Use mortgage investments to diversify

Mortgage investment corporations (MICs) can provide yield and help diversify your fixed-income portfolios.

“You can earn a nice income stream, and have a stable capital base that’s spitting off 6% to 9% return a year,” says Craig Machel, vice president, portfolio manager with Richardson GMP.

However, you have to invest for the long term. Otherwise, you could face penalties.

“Some have clauses where if you invest and then take the money out in the first year, you’re charged a penalty of 1% or 2%,” says Craig Aucoin, an associate with ValueTrend Wealth Management.

Aucoin suggests a five-year time horizon. “So if you need the cash sooner, then maybe this isn’t the right investment for you.”

Here’s what you need to know before investing.

Canada vs. the U.S.

MICs are pools of Canadian commercial mortgages. If that sets your alarm bells ringing, rest assured that MICs have no relation to the mortgage-backed securities that triggered the 2008 market collapse.

After the U.S. housing bubble popped, Canadian investors braced for the negative side effects. But our housing market remained relatively stable because we didn’t have the same lending practices or underwriting styles.

“Canadian banks never signed off on exceptionally high-risk mortgages,” says Machel. “And there was never an investment offered to Canadians in which banks or other investment firms packaged up a selection of non-transparent mortgages and sold them as one investment.”

He adds Canada also requires buyers to have mortgage insurance, which is backed by Canada Mortgage and Housing Corporation (CMHC). So if we’d been severely impacted, this insurance would’ve helped ease the fall.

The safeguards

As banks continue to restrict lending, the private MIC world is growing.

“Banks demand longer, fixed terms; interest plus principle payments; and they typically don’t want to get involved in smaller, new build projects, or with new Canadian borrowers who don’t have a lengthy credit record in the country,” says Machel.

That’s where MICs come in: they offer loans to borrowers who typically wouldn’t get approved by traditional lenders.

But that doesn’t mean the loans are risky. In fact, these vehicles mitigate risk by ensuring borrowers have good credit quality, cash flow and liquidity. Investors should aim for loan-to-value (LTV) ratios of about 65%, he says.

Michael J.R. Nisker, president and CEO of Trez Capital MIC and Trez Capital Senior MIC, says his firm looks at a borrower’s default history before offering a loan. “If you can’t get past that, it doesn’t matter how good the real estate is.”

Another key consideration when underwriting the loan is exit strategy, he says. “We don’t underwrite just the value today, but also the value when our term is to expire.”

This projected valuation builds liquidity because it helps ensure that when the loan comes due, a traditional lender will take it over. “No matter how good the asset is, no matter how good the cash flow is, if we can’t figure out a clear exit strategy when we’re underwriting the loan, we don’t proceed,” he says.

Aucoin adds, “If the commercial business is risky, or the cash flow is riskier, then [borrowers are] going to have to pay a higher rate to get that loan.”

So you should ensure the MIC isn’t only offering high-interest loans. It should include a variety of commercial projects from various regions. For instance, if the Toronto downtown real estate market tanks, the MIC will be protected if it also includes projects in Calgary, Montreal and Vancouver.

And these investments are dependent on the state of the Canadian real estate market. So Machel suggests choosing players that have experienced market ups and downs. Some of his favourites are Trez Capital, Morrison Laurier, and Harbour Edge.

“Invest in guys who know how to get the job done through rockier stretches,” he says.