Qualitas Real Estate Income Fund (ASX:QRI) Co-Founder and Group Managing Director Andrew Schwartz and Director, Real Estate Nick Bullick present a quarterly review of the company.
Andrew Schwartz: Hello. I'm Andrew Schwartz. I'm the Co-Founder and Group Managing Director of Qualitas, and I'm here today to present the QRI September Quarterly Review. I'm joined by Nick Bullick, a director in our real estate group. And Nick has point responsibility for QRI as head of our fund. Nick will shortly take you through a more granular portfolio update.
At Qualitas, we are experiencing a very strong pipeline, and this is happening, interestingly, at a time of a re-emergence of lenders, who were somewhat quiet over the COVID period. On balance, we are seeing quite strong liquidity in the financing market for real estate loans. And interestingly, unlike the last period, where I reported having significant dry powder, we are now fully allocated in the fund again, reflective of our increasing confidence in the sector and the very strong pipeline we are experiencing.
Over the last quarter, we wrote nine new loans at net $56 million of allocated and deployed capital. We are seeing increased investment loans, including being under review of several mezzanine opportunities for consideration, as we feel now might be the right time to consider the introduction of mezzanine loans. Pleasingly, during the quarter, we achieved a 6.23 per cent per annum net return. And over the last 12 months, we have earned a 6.1 per cent per annum net return, and our average distribution was 6.02 per cent per annum during the COVID period. We met our goal of providing regular monthly income to investors. Our portfolio is performing particularly well. We have no impairments and no arrears since the IPO. As of the current date, we remain highly invested in senior loans, and our NAV remains at $1.60, being the IPO price.
I would now like to take the opportunity to talk more about the CRE debt market and some of the themes we are experiencing at the moment.
So, post-COVID, we are definitely seeing a position where the CRE debt markets and conditions have begun to stabilise, and COVID-19 is now much better understood in terms of its effects on various sectors of the market. I will shortly talk about those sectors. The cost of capital is at historical lows, which in itself encourages people to participate in the real estate market and also continues to provide underlying support to values. We are also continuing to see the trend of banks credit-rationing in terms of the real estate sector, providing ongoing opportunities for alternative lenders to participate. Our pipeline remains robust, but what we are seeing is competition across all asset classes, but on balance, we feel that the pricing of our loans remains favourable.
I would like to take this opportunity to present a sector performance and outlook. I'm going to start with a macro analysis pointing out the various tailwinds and headwinds being experienced by the market, and then provide a short summary in respect of our view in terms of various sectors of the real estate market. Of course, no one has a perfect crystal ball, and this is a Qualitas best view as to what is currently prevailing.
So, in terms of tailwinds. Obviously, low interest rates is providing a significant boost to real estate values, making it more enticing for investors to participate in those markets. And thankfully, we've seen a significant fiscal spend by government in respect of programs such as the JobKeeper program. However, there are headwinds for the markets as well, and those headwinds include significant reduced migration estimates, now negative estimates for the next 12 months and the year after, and also the potential for short-term oversupply in the residential markets.
So, taking that and looking at each of the various real estate sector markets, we make the following further observations. Firstly, in regards to residential, we are seeing buoyant conditions for those loans that are secured by residual stock. And what we are seeing is much of that residual stock is selling in an orderly manner in the established markets, particularly in Sydney. We do think that with reduced migration, there is the potential for oversupply in the residential market over the next two to three years. However, most of the estimates we've reviewed do show migration bouncing back in a V-shaped type recovery, looking out to 2024, 2025. We expect to see much higher levels of migration at that time, which will occur at a time the market was caught short on new construction activity.
Industrial appears to be a winner of the COVID crisis. And what we are seeing is that industrial is benefiting from logistical players, particularly off the back of more online retail. We think office has a neutral stance at this point of time. Post-COVID, we can see more moves into suburban office markets and a greater level of appetite for work from home. Both of these factors will be offset by the need for higher density due to social distancing, and we believe that, on balance, this will create a more neutral outcome for office. We do think the more challenged sectors will be retail and accommodation, hospitality, and short-to-medium term, they appear to be challenged, but with repositioning, this should provide some opportunities for debt investment in future years.
In terms of what this implies for our market positioning, we continue to write significant investment loans and residual stock loans. We are comfortable because we can see good liquidity in the market. And we can see developers not getting stuck holding stock, but instead are able to sell down in an orderly manner. We continue to look for construction loans, particularly in situations where those construction loans have been pre-sold and where we deem the market risks to be acceptable because of the pre-commitments. We are seeing an uptick in both senior and also now mezzanine-based construction activity. And we think that some of the banks in particular appear to be looking to restart their focus on the debt market and construction market. And, therefore, borrowers are choosing to maintain bank relationships, and therefore are looking for mezzanine in order to get the benefit of an extended debt package. We continue to look at land loans on the basis that we believe that housing will continue to prosper over the medium term to longer term, and where we can effectively provide a land bank to borrowers who have strong credibility.
Looking to the fund performance, our target return is RBA cash rate plus 5 to 6.5 per cent per annum. We are currently achieving a mid-rate of 6.23 per cent per annum. We are achieving that mid-range, but as noted earlier, we're currently very underweight mezzanine, and we are currently looking to fill that position. On the bottom of page eight, you will see our returns, and Nick will present this in more detail in his part of the presentation.
In terms of trading performance for the quarter, we traded under NAV, but pleasingly, over the last few weeks, we have traded much closer to our NAV. We hope that this is because investors can see the transparency of our model. They like the simplicity and enjoying the relatively solid yield that QRI derives. We remain committed to ensuring, to the maximum extent possible, QRI trades close to NAV. We did undertake a buyback in the June quarter, but buybacks were limited mainly because QRI continues to have a strong pipeline of transactions that provide accretive returns to the fund.
As I said earlier, through QRI, we created a highly transparent and simple fund to understand. Our loans are recorded at cost less impairments, which we deem necessary. But as I also stated earlier, we have no impairments since the date of the IPO. Loan asset reviews are conducted by the manager on a monthly basis. And to the extent we feel warranted, selective loans may be reviewed on a more frequent basis if necessary. We now report NAV on a weekly basis. It is important to note that all our loans are bilateral, which means Qualitas is the sole lender and we don't participate in syndicated loans, traded loans or secondary loans. We hold all our loans to term. As a result of that, it's impossible to undertake a mark-to-market, as there is no secondary market for loans or secondary pricing upon which to benchmark a mark-to-market re-valuation.
In this regard, we deem asset impediment testing as the correct methodology for measuring NAV at any point in time. We don't undertake a general loan provisioning reserve, on the basis that each and every loan is individually assessed for impairment. And therefore is not a portfolio approach, but rather an individual loan by loan approach. We have no foreign currency risk. All loans are denominated in Australian dollars. So we have no foreign currency translation reserve. There is no current fund leverage, and this contributes to a stable NAV because there is no increased risk on assets from leverage.
In terms of our review of impairments, we have no arrears in QRI loans. And we do know that Arch had one arrears of a relatively minor amount of 1.14 per cent of the portfolio. This has since been cleared, so currently Arch has nil arrears.
In terms of assessing our impairments, we have significant equity buffering on our secured properties. Most of our loans contain sponsor guarantees and interest reserves. And we undertake very regular revaluation of our security.
Before I hand over to Nick, I would like to reconfirm our manager commitment to sustainability. Qualitas has made a public comment to sustainability. We created a sustainability policy in February 2020, which is available on our website. An ESG review now forms part of every investment approval that we undertake. Qualitas is a signatory to the UN Principles of Responsible Investment and a member of the Investor Group for Climate Change.
I will now hand you over to Nick, who will take you through more details of the portfolio.
Nick Bullick: Thank you, Andrew. My name's Nick Bullick, and I'm a director in the Qualitas investment team, and I'll be presenting the QRI portfolio update for the quarter.
We've demonstrated disciplined construction of the portfolio, having met all QRI constraints across security ranking, investment type and geography, as well as other internal targets set by the manager. From time to time, we the manager set additional portfolio targets based on our current risk appetite and reflective of the CRE debt market conditions. Currently, that is to have no more than 40 per cent and 25 per cent respectively in land loans and construction loans, and at least 30 per cent in investment loans. In the current market, we believe it is prudent to have lower levels of land and construction loans and a higher level of investment loans, which give the fund an increased certainty of monthly income. The portfolio is currently underweight mezzanine loans. However, we are feeling more positive about mezzanine opportunities, which I will elaborate on later.
In order to provide further flexibility to reposition the portfolio to invest in direct loans, we are seeking to redeem 44.4 million worth of units in the Qualitas Senior Debt Fund, which if accepted, would reduce the trust investment in this fund to 39 million, and is likely to occur in or around January. The redemption strategy seeks to further increase transparency to unit holders regarding QRI investments. As at 30 September, the trust capital is now fully allocated to investments that will settle in the upcoming months. During the quarter, the fund delivered annualised net return to investors of 6.23 per cent, which is a slight increase to the June quarter of 6.2 per cent.
Whilst remaining predominantly invested in senior loans since the IPO, the manager has recently repositioned the portfolio to invest in improved risk-adjusted opportunities, taking advantage of current market conditions. Since the beginning of this year, we began increasing our investment loan exposure, which has increased from 23 per cent in June to 39 per cent in September. Land loan exposure has dropped from 39 per cent of the portfolio to 28 per cent, and construction loan exposure has dropped from 13 per cent to 11 per cent as loans repay as scheduled. Investment activity comprised of four new loans settled and five loans extended. This resulted in an increase of QRI loans to a total of 35. Weighted average LVR of the portfolio has decreased to 60 per cent as a result of increased investment loans with lower LVRs.
The portfolio is predominantly weighted towards residential, which we feel is appropriate at this point in the cycle. The portfolio is currently 58 per cent located in Victoria and 41 per cent in New South Wales. However, we expect this to even out through the next few quarters based on the current mandated pipeline.
QRI's interest revenue continues to be 98 per cent cash paid, all paid in advance, supporting our cash distribution to investors. A large portion of loans are backed by sponsor group cashflow, and we currently have no loans in arrears or impaired. As mentioned previously, our investment loan exposure has increased and now makes up 39 per cent of the portfolio. The majority are secured by income-generating tenanted buildings, with the remaining consisting of residual stock loans secured against completed unsold residential dwellings. During the quarter, we settled four new investment loans totalling $67 million. We are seeing residual stock loans repay faster than expected in Sydney. And we are seeing the weighted LVR come down to 61 per cent off the back of new loans at lower leverage and scheduled amortisation payments.
Our construction loans continue to perform at this point. However, the manager is closely monitoring the impact of stage four lockdown in Victoria. There are potentially some loans that may need to be extended due to builders seeking extension of time to complete the developments. We feel comfortable with extensions given the weighted LVR of the construction portfolio is a moderate 51 per cent. The weighting to land loans has reduced from 39 per cent last quarter to 28 per cent this quarter due to repayments, and this liquidity was recycled into investment loans.
The key portfolio observation I'll point you to is that the current weighted LVR is 63 per cent in land loans, and the average loan term remaining is approximately four months. We see this as a positive, as it allows the manager to seek an updated valuation before any extension is considered.
We now have only one mezzanine loan in the portfolio after one loan was repaid in full this quarter. The remaining project is tracking on time and on budget. As mentioned in our construction loan update, we are closely monitoring the project delays as a result of extended Melbourne lockdowns. However, any cost escalation will need to be borne by the borrower. We are currently mandated on a new mezzanine construction loan, and subject to investment committee approval, we expect this loan to settle in November. The manager is seeing an increase in demand for mezzanine funding as banks continue to seek high presale levels coupled with reduction in LVRs. We believe this is an opportunity for the fund in the near term.
The Arch notes underlying diversified 200-plus loan portfolio overall is performing with very low interest arrears, which maxed out at 1.14 per cent, which was attributed to one loan. However, this is now nil as of the date of this release. The Arch note investment continues to be attractive given its monthly cash income and portfolio diversification benefits.
Thank you. I'll now hand back to Andrew to wrap up the quarterly update.
Andrew Schwartz: Thank you, Nick. In closing, QRI is well-positioned to continue to deliver attractive risk-adjusted returns and monthly cash income to investors. We will ensure that we remain vigilant during this period of time, particularly against the backdrop of continuing COVID-19 risks. Strong pipeline allows us to be choosy with our investments and allocate only the best risk-adjusted deals to our portfolio. We anticipate continuing strong pipeline as we move through the busiest period of the CRE debt market, leading up to the Christmas and new year period.
Thank you for your time. Wishing everyone well. That concludes the presentation.