Australia’s Consumer Price Index (CPI) jumped 6.1% this week, the fastest pace in 30 years. The rise is largely due to higher petrol prices and ongoing increases in food, housing, and energy costs. In response, the Reserve Bank of Australia (RBA) is expected to raise interest rates again, with predictions of a 50-basis-point hike and further increases each month until the end of the year.

With inflation eating into asset values and future returns, investors are reshaping their strategies. Many are focusing on areas like energy, inflation-linked bonds, commodities, and floating-rate debt to weather the storm. But there’s one niche sector that’s thriving in this environment: commercial real estate (CRE) debt. Craig Bannister, co-founder of Pallas Capital, a specialist lender, highlighted this at The Inside Network’s recent Income and Defensive Asset Symposium.

After the Banking Royal Commission, tighter lending rules forced banks to scale back, leaving a gap in the market. Non-bank lenders like Pallas Capital stepped in to fill the void. While CRE debt is one of the fastest-growing asset classes in Australia, it’s still relatively small compared to other developed markets.

“The Australian CRE debt market is currently worth $400 billion and is expected to reach $500 billion in the next few years,” says Reuban Sivarajasingam of Pallas Capital. “Banks dominate 95% of this market, compared to a global average of 50–65% for non-bank lenders. There’s a huge opportunity for growth.”

Non-bank lenders offer a compelling proposition. While bank construction loans usually come with interest rates between 4.5% and 6%, non-bank lenders charge 8–9%. This higher return is possible because non-bank lenders are more nimble, flexible, and maintain closer relationships with borrowers.

“By using institutional capital, we can lower costs for borrowers while still delivering strong returns for investors,” explains Sivarajasingam. Non-bank lenders also approve loans faster, which can significantly boost borrowers’ returns.

The CRE debt market has three main segments: loans under $3 million, dominated by smaller lenders; loans over $50 million, mostly handled by banks and large institutions; and the middle market, covering loans between $3 million and $50 million. This middle segment is where non-bank lenders thrive, offering flexible, full-recourse loans to small and medium businesses backed by real estate.

Despite market volatility, CRE debt has proven to be resilient, historically delivering annual returns of about 8%. Bannister explains that this is because borrowers typically pay interest rates of around 10%, with investors receiving a healthy slice of that. Non-bank lenders also keep things conservative, with loan-to-value ratios (LVRs) capped at 65% for first mortgages and up to 75% for second mortgages, ensuring a strong equity buffer.

“Property values might fluctuate, but with a 35% equity buffer and conservative LVRs, we’re well-protected,” Bannister says. “Our approach allows loans to mature or refinance within a year, giving us the flexibility to reinvest into new opportunities.”

The CRE debt market has been growing at a steady 5.45% annually since 2004, with non-bank lenders expanding at an even faster 10% per year. Bannister concludes, “In this challenging market, it’s all about being selective and finding the loan opportunities that offer the best balance of risk and return.

Visit Pallas Capital: https://www.pallascapital.com.au/ to explore opportunities and speak with our team of experts

Source: https://insideadviser.com.au/tailwind-for-private-lending-is-just-beginning-pallas-capital/