Qualitas Real Estate Income Fund (ASX:QRI) Quarterly Portfolio Update, June 2020

Company Presentations

Andrew Schwartz, Group Managing Director and Co-Founder of the Qualitas Group, and Nick Bullick, Director, Real Estate, present Qualitas' June 2020 portfolio update.

Hello. I’m Andrew Schwarz, Group Managing Director of Qualitas, and with pleasure today I present the quarterly review of QRI.

Today I’m co-presenting with Nick Bullick, the director in our real estate investment group, who has portfolio responsibility for QRI.

QRI June quarter highlights

Starting on page 2, are the highlights for the June quarter. During the quarter we experienced:

  • A significant increase in deal flow and pipeline.
  • Mainly due to less competition.
  • Notably, it seemed as if there was a withdrawal of foreign lenders.
  • This resulted in increased pricing.
  • Over the quarter, we settled $62 million of new loans and extensions.
  • Our net deployment increased from 79 per cent to 86 per cent of trust assets, albeit we still hold $52 million of cash in QRI and its subfunds.

On page 3, we highlight that there was solid secondary liquidity in the market.

Post 30 June, QRI was repaid $35 million on a land loan, which equated to 70 per cent LVR for the incoming lender.

Notwithstanding, we continue to hold 14 per cent cash at balance date. We achieved 6.2 per cent return over the quarter, and 6.1 per cent for the previous 12 months.

Manager key focus

On page 4, the manager continues to heavily focus on capital preservation and continually reviews its portfolio in this COVID-dynamic environment.

Our model remains simple:

  • 33 loans.
  • We insure we know every borrower and each secured property.
  • We continually work with the portfolio to drive efficiency and achieve favourable returns.
  • It’s important to note that QRI has no third-party debt and is 100 per cent equity-funded by its unitholders.

CRE debt market - June quarter recap

On page 6, as the fallout of COVID continues to unfold, we can see both heightened risk and opportunity.

Compelling opportunities emerged as borrowers seek certainty amidst a pool of diminishing capital.

This improved our returns for similar risk profile.

Sectors where QRI has very limited exposure are retail, leisure, and hotels, reflecting the COVID fallout.

We are seeing strong demand for residual stock loans.

CRE debt market outlook

Turning to page 7, overall I would describe the last quarter as one where there was steady volumes, but our success rate and pipeline grew due to diminishing competition.

Pricing improved as borrowers sought capital certainty, and deal with known and trusted capital sources.

Target return

On page 8, we have made a decision to amend and restate our target return.

The amendment is to restate as a relative return as opposed to a fixed return.

The restated target return will be the RBA cash rate plus a risk margin of between five and 6.5 per cent.

This is the same risk margin as existed at the time of the IPO.

If we don’t amend our target return, it would result in QRI being forced to up the risk curve to achieve higher risk margins, which we do not believe is in the interest of unit-holders at this point in time.

Fund performance

On page 9, we outline the fund performance. It has been steady over the last three months at 6.2 per cent per annum, and over the last 12 months at 6.1 per cent per annum.

We need to keep in mind these returns were achieved during a period of the trust holding circa 15 to 20 per cent cash.

Loan reviews and impairment

On page 10, over the June quarter impairment testing continued, and no assets were deemed necessary for writedown.

There were no interest arrears.

The loan I noted last quarter as being subject of negotiation was recapitalised by the borrower and is now no longer considered in default.

Trading performance and NAV

On page 11, we show the trading performance and NAV for the trust.

The QRI unit price has firmed since its late March low. I believe that factors that may have contributed are:

  • Consistent monthly distributions.
  • More detailed information flow.
  • More frequent NTA disclosure.
  • All providing greater confidence, leading to more support.

Unit price discount to NAV

On page 12, we show a mathematical calculation to numerically demonstrate what it would take for the NTA to equal $1.50 (the current unit price).

In order for NAV to reduce to $1.50, this can only occur on a writedown of the receivables.

But the receivables are secured against assets, and on average have 38% of equity behind each loan.

We would need to lose 38% of the gross asset value plus more to impair the loan receivable.

We calculate the loss of asset value to justify $1.50 would be 42% of the secured property value. In other words, a $100 asset would need to have fallen to a value of $58.

To summarise, page 12 shows the mathematical relationship between unit price and the reduction in value of the secured property. It hypothetically allows investors to form a view as to whether a 42% reduction in property value is justified.

I am now turning over to Nick Bullick, who will present the portfolio in more granular detail.

QRI portfolio

Thanks Andrew. My name is Nick Bullick and I am a Director in the Qualitas Investment Team and I will be presenting the QRI portfolio update for the quarter.

Portfolio composition

We currently have 33 loans in the portfolio of which 99% are senior loans.

One hundred per cent of the portfolio is located in Australia and 85% is located in Qualitas' core markets of Melbourne, Sydney and Brisbane.

All loans are performing with respect to amortisation and repayment requirements.

We have a strong pipeline to deploy remaining cash largely focused on investment loans.

We have had a number of loans repaying progressively and had one full exit this quarter.

We are strategically repositioning the portfolio and this quarter investment loan exposure increased from 17% to 23%.

The weighted average LVR of the portfolio is on a downward trend, and has come down slightly from 64% to 62% since last quarter, driven by loan repayments on time and new loan valuations.

As Andrew mentioned, post 30 June we were repaid on a significant land loan exposure at LVR ~70% evidencing liquidity in the market.

It is our intention to continue to reduce weighting to construction loan exposure at this point in the cycle.

Interest servicing

QRI's interest revenue continues to be 97% cash paid or paid in advance, supporting our cash distributions to investors.

We closely monitor any non-payment of interest which is a default under the loan obligations.

We have no loans in arrears and take further comfort that interest income, is secured by personal or corporate guarantees over 98% of loans.

Senior investment loans

Investment loans make up 23% of the portfolio and of which the majority are secured against income generating tenanted buildings with the remaining consisting of residual stock loans secured against completed unsold stock from projects.

During the quarter we converted two construction loans to investment loans following successful project completion.

We also settled one new investment loan provided to an inner-CBD property.

We have a high weighting to the more favourable sectors commercial and industrial properties, which total 78% of investment loans.

Loan case study

I will now like to take you through an overview of an investment loan within the portfolio.

It is a residual stock loan provided to finance 90 recently completed residential apartments located approximately 3km from the Sydney CBD.

The loan funded at an LVR of 65%, interest rate of 7.25% and for a 24 month term.

What was attractive about this opportunity was the location and quality of the borrowers track record.

The location was undergoing significant urban regeneration with excellent access to amenities and transport routes.

Why this loan suits alternative lending is due to the non-income producing nature of residual stock loans and allowing the borrower early access to embedded equity.

The loan is performing well and all sale milestones have been met thus far.

In the current COVID-19 environment we will be closely monitoring both sales rates and prices, and the borrowers ability to continue servicing interest.

The transaction is a senior investment loan provided to refinance a construction facility, secured against ca. 90 completed residential apartments. Residual stock loans are sought by developers to gain access to development profit and equity tied up in unsold stock.

What was attractive about the investment?

  • Location undergoing significant urban regeneration, good access to amenities and major transport routes.
  • Top tier Australian based developer with 20+ years residential development track record.
  • Extensive security package to support interest servicing.
How did the Manager secure this opportunity?

  • Existing long term relationship (repeat client) and competitive terms.
  • Alternative debt opportunity due to residual stock not income producing and permitting further equity release (a portion of sales proceeds) when LVR is <55%.

What are the key risks that will be a focus for managing the loan during COVID-19?

  • Slowing sales rates and prices in more subdued market.
  • Sponsor group financial position to support interest servicing.

Senior construction loans

As mentioned, during the quarter we converted two construction loans to investment loans upon project completion.

For the remaining construction loans, their projects are still under construction, apart from one which has reached practical completion and will be calling for settlements in July.

We rectified a default in one construction loan which underwent a restructure and recapitalisation.

The intention is to reduce focus on construction loans at this point in the cycle.

Senior land loans

The weighting to land loans remains unchanged from last quarter at 39%.

I will highlight, post 30 June we were repaid on a senior land loan which has significantly reduced the land loan weighting on a pro-forma basis.

Mezzanine construction loans

Our mezzanine loan exposure has been reduced to 1% of the portfolio as a result of a project completing and significant repayments made.

The loan that reached project completion, the senior lender has been fully repaid and the loan is now at a conservative LVR 28%.

The other mezzanine loan in the portfolio, is secured against a project that is tracking on time and on budget.

We are starting to see increased opportunities for mezzanine loans at this point in the cycle.

Arch notes

We will now look at the Arch notes within the portfolio.

The note investment continues to provide benefits of cash interest paid monthly on investment loans only which are secured by completed income generating property.

The Arch loan portfolio with exposure to 219 loans also provides excellent diversification.

We have recently undertaken extensive bottom up stress testing of interest serviceability of the notes, having regard to COVID-19 risks. The position has not changed from last quarter in that approx. 30% of the Arch loan pool would need to be in default to impact interest paid to QRI.

I will now hand back to Andrew to wrap up our quarterly update.

Manager wrap up

Thank you, Nick.

In conclusion:

  • We are committed to capital preservation.
  • At balance date, we were holding 14% of trust assets in cash.
  • We achieved, for the last quarter, consistent returns of 6.2 per cent.
  • Over the last quarter, we experienced more favourable conditions and a growing pipeline.
  • We have no debt in our trust structure.
  • We retain dry powder to enable us to take advantage of future opportunities and conditions.

Thank you for taking the time to hear our quarterly review.


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