The private credit elephant in the room
There have been countless articles criticising private credit, but not many have discussed how we got here? The current predicament didn’t occur over night; and criticising the symptom without understanding the cause is futile.
The issue is now affecting some family offices and investors who have invested in certain private credit construction funds or who have directly funded individual construction deals themselves. Some of these Investors are now reporting to us that they are unable to withdraw their investments, haven’t received quarterly distributions and that they may need to wait up to a year to get their principal back.
Whilst poor decisions and greed by certain private credit construction fund managers may have contributed to the problem. The fact is that the compromised state of the economy was already written before some fund managers poorly deployed capital.
Let’s be clear, this is not reflective of all private credit funds, or private credit construction funds, however it is an issue facing all lenders to varying degrees.
Since Cov-19 we have seen Increased interest rates (capping how much end consumers can pay for property), increased construction costs, higher property taxes, supply chain issues, poorly thought-out projects by developers, a struggling Victorian economy, collapsed builders and the greed of investment managers. All of this came together to create the perfect storm that we are facing today.
To be more accurate, this isn’t just a reflection of private credit, it’s a reflection of the state of the broader Victorian economy.
In all of this is there is a valuable lesson, if one chooses to listen.
That is, just because the numbers stack up on paper to pass a credit committee, it doesn’t mean the perceived value and numbers will stack up for the consumer at the time of selling!
We go deeper below, and what all this means for private credit investors and the causes of the problem.
Why did the private credit elephant appear?
The reality is we know there is a problem in the Victorian property market, and even seasoned property developers are now asking for second mortgages, when normally they never would.
Even some of our family office clients that are in the property development game themselves, are advising us of difficulties in off-loading finished property stock. Whilst other family offices, are advising that they can’t make some property development projects feasible in the current environment.
So, where did the problem come from?
1.0 The cost of capital and lack of strong sales
As interest rates rose during the last four years from a RBA rate of 0.1% to 4.35% and now 3.6% (RBA rate guide here). The cost of borrowing increased for property developers and consumers!
For private credit funds, as rates rose this also meant they earned higher returns. However, the higher borrowing costs also meant that consumers had to pay more for their home loan and were caped in how much they could borrow due to higher serviceability requirements. This in turn put a cap on how much consumers could pay for completed stock.
What this meant in past and still till today, is that developers were unable to off load stock, which also meant their private construction credit fund lenders weren’t able to get their debt repaid on time. Which in turn inconvenienced investors, as they weren’t receiving their principal and distributions due to the delay in sales.
2.0 Cost of construction effect on private credit funds
Over the last 4 years construction costs spiralled out of control, with some estimates putting increases as high as a 33% from prior to C-19 (read more here). This had three core impacts on property developers, builders, private credit funds and their investors.
2.1 Project feasibilities for some new projects were destroyed
Several projects that seemed feasible before and whilst permits were being obtained, ceased to become profitable, as borrowing costs and construction costs rose.
This meant several property developers put projects on hold, or tried to off load these assets. Some private credit funds holding mortgages on these assets, either couldn’t get an exit on the expected maturity date (investor payments got delayed), or in a worst cases took a loss against the deteriorated asset value (or are still waiting for property prices to go back up) so the development becomes feasabile.
2.2 Construction projects underway
Construction projects that were underway, had several builders asking for more money or secretly breaking specification requirements to save on costs as their margins eroded.
In worst case scenarios, some builders simply shut down leaving developers and private credit construction funds with the reality of having to appoint new builders. This meant private credit funds and their developers, now had to find new builders who were also asking for higher prices, in turn eroding project profitability. This also impacted the degree to which private credit funds could recoup their funds (principal and penalty interest), and the timing of funds coming in from sales to repay investors.
In some instances, private credit funds will not realise the penalty ratees they’ve been charging due to the severe length of construction delays or at worst a possible principal loss may occur to investors.
2.3 Phased development projects that were already underway
Similar to the above, some phased projects that developed groups of townhouses together are now facing shortfalls of capital as new phases become more expensive to complete.
We have now seen projects created by builder developers, that are facing a capital shortfall even with a senior lender and mezzanine finance in the mix. What this means, is that some private credit mezzanine providers and their investors are now at risk, if projects aren’t competed on time.
For builder developers (who work on higher margins) to be taking mezzanine finance, and to still not have enough funding, shows the extent of the problem Victoria is facing.
