April 2023 – Market Commentary
The Fund delivered +0.79% in April, 8.41% over 12 months and 6.53% annualised since inception.
Across our three Funds, we participate in numerous transactions where the underlying borrowers pledge property as security either directly (via a mortgage) or indirectly (via broader loan terms). We therefore, track and contemplate how the Australian property market is performing and what this means for the Funds.
Firstly, our clear bias is towards residential property for the following reasons. Compared to office, retail or industrial, there tends to be a deeper pool of potential purchasers of residential property and, thus, greater liquidity should the property need to be sold. Loan sizes are smaller and, combined with the fact that there are many more residential loans than commercial loans, enables a more granular and diversified portfolio. Lastly, residential property tends to be more homogenous I.e. a 3-bedroom house in a particular postcode will largely perform like others in that area, thus, making longitudinal studies more predictive and less influenced by one-off property-specific factors. We do in limited circumstances, finance commercial properties when they share some of the characteristics above.
When stress testing the Fund’s portfolio, we consider recent increases in property prices in addition to the possibility of a sharp decrease in property prices.
Borrowers faced with rapidly rising interest rates either via their current variable rate mortgages or rolling off of cheaper fixed rates will struggle to afford new and higher mortgage repayments, particularly when faced with the higher cost of living pressures, lower household savings and the possibility of a weakening job market. In this scenario, all borrowers are at risk, particularly those who recently upsized and took on a large mortgage with any potential government stimulus or relief measures likely to be less targeted towards meaningfully helping those borrowers vs lower loan balance/lower-income households.
Assessing this scenario, one needs to consider both the length of the loan, the current property valuation and how that valuation was derived. While on average the Fund lends just circa $62 against every $100 of equity, meaning technically prices would need to fall substantially over our 12 – 24 month term to adversely impact the fund, the analysis doesn’t stop there. For example, the valuation may consider ‘like’ properties sold in the prior 12 months and factor in an assumed growth since those sales. But has that property appreciated in that period? To answer that, we consider the qualifications and experience of the valuer, the valuer’s incentives influenced by who appoints/pays them (the lender, homeowner or real estate agent who wants to sell the property) and how ‘comparable’ are comparable properties which are used to substantiate a valuation, to name just a few. In short, the protection of capital in a market where property prices fall further is centred around conservative loan amounts against targeted property as detailed; however, such an approach without a critical assessment of how one determines it to be ‘conservative’ shouldn’t be overlooked.
We should also note that Manning has a relatively consistent purchasing pattern to avoid having significant exposure to loans originated at any particular point when valuations may be elevated. In this regard, investors can also diversify away some of this risk.
Many associate price increases with reducing the risk of property backed lending, however the opposite applies. Most simply, rapidly appreciating prices are more susceptible to mean reversion, or a significant increase in prices could cause a significant decrease. In this regard, the prior 12 months have been a healthy period in lowering this risk.
As we face a softening economy, some of these above considerations can materially and favourably influence the risk profile of the Fund. The Fund has never had a negative monthly return from credit which we are focussed on retaining.