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Pallas Capital’s new bonds could help investors seeking higher returns

The Australian .

We rarely see innovation in the bond market and it’s always worth checking out those rare occasions when someone launches something new. Commercial debt and real estate investment firm Pallas Capital recently raised $30 million in a tradeable wholesale bond backed by a diversified portfolio of commercial real estate loans.

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It is the first of its type and creates a new way for investors to gain access to this type of investment. It pays a 7.5 per cent fixed yield for a four-year term and Pallas hopes to continue accepting investors into the bond up to a $100 million cap.

Seasoned investors are generally cautious about loan investments given the hundreds of millions of dollars that were lost during the GFC when debenture managers such as Australian Capital Reserve collapsed after highly leveraged construction loans and mezzanine finance deals went bad.

In addition, the recent financial woes of James Mawhinney’s boutique investment group Mayfair 101 (where investments included a North Queensland tropical island) has been another cautionary tale for investors exploring new products.

So what exactly is under the bonnet of the Pallas bond? Or in simple terms, what is your money being exposed to?

“There are three different types of loans that proceeds of the bond will be used to fund”, Executive Director at Pallas Capital Craig Bannister says, “pre-construction finance, construction financial for boutique luxury residential apartments/offices, and residual stock finance. Across all investments in this portfolio we hold a first registered mortgage and only lend up to 65 per cent of the asset value.”

Drilling down into each of the three loan types, pre-construction finance is the lowest risk and easiest to understand. A loan is secured against a property that a developer wishes to acquire and subsequently develop.

Typically an old house on a big block in an established suburb within 15km of the Sydney or Melbourne CBD with zoning conducive for townhouse or apartment redevelopment.

The finance facility is usually for 12 months which allows the developer purchaser enough time to draw up development plans and have them approved with council.

Once the owner is ready to develop the property, the pre-construction finance is paid out and usually replaced with a construction loan, which also happens to be the second type of loan in the Pallas Capital bond.

“We are seeing a trend where businesses are moving out of the CBD and demanding quality boutique office space in the likes of Double Bay in Sydney and South Yarra in Melbourne”, says Bannister.

“We are also seeing pre-retirees and retirees downsize from the family home to new luxury apartments in the exclusive fringe suburbs of the CBD. These are types of projects where we are comfortable banking construction loan deals.”

Once the development completes, for the apartments and office suites that have not already been sold by settlement, Pallas Capital is able to provide what is known as a residual stock loan.

For example, in a boutique apartment development of say 20 apartments, if only 10 are sold by the time the construction completes and the property titles are registered, the construction finance is paid out by a residual stock loan which is then secured over the value of the 10 unsold apartments up to 65 per cent of their independently appraised value.

As the 10 apartments are sold, 100 per cent of the sale proceeds are used to reduce the lending facility on at least the first few apartments, which effectively means the loan-to-value of the lending facility drops reduces to approximately 61 per cent after the first property is sold and then 56 per cent after the second is sold and so on. In other words, the risk of a loss upon default decreases as the apartments are gradually sold.

And speaking of loss, Pallas Capital has never had a default on any loan it has arranged.

The last feature that makes the Pallas Capital bond interesting is that they require prepayment of interest from all their loan borrowers.

The Pallas Capital bond is only available for sophisticated investors but it may be available to retail investors after 12 months.

For retirees getting 1 per cent or less in a bank account and not knowing how to get a return higher than the inflation rate, investments such as the Pallas Capital bond are worth exploring, but as always, the risk and return characteristics need to be considered and it is crucial that the investor has a clear understanding of the background of the company they are dealing with and what underlying investments (and the terms) that their money is being loaned against.

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