Commercial mortgage fund built on yield

At first it might seem that 2007 was a most unfortunate year to launch a mortgage fund. Asset backed commercial paper offerings began to implode mid-year and anything with the word mortgage attached to it became tainted in the eyes of investors.

In the years that followed though, conditions were such that managers of the ACM Commercial Mortgage Fund were able to make some “incredible deals” while their competition was forced to sit on the sidelines.

Today, with four solid years of performance on the books, credit spreads have normalized. Even Canada’s big banks say it is a good time for companies to be in the commercial loan business. At the recent Scotia Capital Financials Summit, both Gord Nixon, president and CEO of the RBC Financial Group and Bank of Nova Scotia president and CEO, Rick Waugh said they’ve seen an increase in commercial loan demand and that loan growth continues to look good.

Yield-hungry but market-shy investors, meanwhile, are looking for ways to diversify their fixed-income holdings. Marrying this demand from both borrowers and investors is what ACM Advisors Inc. does when it raises capital from investors and then lends to commercial real estate borrowers.

Since launching in May 2007, the ACM Commercial Mortgage Fund has grown from $15-million to $119-million (as at the beginning of September 2011). It currently sits at the top of Morningstar Canada’s list of top performers in the Canadian Short Term Fixed Income category for one month, three month, one-year and three-year returns. Its three-year return numbers range from 9.3-9.8% with the two nearest competitors bringing in just 5% and 6.2%.

Although crystal balls are notoriously unreliable, the fund appears poised to keep its top spot as it works toward building a track record that includes five-year returns—the $1.7-billion HSBC Mortgage Inst fund (minimum investment, $1-million CAD) which currently holds the top spot on the longer term performance charts, returned 5.1% over five years.

With this combination of returns, public interest in real commercial property and the demand for yield, Chad Mallow, vice-president of business development and Graham Collings, portfolio manager and vice-president of investments, say they expect to be popping up on the radar of different investor groups soon. “It’s going to be a big fall for us,” they say.

Originally an institutional mortgage portfolio manager, Collings and Mallow say the firm decided to launch the fund for retail distribution because there was a gap in the marketplace between institutional funds and the higher yielding mortgage investment corporations.

The ACM Commercial Mortgage Fund invests purely in Canadian commercial real estate debt. It lends money to borrowers and secures the loans with mortgages after raising capital from pension plans and retail investors. The fund does not invest in residential mortgages, construction financing or condo construction.

“Our internal view is that’s a one-way-out deal. They either get built or they don’t,” says Collings, referring to condo construction projects. “We prefer to stick to the commercial asset classes with income.”

Although the fund might end up holding title to a property as a result of any foreclosure proceedings, the fund does not invest directly in real property either. According to Collings and Mallow, ACM Advisors has not experienced a loan loss in its entire 19-year history.

As for residential mortgages, Collings says the yield on such loans is not attractive enough for the firm or the fund to be interested. This alone forces the fund to be sold by offering memorandum, not prospectus, Collings says.

“Our investments do trigger us to be caught under National Policy 29. It’s an old piece of regulation that basically says to be a prospectus mortgage fund, you need to be over 50% invested in insured residential mortgages,” he says. “The credit spreads on those products are very low, very tight and there are a lot of groups out there doing that. You can’t get the yield on the residential mortgage side of things. To get into the yield range we’ve been able to, we went offering memorandum.”

Investors outside of British Columbia need to be accredited, as defined in the Canadian Securities Administrators’ National Instrument 45-106. Those living in B.C., accredited or not, may also invest if they complete and sign regulatory forms acknowledging certain risks.

Collings and Mallow attribute most of the fund’s success in recent years to their strict adherence to the firm’s process and mantra: “People, property, deals.”

“We control the entire process in house, all the way from origination of the investments, the mortgages, through the underwriting, closing and administration on an ongoing basis—until they either refinance or get paid out by a new lending source or new equity funding,” says Collings. “Our process is really engrained here. People, property, deal. We deal with people who have a strong track record and the financial wherewithal to get through any kind of market turbulence. Good people will help you get through any situation. Bad people (on the other hand) can turn a good situation bad.”

He adds that everyone believes the old real estate chestnut about “location, location, location,” but it’s the strength of a property’s tenancies that are equally, if not more important since the tenants are the ones making payments to the property’s owner. In addition to reading lease documentation, he says the group looks to understand who will be competing with the property owner and its tenants, how economic factors will impact both and how the property fits within its submarket.

“Vacancy rates in a big market don’t really tell the story. There are a lot of properties on the very secure side, but others that will drag that occupancy numbers in a different direction,” he says. After reviewing the people involved and the property, he says examining the deal involves making sure that the group and its investors are properly secured, “that the return and the parameters of the mortgage loans accurately reflect the risk we see in the property.”

While investment opportunities are found and secured through the relationships ACM has with borrowers and the mortgage brokerage community, and the underwriting process is conducted with the “people, property, deal” mantra in mind, the third part, administration, covers the closing process, issuance of funding, investment tracking and compliance monitoring to ensure property owners are paying their property taxes, keeping their insurance up to date and complying with any other mortgage conditions.

“Before we lend on any property, we visit the property and meet the people, the borrowers,” says Mallow. “We also go visit the properties ourselves each year to make sure that what’s on paper actually corresponds with what’s happening in the physical asset.

“We rerun our entire financial analysis and our tenancy reviews. We look at all the tenancies to ensure that their outlooks are the same and in most cases better than they were the prior year and we also run through our risk rating system,” he adds. “We have a proprietary system that, we’re told, is on par if not better than quite a number of the institutional lenders in the marketplace.”

The fund is also diversified in such a way that no single property or borrower makes up more than 25% of the total portfolio.

ACM Commercial Mortgage Fund

Invests in: First mortgages secured by real property in Canada. Up to 33% of the fund’s assets may also be invested in second mortgages and up to 20% may be invested in liquid investments to fund redemptions. The fund also maintains a credit facility, worth $10,000,000 to assist in financing day-to-day liquidity requirements. In addition to interest on this loan (prime plus 0.50%) the fund also pays an annual standby fee of 0.25% on the daily undrawn portion. Risks • Commercial real estate loans tend to be large and therefore do not provide the kind of diversification found in a portfolio with a large number of smaller loans. • Performance is dependent on the capability of property managers and the financial performance of a property, not the assets or income of the borrower. • Although managers review tenancies, there is no guarantee tenants will renew their leases on expiry or that they will continue operations throughout the terms of their leases. Refinancing is also significantly dependent on economic conditions, where the mortgaged properties are located and the creditworthiness of the borrower. • Supply, demand, availability, occupancy levels and rental rates, along with property operating expenses and property values can all impact the portfolio’s value. • Mortgage loans are generally not insured or guaranteed by any government or underwriter. Minimum investment: $5,000 initial investment; $1,000 for subsequent investments. Management fees: Range from 0.60% (Class F and Class I units) to 1.05% (Class B-E units). Redemptions: There is no market for units of this fund. Redemptions requests are made to the manager are processed monthly. Redemption fees: Range from 2.5% (year one, Class E shares) to 1% (year two, Class C shares and year four, Class D and E shares.)