In the world of private CRE debt, the moniker "First Registered Mortgage" gets bandied about a lot - but are all loans secured by first registered mortgages built the same?

While Shakespeare’s Romeo & Juliet, from where we lifted the title of this Monthly Insights piece, features an ongoing feud between two warring Houses (that of the Capulets and the Montagues, respectively), any other connection to modern day real estate from this work is a stretch.  Irrespective, the Bard’s claim remains sound: that a rose would cause just as pleasant an olfactory sensation even if, as a collective, they were labelled “shoes”, or “dandelions”, or “barnacles”, rather than “roses”.

On occasion, investors have pushed back on the Harbour Credit Partners’ offering on the basis that our returns are too low – they are getting <insert low double digit target return here> on their existing exposure to a single loan, or portfolio of loans, secured by First Registered Mortgages.  Higher return for the same risk – sign me up!  Sadly, this is not how the world of investments tends to work – the devil in the detail lies in differentiating the nature of the property which is backing the first registered mortgage. In our view, such securities do not all smell just as sweet.

In differentiating the nature of property backing one mortgage versus another, three variables tend to stand out, although this list is by no means exhaustive: i) property type, ii) market/location, and iii) nature of the valuation of the property.

At HCP, most of our loans are secured by first registered mortgages against completed (largely residential) properties.  These tend to be situated in metro Sydney (within 25 km of the Sydney CBD), and we lend at modest LVRs (the weighted average LVR across our current active loan book sits at around 54%).  Importantly, this LVR is calculated on a valuation that represents an “as is” condition (i.e. no construction / redevelopment potential assumed).  Any lending that we undertake with features that fall outside these norms is priced at a level that accounts, in our view, for the incremental risk introduced by such nuances.  In terms of the three most common variables cited above, here is a bit more detail on each:

1. Property Type

At the highest level, a property can be classified as residential, commercial or industrial, and the risk associated with each of these broad categories will vary.  Completed residential properties (those which have an Occupation Certificate), where HCP tends to focus, are likely to be the least complex of real estate classes and claim the largest buyer pool (thereby making them the most liquid class).  That said, residential property can be further broken down into sub-categories such as houses, duplexes, townhouses, apartments, etc., all of which will impact on their valuation and liquidity.  Add in other dimensions – infill metro areas, subdivisions/land lots, development sites (whether pre or post DA) – and it becomes abundantly clear that different risk premiums should apply to each.  Instead, quite often, these material differences are masked by the “First Registered Mortgage” headline.

2. Market/Location

Metro Sydney has the largest buyer pool in the country, thereby also having the most depth of liquidity – this results in less errors in clearing price of an asset relative to valuation, as well as the lowest time typically required for sale of security and return of the secured creditor’s capital.  The quality of security associated with other locales will fall off with decrease in size (and hence prospective buyer pool), irrespective of the existence of a First Registered Mortgage.

3. Nature of Valuation

Herein is where the most significant complexities and associated nuances are likely to be found.  The adopted valuation that HCP applies in determining a lending amount is our best estimate of the clearing price for the security property if we had to sell the collateral tomorrow on an “as is” basis.  Frequently, the valuation applied, even to a property backed by a First Registered Mortgage, will be muddied by considerations such as the potential upon redevelopment, leading to riskier lending than our more straightforward valuation approach.

With these three summaries in mind, let us make a comparison to several other types of First Registered Mortgage which, in our view, should attract a risk premium over those backed by completed properties in a major metro centre – but which, in the current market environment, are not yielding nearly enough in our view to compensate for the additional risk involved.

“First Registered Mortgages over Residential Property in Bathurst!”

Even in a well-known regional centre such as Bathurst, there is a clear gap in terms of breadth of buyer pool and, consequently, depth of liquidity when compared to larger metropolises such as Sydney.  In accordance, a sufficient risk premium is needed to compensate for the combination of illiquidity risk as well as the risk of the clearing price failing to meet a property’s stated valuation in these regional centres. 

“First Registered Mortgages over a Residential Land Lot in Metro Sydney Valued on an ‘As Is’ Basis!”

A mouthful, perhaps, but one that, at first blush, may seem comparable to the collateral properties that typically feature in the HCP portfolio.  The question is around the term “as is”, and whether this translates into the property’s highest and best use – a freestanding home that currently sits on the land might be an inferior proposition to the development of a block of townhouses or duplexes.  Valuing the property on this highest and best use reduces the liquidity profile (as the buyer pool principally becomes developers rather than owner occupiers) and adds complexity to the valuation given a dependence on the developer’s operating cost base and ability to source financing.  All of these added complexities lend themselves to a (prospectively) sizeable risk premium, one that we do not commonly see in the current market environment.

“First Registered Mortgages over Freehold Operating Pubs!”

The implication of this security type is that the collateral real estate has an operating business attached to it; as such, the performance of the operating business is also linked to the value of the real estate.  Consequently, the lender is bearing operating business risk.  If the operating business is not doing well then, in the event of a default, the lender would potentially need to turn around the operating business before being able to sell the security property at the same valuation against which the loan was made, introducing uncertainty over repayment, timing, let alone if the lender has the operating business experience to achieve a turnaround, etc. – all factors that should earn a risk premium. In addition, this security type is less liquid when compared to, say, a residential property as the buyer pool becomes mainly pub operators or specialist pub investors.

The above illustrations focus on differentiating features such as type of property, location, and nature of valuation – to say nothing of other variables such as the length of the loan term, the degree of leverage (ie. magnitude of LVR), or whether the associated interest rate is fixed or variable in nature.

In our view, the problem is the phrase “First Registered Mortgage” (or “Senior Secured”) creates the implication that the loan is backed by a tangible asset that can be readily sold with minimal effort or modification to the asset, and within a fast timeframe to recover capital.  In many cases, this is not the situation – and yet often the pricing associated with these loans would imply that there is de minimis risk premium currently on offer for these more complex opportunities.  At Harbour Credit Partners, we continue to believe that the best risk-adjusted returns amongst the broader CRE debt ecosystem writ large, at this point in the cycle, is in loans secured by completed properties in major Australian cities at conservative LVRs – and will continue to allocate our clients capital towards these loans until that landscape changes. 

About Harbour Credit Partners

Harbour Credit Partners is a Sydney-based private real estate loans manager and a joint venture with a local single family office. Wholesale investors are eligible to coinvest in specific loans settled by the HCP investment team in the Harbour Credit Partners Master Trust, 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

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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.