A follow up commentary on how another simplified and generalised concept deserves much more consideration.

Don’t the hours grow shorter as the days go by?
            You never get to stop and open your eyes
            One day you’re waiting for the sky to fall
            The next you’re dazzled by the beauty of it all

             When you’re lovers in a dangerous time …

What do Bruce Cockburn’s lyrics about young love blooming against a backdrop of the Cold War have to do with one of the key risk metrics associated with the world of private credit?  Nothing.  But who are we to resist that time worn tradition of starting an investor update with a song lyric, let alone do so when the opportunity exists to simultaneously take advantage of the similarity of the word “lovers” with the acronym “LVRs”?

And yet, while perhaps a stretch to refer to it as a “danger”, it is to the prospective detriment of an investor’s financial results to misinterpret the Loan-to-Value Ratio (“LVR”) associated with a lending opportunity.  In the HCP Monthly Insights piece “A Rose By Any Other Name …” (HCP Insights 007 — Harbour Credit Partners), we studied the common use of the term First Registered Mortgage.  We now turn our attention to the homogenous way a loan’s LVR – the fraction of the underlying collateral’s value that is being extended to a borrower – tends to be interpreted.  Given that the LVR is frequently (and sometimes exclusively) used as a measure of the overall risk of one loan compared to another, understanding any nuances helps to normalise this metric and make this comparison a more sensible one.

As was referenced briefly in our most recent HCP Monthly Insights piece, there tends to be four common ways in which the value of a collateral property is derived:

1. “As is” (based on Current Use)

2. “As is” (assuming the Highest and Best Use is to be redeveloped into [X])

3. On an “As if Complete” basis

4. On a “Going Concern” basis

In navigating this list from north to south, the complexity of the valuation, and therefore the probability of error, increases – particularly with the latter two where the performance of the borrower/sponsor comes into play – thereby increasing the volatility of the commensurate LVR calculation.

This is important, for a loan’s LVR is intended to provide a measure of comfort – to borrow parlance from the world of equity investing, it is widely interpreted as the “margin of safety” embedded in a loan. If a lender caps the amount that they will extend to a borrower at a certain threshold – say, 65% of the value of the underlying collateral – the implication is that there would have to be a prodigious decline in its value to eat into the equity of the loan and prospectively cause a loss of capital to the lender.

Uncertainty in the calculation of collateral value erodes this margin of safety. In addition, there are several common presumptions made by investors and lenders alike that warrant interrogation:

Valuation is Mathematically Precise

Even when derived using the most sophisticated of financial models and via the application of bottom-up analysis using the most rigorous of assumptions, valuation is ultimately an exercise in human judgment – and yet this figure is often treated as being as inviolate as mathematical law. In the world of real estate, where HCP focuses its lending, there are undoubtedly firms with widespread experience and credibility, and there is a spectrum of believability when it comes to valuation reports. Irrespective, the introduction of more assumptions (such as building costs) and complexity (such as end use) makes the concluded valuation report of a collateral property more prone to deviation to its actual market clearing price.

Valuation Remains Constant

LVR is based on a point in time estimate of the valuation made under certain prevailing conditions. The reality is that not all assets can be readily sold with little to no modification, with immunity to prevailing market conditions, and/or independent of conduct or performance of the borrower/sponsor.

Default Does Not Impact Valuation

When an LVR is quoted, this reflects a loan performing. In such circumstances, the margin of safety embedded in an LVR is not all that consequential as there is no need to recover one’s capital. It becomes of preeminent relevance when a loan is in default, and so what happens to the margin of safety in these circumstances is key. The reality is that the collateral valuation, and the margin of safety assumed when a loan is first written, only stays reasonably constant when:

i) It relates to assets that can be readily sold with little to no modification; and

ii) The value of the asset is not contingent on the borrower performing its stated plan or complying with its obligations under the loan. 

Situations where the LVR is more likely to increase when a loan is in default include construction loans (given the lender relies on the borrower/sponsor to deliver the completion value) and loans to borrowers of operating businesses and operating real estate (which depends on the management team to maintain a baseline level of free cash flows).

That said, even the most conservative of loan types are not immune from the fragility of an LVR for a reason that we suspect is underappreciated by investors in this asset class: enforcement can be an expensive exercise.  A loan that is conservatively underwritten at an LVR of, say, 65%, and subsequently goes into default, could prospectively see the embedded equity significantly eroded by mounting costs associated with a lender exerting their rights upon a litigious borrower.  A starting LVR of 65% starts to encroach on 70% … 75% … 80%, even – and then, the risk of losing capital starts to increase if the clearing price of that asset is markedly different than the assumed valuation.

The current strategy of Harbour Credit Partners is to invest in short-term bridging loans backed by completed properties at modest LVRs, and so we think that this helps to reduce our exposure to many of the dynamics which bring the reliability of a loan’s LVR into question.  In particular, the value of completed residential real estate is agnostic to the actions or performance of a borrower (which is likely to have been poor if we are in a default situation), and we can sell the property in its current form given it is already completed.  Whilst HCP does, of course, assess borrower quality in its due diligence, this is done more in the context of mitigating default risk and avoiding the increased illiquidity that stems from defaults, as opposed to mitigating the risk of impairment of collateral value if the borrower fails to perform.

In more complex situations, where the valuation of the collateral is not done “as is” based on current use, we may look to other metrics alongside, or apart from, LVR to more accurately calibrate and identify the risks associated with these loans – a laundry list of which might be the subject of a future Monthly Insights piece. 

Irrespective, the reality is that LVR is an important credit risk metric but, at the same time, needs to be considered in the context specific to the underlying loan at hand.  This helps to improve the likelihood that this figure is most accurately capturing the degree of risk involved in a transaction.

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

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.