Lord, Grant Me Prudence
Thoughts on why we, at Harbour Credit Partners, are keeping our deal parameters narrow (for now)
Over the past few months, we have seen a familiar story unfold across credit markets: risk premiums are compressed, and the dispersion of returns across strategies is narrowing. In plain English, lenders are being paid less to take on more risk, and everyone’s returns are starting to look uncomfortably similar – regardless of strategy or asset type.
Using the U.S. listed credit markets as a proxy (given the lack of depth in Australia), we have seen persistently tight spreads between investment-grade and high-yield credit over the past year. This same trend is now mirrored in private markets.
In real estate debt specifically, we are observing a striking compression of risk premiums across transaction types and leverage points. Deals at 75.00% LVR are priced almost identical to those at 60.00% LVR, despite the heightened risk. Likewise, development sites, despite their volatility, complexity, and illiquidity, are attracting little to no premium. While a modicum of risk premium remains, it is immaterial in many cases. And that leads us to the core question: are we being adequately compensated for the risks we’re taking?
To answer that, we return to first principles.
Our Risk Lens
Harbour Credit Partners (HCP) evaluates real estate credit risk through four primary lenses:
Appraisal risk – How confidently can we determine what an asset is worth today?
Market volatility – How likely is that value to change dramatically in the short to medium term?
Complexity – How many moving parts must be managed for the borrower’s exit strategy to play out?
Illiquidity – If we need to enforce our security, how difficult and time-consuming will it be to recover capital?
We apply this framework to each deal to determine whether the reward justifies the risk. And right now, in too many cases, our conclusion is that it does not. A good example of our current state of prudence is a form of security that we avoid in the current market environment, as illustrated in the next section.
Case Study: DA-Approved Land
We are sometimes asked why our Diversified Mortgage Fund doesn’t accept development sites – even those with DA approval – as security. The argument is often framed as follows: “It’s DA-approved! Surely the site’s value is underpinned by its highest and best use!”
Let us test that logic within our risk analysis framework.
Appraisal Risk
Sites are typically valued on a “comparable basis” using $/sqm of buildable area (GFA). But this methodology relies heavily on what others have paid in recent transactions, thereby introducing a problematic assumption: that the entire cohort of buyers made rational decisions based on accurate, conservative inputs. We simply do not know what cost estimates, sale price assumptions, or profit margins underpinned those past purchases. It is a lot of blind faith to put in other developers’ spreadsheets.
Market Volatility
Land values, especially for development sites, can be far more volatile than the value of completed real estate. Take this simplified example:
| Category | Amount | % of Total Costs |
|---|---|---|
| Land Price | 7,000,000 | 36.49% |
| Planning Costs | 600,000 | 3.13% |
| Construction Costs | 10,000,000 | 52.13% |
| Finance Costs | 1,267,200 | 6.61% |
| Holding Costs | 315,000 | 1.64% |
| Total | 19,182,200 | |
| Projected Net Realisable Value | 23,393,500 | |
| Project Profit | 4,211,300 | |
| Development Margin (Profit / Cost) | 18.00% |
A site is bought for $7.0 million with the goal of developing apartments expected to sell for $23.4 million.
To achieve an 18% development margin, the land cost makes up about 36% of total costs.
If the finished apartment prices drop just 10%, the developer would need to reduce land costs to $3.9 million to maintain the same margin—a 44.61% drop in land value. This is demonstrated below:
| Category | Amount | % of Total Costs |
|---|---|---|
| Land Price | 3,877,269 | 20.21% |
| Planning Costs | 600,000 | 3.13% |
| Construction Costs | 10,000,000 | 52.13% |
| Finance Costs | 1,042,363 | 5.43% |
| Holding Costs | 1,744,771 | 9.10% |
| Total | 17,264,403 | |
| Projected Net Realisable Value | 21,054,150 | |
| Project Profit | 3,789,747 | |
| Development Margin (Profit / Cost) | 18.00% |
This suggests land can be 4.4x more volatile than the finished product (without factoring in any increase in required margin due to market uncertainty!)
Complexity
Valuing a completed home is straightforward. Valuing a development site is not. It is an exercise in stacking uncertain variables: build costs, sales timing, absorption rates, interest rate trajectories, and more. The more inputs you rely on, the more room for error.
Illiquidity
Completed homes typically sell within 90 days under most market conditions (there are numerous exceptions to this which we remain conscious of). Development sites, on the other hand, can sit on the market for months—or even years—especially in a downturn. This is exacerbated further by the often-required long settlement terms required by developers to secure finance and engineer better financial return metrics on the transaction. These dynamics hamper our ability to recycle capital or reposition the portfolio quickly in response to market shifts. In credit portfolios, reduced flexibility equals increased systemic risk.
Considering these elevated risks inherent to the collateral, we would expect to see a significant risk premium introduced for loans secured against the ‘as-is, highest and best use’ of a property. However, this is almost universally not the case.
If not now, then when?
The above commentary is not a blanket dismissal of all development exposure or land loans. But it is a call for prudence. Right now, the risk-adjusted return profile of loans against development sites or land is not compelling, in our view, as the risk premium relative to loans against completed properties does not sufficiently compensate for development risk.
This landscape could change. Markets move. But until they do, we are content to remain patient.
To be clear, we are not criticising developers or those who finance development sites and construction. There are experienced players who execute very well in this space. But we believe that if you are not being sufficiently paid for the risk involved, then the risk holds no value for your investors – and should be avoided.
… But Lord, Please Hurry!
Risk premiums continue to be compressed at higher leverage points. Our response? Don’t chase. Instead, HCP is competing where we believe pricing best compensates for the risk adopted – on low-leverage, low-volatility assets.
This might mean slightly lower near-term returns (in an absolute sense) for our portfolio. But over time, we believe this approach will deliver superior risk-adjusted performance. In a market that seems to be forgetting the difference between “return on capital” and “return of capital,” we are choosing the latter.
As the perennially thoughtful Howard Marks has expressed, when the pendulum swings back – as it always does – we will be ready.
About Harbour Credit Partners
Harbour Credit Partners is a Sydney-based private real estate loans manager and a joint venture with the IJD Group, our capital partner. Wholesale investors are eligible to coinvest in specific loans settled by the HCP investment team in the Harbour Credit Partners Master Trust (funded via the IJD Group’s balance sheet), or to invest in a diversified pool of underlying loans via the Harbour Credit Partners Diversified Mortgage Fund.
For a complete list of HCP’s current active loan portfolio (including those opportunities where the capacity available to external investors has been exhausted), please access the following link:
https://harbourcreditpartners.portal.agorareal.com/#/public/offerings
Please contact Jonathan Goll, Head of Investor Solutions, with any questions or comments that you might have, or should you need assistance with setting up an account and applying for investment with the firm.
Jonathan Goll
Head of Investor Solutions
M: +61 438 082 247
E: jgoll@harbourcreditpartners.com
Level 5, 131 Macquarie Street, Sydney NSW 2000
harbourcreditpartners.com
Any information or advice contained in this newsletter is general in nature and has been prepared without taking into account your objectives, financial situation or needs. Before acting on any information or advice in this newsletter, you should consider the appropriateness of it (and any relevant product) having regard to your circumstances and, if a current offer document is available, read the offer document before acquiring products named on this website. You should also seek independent financial advice prior to acquiring a financial product.
All financial products involve risks. Past performance of any product described in this newsletter is not a reliable indication of future performance.
Harbour Credit Partners Pty Ltd is the Investment Manager of the Harbour Credit Partners Master Trust. It holds a Corporate Authorised Representative authorisation CAR No.001308393 from Quay Wholesale Fund Services Pty Ltd (Quay) (AFSL No. 528 526). Harbour Credit Partners Pty Ltd also holds a Corporate Authorised Representative authorisation from Quay allowing it to provide General Product Advice.