteristics of a loan, it is arguable that the price equilibrium, being an interest rate a borrower will pay, is likely to decrease given the increase in the supply of non-bank credit in the market. Given the increase in market participants (non-bank lenders, borrowers and brokers), this situation will likely push the price of debt down the yield curve to point of marginal inefficiency, with non-banks likely to consider other investment options to deploy their capital.

The graph below is a (simplistic) example of how increased supply of non-bank capital is likely to drive down lending rates and correspondingly drive reduce investor returns.

How Low Can Non-Bank Rates Drop?

We have seen non-banks advertising commercial loans as low as 2-3% above bank commercial loan rates with comparable fee structures. This is, of course, great news for the borrower but suggests ominous signs for investors chasing higher yields than current cash rates. Many of the non-banks are sitting on significant capital raised or mandated with the resultant cash drag likely biting deep into their target returns. It will be interesting to see how this plays out over the short to medium term and if we see any consolidation amongst non-banks and/ or if they follow the banks from 10-15 years ago and start locking in their distribution channels by buying into and taking equity in the finance broking networks and aggregator groups. I’m guessing the latter.

Kevin Said
Director, Chief Investment Officer
TierONE Capital