Investing amid inflation with property credit

High inflation is nothing new to experienced investors who perhaps remember as far back as the 1970s and 80s, a period punctuated by double-digit inflation and eye-wateringly high interest rates. For much of the last 20 years however, inflation readings have been benign. That is until early 2022, when inflation took off in earnest.

In an effort to curb inflation, central banks the world over undertook an aggressive interest rate hiking cycle. And while much of the Reserve Bank’s heavy lifting is behind us, the pace of change has shifted the narrative for investors: the ‘hunt for yield’ is now over.

With the Reserve Bank forecasting inflation to remain above target until mid-2025, investors will have to navigate high inflation, high interest rates and ongoing volatility for some time yet. The key theme for investors therefore is not where yield can be sourced, but rather how it can be delivered while minimising volatility and preserving real incomes and accumulated wealth.

Enter property credit.

Over the last decade, property credit has seen a re-emergence as yield-hungry investors sought income. A solution to the “hunt for yield” problem, with the sector delivering low-volatility income across the last decade, assisted by a property market appreciating in value.

It is a sector which Australians have a deep affinity and familiarity with, whether as an investor or a borrower. From an investor perspective, it is – put simply – investing into loans made to borrowers and secured by mortgages over real property: underlying security which can offer downside protection during periods of volatility.

As with any sector, the size, scope and variety of investments provides genuine alternatives for investors irrespective of risk, return or duration profiles.

Investments can be made on a loan-by-loan basis (i.e. peer to peer), via a portfolio of loans, or through structured notes which present as a more complex entry into the asset class. Some structures allow immediate liquidity via an exchange, while others extract an illiquidity premium for investors with a longer-term mindset. Some investments support multi-dwelling developments, others the more resilient residential property sector.

But let’s not lose sight of the role property credit plays in investor portfolios. It is an income generator. An income generator during all environments, including that of high inflation.

With inflation remaining uncomfortably high, investors need to outperform the inflation print across their portfolios just to preserve the real value of their money. And with the majority of property credit in Australia written on a floating or variable rate basis, as an asset class it can operate as an inflation hedge.

The last 18 months has presented a unique environment for property credit: high inflation and rising borrower rates yes, but how about the added complexity of a depreciating property market. A thematic which erodes equity and can expose property credit investors to an uncomfortable truth: that their investment can also be at risk.

This is where the selection of the underlying property credit investment strategy becomes so important. Selecting a strategy – and a manager – with demonstrated ability to construct and guide portfolios through volatility while delivering ongoing performance.

So back to the fundamental question now facing investors: how to invest for income while avoiding volatility.

The quality of assets within a portfolio is important at any stage, but particularly so after an aggressive rate hiking cycle. In property credit circles, this speaks to the quality of the underlying borrower and – at this point of the cycle – borrower arrears.

Likewise, a manager’s approach to diversification and track record in the preservation of capital. Highly concentrated portfolios, high loan-to-valuation ratios or overrepresentation to more susceptible construction development or vacant land loans are markers of potential volatility in capital outcomes.

With elevated inflation set to remain into the medium term, a targeted exposure to property credit can add real value to portfolios to maintain real income and maintain real wealth.

Better yet, selecting an investment strategy backed by a portfolio of high-quality, highly granular property credit assets diversified by geography, sector and loan size can deliver real income for investors while avoiding the volatility.

Chris Paton is chief investment officer of La Trobe Financial, a leading Australian alternative asset manager specialising in property credit. Financial product advice in this article is general only and does not consider your personal circumstances.