Property finance is on top of many Australians’ minds at the moment. For homeowners, high mortgage rates are adding to the cost of living crisis. For property investors, property investing fundamentally is a game of finance. For first home buyers, high-interest rates not only make home ownership more expensive but also reduce borrowing capacity, further pushing the dream of ownership away. Despite the blame from Australians, banks are suffering from margin compression and are even writing a significant percentage of unprofitable loans.

The current state of property finance is very twisted indeed. But I do see a way out—the future of property finance may indeed be bright for all, including borrowers, lenders, and brokers alike, if we can execute things properly.

The Rise of Brokers

The broker market share of the residential home loan market in Australia is almost 75% at the time of writing. If we see brokers as the market makers between the two sides of the marketplace—lenders and borrowers—then this is not a bad thing as the market liquidity will increase, benefiting both sides of the market. However, the issue is that the cost of originating from the broker channel is way too high for the banks.

Here is how the broker business model works. For the first year of business, brokers will be paid an upfront commission close to the size or higher than the net interest margin of the loan for the banks, which means that the banks will not make money or even lose money for the first year of acquiring customers. For the life of the loan, brokers will be paid a smaller trailing commission.

The unique incentive structures give rise to a behaviour pattern: brokers will keep the customers in the bank for 1.5 to 2 years so that the upfront commission won’t be clawed back. After that, brokers have an incentive to shift customers away to a different lender and rinse & repeat. The byproduct of this behaviour is that competition among the banks will increase, net interest margin will race to the bottom, as home loans are increasingly seen as a commoditised product.

The combination of higher broker market share and a lower interest margin is undermining the long-term viability of Aussie banks’ core residential mortgage business.

Why are banks at the mercy of brokers then? For small banks without strong brand awareness and an effective proprietary channel, brokers make their businesses viable, functioning like paid advertising. For them, it is cost-effective to use brokers as opposed to setting up the proprietary channel as the cost of the latter will be much higher than the broker channel. For major banks, the reasons are more complicated—they will be discussed in the next section.

The Missing Economies of Scale

Major banks’ struggle is a bit of a myth if we look from the lens of economies of scale, a mechanism where the moat increases with size.

As a bank gets larger, its cost base should reduce as a result of:

• Lower cost of acquisition due to brand awareness

• Lower operational cost due to the scale

• Lower cost of financing due to higher creditworthiness

• Lower cost of funding due to a higher ratio of low-cost deposits

The lower cost base combined with a brand premium that comes with size should make major banks undefeatable in the mortgage market as their expected margins are significantly ahead of competition even if they charge the same price.

The reality is that major banks have an increasingly thinner margin despite having a premium price over smaller lenders. The result suggests that major banks have a cost issue—the backend processes in originating a loan and the productivity of lenders aren’t as low cost as you’d expect for large-scale businesses.

One type of business where costs don’t go down with scale is service businesses. The missing economies of scale may come down to the fact that major banks are still running the home lending business as a service business similar to accounting and legal, as opposed to a product-led business like a digital product.

Valuation can be expressed in revenue multiple. The revenue multiple of service businesses is significantly lower than that of SaaS businesses, given service businesses are scale constrained. This drawdown also presents an opportunity to unlock huge shareholder values, especially in the AI mass adoption age.

Service at Scale

Marc Andreessen famously wrote the piece Why Software is Eating the World in 2011, inspiring a whole generation of service business founders to build software.

For example, Ben Thompson, founder of Employment Hero (a $2B unicorn in Australia), was motivated by this article to pivot his legal service business into a software business in a recent podcast interview.

Now we are entering a new age again with the rise of AI, with heaps of disruptive features to the incumbent. It will be easier than ever for the incumbents’ competitors to launch competitive products and push down their operational costs. On the customer end, they would take a smooth process and a smart banking system for granted and don’t expect to pay more.

For the incumbents, reducing the cost of service and accelerating the rate of AI adoption for smarter, faster, and more personalised service will be essential to stay relevant. There is one tailwind though—the fact that banks’ data are proprietary does give the large players a leg ahead, as the core insights buried in the data won’t be commoditised away but retained as a unique edge in the future.

It All Comes Back to the Customer Needs

Large lenders, small lenders, brokers, and customers. What will the future be like? It is way too easy to indulge in the tech trend and forget that great products are what people want.

In the world of property finance, there is not just one type of need. Different segments want different things.

• For the first home buyers and simple owner-occupied mortgage holders, they want a cheap rate and are more than happy to go without any services.

• For customers with complex loan arrangements, they’d realise pretty soon how much they need services.

• For business borrowers, they want a smooth experience and policies tailored to their situations.

• For investors, they want borrowing capacities and the best borrowing arrangement for their mix of various structures.

Lenders need to understand this and design various products, experiences, and channels around customer needs, as opposed to pushing a blockbuster product to all people.

If I were to imagine what the future would look like for property finance, it will be more similar to the fund market where there are low-cost, major index providers, various higher cost funds with niches, and fully managed account services.

Full Service Banks

For full-service banks like the big four, an inevitable trend is to achieve operational excellence and reflect this in the form of low-cost, digital home loans with a minimal service component. This is akin to scalable SaaS products with close to zero marginal cost when onboarding new customers.

For borrowers with more complex loan arrangements, digital home loans may still be possible with the emergence of AI assistants. This is akin to the premium tier of SaaS offerings where more features need to be built to allow for more customisations, but the marginal cost of new customers is still minimal.

Traditional forms of human-initiated, service-heavy home loan products will gradually disappear in the retail context, similar to the phase-out of passport accounts. In relationship-heavy segments like wealth management and private banking, the service components will remain due to the high value and high margin nature of the segment.

Culturally, major banks will not charge the lowest price in the market despite they can. Instead, they are likely to charge a premium. It is not all about the banks being profit-seeking as this is a simple yet effective strategy to:

• Achieve a better margin profile.

• Prevent customers from the lowest quality segment from getting on the book, a strategy similar to Cosco membership.

• Leave some values on the table for small lenders and use this to insure against anti-competition probing.

Small Lenders

Winners don’t want to take all (otherwise they will get in trouble) so there will always be a place for small lenders. Small lenders have three ways to stay relevant in the future:

1. Lower Price

2. Differentiated Propositions

3. Unique Channels

The small lenders who compete on price may get away with minimal services and poor tech infrastructures, but they probably need to accept a permanently lower margin of doing business compared to the large players in the market, and the customers acquired will be purely price-oriented, making it hard to cross-sell and presenting with low lifetime value.

Small lenders may also survive, or even thrive on a differentiated proposition. For example, some small lenders may take risks that major lenders wouldn’t be willing to take so they can acquire subprime mortgage holders. Some small lenders may build the best-in-class experience for a particular segment in the market and achieve high penetration in that market, for example, home loans for medical professionals, self-employed, or retirees.

Small lenders can also choose to go deep in certain channels. For example, they can use content strategy on social media to channel customers to their products, or they can white-label home loan products and distribute through brokers with no physical infrastructure in place.

Brokers

The current high penetration of broker-originated loans is a reflection of brokers delivering everything borrowers need: low price, education around home buying processes, advice on lending, portfolio strategies, and sometimes after-hours and weekend services. More importantly, all of them are free to the borrowers despite borrowers being the main beneficiaries.

For a system to be long-term viable commercially, the payer and the beneficiary need to align. Simple home loan products are likely to be highly commoditised. I’d argue that brokers won’t have access to the lowest-cost products in the market anymore as their fee model won’t be compatible with low-cost home loan products. Instead, brokers will work as a solution provider for borrowers and channel partners for small lenders, as opposed to functioning as a marketplace today.

For brokers to be a solution provider for borrowers, they will function more like lawyers. There will be mortgage prisoners who are stuck with their current lender’s high-rate product, and mortgage brokers are likely to be the people to help them unlock and charge a fee as a fraction of savings for the customers. For people with multiple entities or hitting the limit of borrowing, brokers are likely to provide advice around borrowing strategies, to maximise customers’ goals. Again, this is likely to be paid by the customers as opposed to lenders.

Conclusion

The landscape of property finance in Australia is undeniably complex and evolving. As the market adapts to changing conditions, the roles of brokers, lenders, and even the borrowers themselves will continue to shift. For full-service banks, embracing digital transformation and operational efficiency will be key to staying competitive and relevant. Small lenders will find their niche through unique value propositions and targeted strategies, while brokers will transition to more advisory roles, focusing on customer-centric solutions rather than merely functioning as intermediaries.

Ultimately, the future of property finance will be defined by those who can innovate and adapt to meet the diverse needs of the market. The drive for convenience, efficiency, and tailored solutions will shape the offerings and services provided. By understanding and anticipating these needs, the industry can pave the way for a more sustainable and customer-focused property finance ecosystem.

Disclaimer: The data and information mentioned are from third-party sources, and accuracy is not guaranteed. This article shares information and personal views, not professional investment/legal advice or professional views of the company that the author works for. Consult professional advice before making investment decisions.