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 investment 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 a number of them.
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 are unable to off load stock, which also meant their private construction credit fund lenders aren't able to get their debt repaid on time. Which in turn inconvenienced investors, as they aren'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 / private lenders holding mortgages on these assets, either couldn’t get an exit on the expected maturity date, took a loss against the deteriorated asset values (as feasibility didn't stack up for construction) or they are still waiting for property prices to go back up (so the development becomes feasible).
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, whilst completion also got delayed. This 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, a principal loss may occur if there are build defects from the liquidated builder, that the new builder may be required to repair. Most senior private credit funds should get their principal back, however mezzanine funds are at highest risk.
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 (as senior lenders take priority).
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 in Victoria.
3.0 Presale lock in price
In order for developers to get construction bank or private credit funding, usually a degree of presale stock is required. This however locks in the developer at a discounted price for properties sold at this price. In a normal environment this might be fine, however in a hostile environment with rising building costs and borrowing costs, this is a developer’s worst nightmare.
This means on some stock; developers were selling at breakeven prices or even a loss after all costs were considered on completion.
4.0 Greed and poor decisions by private credit investment managers
Investment managers have a problem; they must deploy capital to provide investors with a return and for them to make a living.
But what happens if there are no good deals?
The problem starts when some investment managers get greedy and “follow” a system blindly to ensure all the criteria is met for deploying capital. If all the boxes are ticked, then it must be a good project right and investors should feel safe?
The reality is, following a system 99% of the time works providing the environment stays the same. However, once the environment changes, the system starts to break down.
The tenth man rule exists for a reason in Israeli intelligence circles, because it assumes group think is fundamentally wrong. This is what good private credit funds get right. They don’t look for excuses to deploy capital, but rather they look for excuses not to deploy it, which is contrary to them making more money, but protects capital. Only after all scenarios have been tested, do they deploy it.
5.0 Poorly thought-out projects by property developers
Imagine creating beautiful penthouses with a sale price of $3M plus, in suburbs that do not command a luxury premium. This is just one example that illustrates the incompetence of some developers and private credit investment managers.
The result is these poorly thought out properties take a long time to sell and eventually sell at a large discount, which puts investor capital in the private credit fund at jeopardy. Simply because if the developer can't off load the stock, the private credit investment manager can't get their capital back on time.
Whilst a valuation can tell you the estimated GRV of a project, it can't tell you how the market will perceive a project on completion. Only logic, and good experience can (something which we seem to lack more and more of).
6.0 Victorian economy
The reality is that most of the job growth in Victoria up to “88 per cent of it – was created either in the public sector or industries overwhelmingly funded by taxpayers, such as education and health (read full article here).”
This is in part because the private sector has in many respects had enough of the Victorian government. Business is harder, and consumers simply aren’t spending how they use to with higher mortgage repayments, and less discretionary spending.
In many respects, whilst Victoria isn’t officially a centralised communist state, it’s economy is reliant on big government spending to survive. But this big spending comes at a cost. “Victoria’s interest bill is projected to climb to $10.5 billion in 2029 – when net debt reaches $194 billion and gross debt $237 billion (article here).”
Whilst Victoria reaps the benefits of this now, the question is, who will pay the bill? Taxpayers can only be burdened with so much.
In our humble, opinion, the Victorian government will eventually be forced to seek a bailout from the federal government or large external power at some stage. With the ongoing cycle of money and debt creation continuing, whilst dollar purchasing powers decline for the average person.
7.0 Introduction and increases of taxes
The increase in Victorian land taxes, the Windfall Gains Tax, Congestion Levy's and Vacant Land Tax just to name a few do not incentivise investors. If investors can make the same returns with lower taxes in other states or countries, what incentive do they have to buy stock in Victoria? Once again, government policies are not helping the situation.
Where to from here, the risks and opportunity?
Risk from Interest rate rises
Putting aside builder risk, construction cost risk and developer liquidity. One of the main risks at present to the Victorian economy is if interest rates were to rise. This would significantly impact demand for property and the overall liquidity of the economy.
Our key concern is that as western governments take on more debt, and in turn create more fiat currency, inflation could rise again forcing rates to rise in the long term.
Risk from further taxes
New or increased taxes from the state government would further deteriorate investor confidence. The reality is, the easisiest thing for the state government to tax, is your property. Which presents a major hurdle both for home owners and investors.
Risk in the reduction in government spending
With news of the state government cutting 1000 jobs (article here), and the financial state of the Victorian govenment. A real risk for the state would be if the Government were to radically cut spendng on large projects. Unfortuantely the situation is a catch 22, if they want to cut the debt, they have to cut spending, which will also cut jobs. This is a balancing act few will get right.
The silver lining for Victoria and investors
Victoria is slowly seeing more liquidity, as interest rates stabilise and prices become more competitive with other states, as they have stayed relatively stable since 2021 (article here on pricing). This should translate to more properties being sold, and private credit investors getting back their capital.
We suspect that in most cases first mortgage private credit construction fund investors will get back their principal. We do doubt however, that impacted investors will get all the standard and penalty distributions they are entitled to.
In the small number of cases were new builders had to be appointed, we suspect some first mortgage construction funds investors may be impacted in terms of principal in worst case scenarios (but only a small number).
Investors of mezzanine construction funds and equity investors are at the highest risk, and will be the most impacted. Subject to project and sales delays, some of these investors could likely face a principal loss on badly managed projects.
Overall, we are optimistic about Victoria for developers that are developing stock to be purchased as a principal place of residence, but not investor stock. We are also confident about the capability of most private credit funds to do the right thing by their investors.
If Labor or the Liberals, can actually adopt good policies to promote real inflation adjusted growth in per capita salaries, and higher discretionary spending, then Victoria could be a boom state in the years ahead.
For a confidential discussion click here.
To find a different way of doing private credit investments where you have control and oversight, click here.
