Don’t overlook mortgage investing

One path to yield may be through commercial mortgages. Investing in a mortgage investment corporation (MIC) could provide more income than the bond market, says Craig Machel, a portfolio manager and investment advisor with Macquarie Private Wealth in Toronto. That’s because when interest rates rise, so do lending rates; and investors will benefit from those higher rates.

MICs are loans extended to high-quality commercial property borrowers by asset management companies. These borrowers don’t go to a bank because the loans are too big, or the borrower has some credit issues.

But those factors don’t necessarily make MICs risky. In fact, these loans have loan-to-value ratios of “60% to 65%, and cash is distributed on a project-by-project basis,” says Machel, so there’s less risk to investors. He adds the borrowers simply require more flexible mortgage terms. For instance, if a building is worth $1 million, a non-conventional lender would offer $650,000, so there’s still $350,000 equity left. This means the value of the property “would have to fall a long way before the loan is in jeopardy,” he says.

And as long as investors don’t reach for higher yield, they can get consistent income. “If you want higher yield, you’re putting yourself in a position of risk,” says Machel. “Also, if you extend yourself on the risk side and start getting into second or third mortgages, or mortgages with less collateral on income or excessive loan-to-value ratios, then you could also be in trouble.”

How mortgage investing has changed since ’08

Residential property loans

• The non-agency MBS market has dwindled to about 1% since 2008, says James Rowley, senior investment analyst, Vanguard Investment Strategy Group. But the agency-backed market is the same.
• There’s also more investor awareness since the downturn.

But advisors and their clients should still research the mortgages, warns Craig Aucoin, an associate with ValueTrend Wealth Management in Barrie, Ont.

“Pay attention to the smaller players, [and determine if] the managers are doing their due diligence on the mortgages they’re putting in the basket,” he says.

Machel agrees, adding, “There are a lot of new guys who’ve come into this market.”

He recommends two managed funds: Harbour Edge, which has been around since 2005, and Morrison Laurier, which has been available for 25 years. Both pool numerous mortgages—Harbour Edge more than 100, and Morrison Laurier 19.

After fees, Harbour Edge returns 9% annually, and Morrison Laurier 7.5% (both figures as of July 2013). Machel says the two funds have transparent documentation and histories of capital protection. “Neither has lost any money for clients.”

He adds MICs are often brought to advisors in open-ended funds or closed-ended, TSX-listed offerings. Advisors unfamiliar with these loans should ask the following questions to ensure they’ll provide returns for clients:

• What’s your history with loans that have gone into default? This happens every few years, says Machel, so learn how the MIC works through them. “Find out the net impact to investors and the valuation of the funds,” he says. “You want MICs that have had zero impact, meaning no capital loss for investors.” (For instance, Morrison Laurier has had one default in the last five years and it didn’t impact clients or the fund.)
• How many loans have you had go through power of sale? In this situation, if a borrower defaults on a loan, then the courts dispose of the asset and settle debts. The property usually sells at fair market value, adds Machel. Once again, you want to ensure the MIC hasn’t harmed investors. MICs very rarely go through this situation, he notes.
• Are you public or private? Private MICs that don’t trade on the TSX didn’t lose money during the downturn and still pay 6.5% to 8.5% yield each year, according to Machel. Ones that trade on the TSX are currently paying about 6% yield.

MBS in the U.S.

The financial crisis put residential mortgage investing in the limelight—in a bad way. Many clients who’d invested in U.S. mortgage-backed securities (MBS) found loans to borrowers with poor credit bundled in their portfolios.

Times have changed. The U.S. government has clamped down on lenders, and made mortgage rules more stringent.

Investors who want a piece of the U.S. residential mortgage market should consider MBS, says James Rowley, senior investment analyst with Vanguard Investment Strategy Group in Valley Forge, Pennsylvania. But they should stick to agency-backed securities, which are high-quality bonds.

“There’s a misconception when investors hear the phrase mortgage-backed securities,” says Rowley. “Investors don’t always understand the difference between the U.S. agency market and the subprime market.”

How do they differ? Agency MBS are high-quality, liquid investments. Big underwriters like Freddie Mac, Ginnie Mae and Fannie Mae back these conventional loans. Borrowers must have solid credit scores and meet minimum down payment requirements on their homes, which depends on the loan-to-value ratio. Also, there’s a limit to the loan amount, usually about US$410,000.

Agency MBS take up 30% of the market, almost as much as government and credit bonds, so they’re not niche.

At the other end of the spectrum is the subprime market, which he suggests avoiding.

“We’re talking about much larger loan amounts and borrowers who have less desirable credit quality,” says Rowley.

To tell the difference, look at the portfolio characteristics of the fund.

This information should be readily available on the fund’s website, says Rowley. It’ll say the fund is invested in mortgages generally, or break down the percentage invested in agency and non-agency MBS. If the latter details aren’t there, ask the fund for this breakdown.

Suzanne Sharma