Mortgage investing offers opportunities

In our continuing low interest rate environment, the search for yield continues.

One option is mortgage investment corporations (MICs), says Craig Machel, vice president and portfolio manager with Richardson GMP.

These instruments can help with diversification in 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.”

However, they’re still long-term plays. Clients face penalties if they exit too early. “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.

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

Also, these funds aren’t available to all clients. Offering memorandum funds are for accredited investors only, and that includes MICs like Morrison Laurier and Harbour Edge, says Machel. There are TSX-listed funds that anyone can buy, he adds, including Timbercreek, First Capital and Home Capital. Here’s what clients need to know.

Read: How to invest in real estate

Canada vs. the U.S.

MICs are pools of Canadian commercial mortgages. Still, clients sometimes confuse them with the mortgage-backed securities that triggered the collapse of the U.S. residential real estate market. So explain the differences to investors (see “Explain the market collapse,” page 4).

After the U.S. housing bubble popped, Canadian investors braced for the negative side effects. But our housing market remained relatively stable because we had stricter lending and underwriting practices.

“Canadian banks never signed off on exceptionally high-risk mortgages,” says Machel.

Explain the market collapse

In the early 2000s, U.S. housing prices were going up, but consumers were earning well and low rates allowed them to keep buying.

But by 2007, the cost of a home was out of reach for many buyers. Still, many U.S. lenders didn’t want to sacrifice deal flow so they started offering what the industry refers to as NINJA (no income, no job or assets) loans.

“There was this greedy, shortsighted trend that was unfolding,” says Craig Machel of Richardson GMP. “Companies were lending to people who shouldn’t have had mortgages.”

U.S. investment banks packaged these ultra-low-quality mortgages and offered them to investors. Then, the bubble burst: investors lost money, many lenders went out of business and foreclosure rates skyrocketed.

“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 that our regulations require buyers to have Canada Mortgage and Housing Corporation (CMHC) insurance. So if we’d been severely impacted, that would’ve helped ease the fall. And because CMHC is a government-backed entity with billions of dollars behind it, a housing downturn might’ve stung but wouldn’t have caused a collapse.

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.

Read: Rich see advantages in holding mortgages

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

MOBut 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.”

Underwriters are also concerned about 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, and 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.

Read: Alternatives a solution to high correlations

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 investors and advisors should ensure the MIC isn’t only offering high-interest loans. Also, it should include a variety of commercial projects from various regions.

For instance, if the downtown Toronto real estate market tanks, the MIC will be protected if it also includes projects in Calgary, Montreal and Vancouver.

Machel also ensures borrowers have tight relationships with their tradespeople, including builders and contractors. If they’ve done business in the past, “the process is smoother, contracts get drawn up quickly and the deal can get underway quickly.”

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

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

Read: Mortgage products making a comeback

Source: quotemedia.com; Craig Aucoin, associate, ValueTrend Wealth Management This chart compares a number of publicly traded MICs in Canada to the fixed income market in Canada (ETFs: XGB and XCB). The MICs are: Atrium Mortgage (AI); Eclipse Residential Mortgage (ERM); Firm Capital (FC); ROI Capital Canadian High Income Mortgage (RIH.UN); Timbercreek (TMC); and Trez Capital (TZZ).

Case study

Michael J.R. Nisker, president and CEO of Trez Capital MIC and Trez Capital Senior MIC, details one of the loans in his firm’s portfolio.

The project: Chrysler Canada’s headquarters in Windsor, Ont.

Three years ago, a group of German investors owned a building with Chrysler as the primary tenant. Those investors needed a non-traditional loan for three reasons:

They had a five-year mortgage with a Canadian bank that was coming to term, but they’d decided to sell the property.

“So they had to refinance the expiring mortgage, but they only wanted a short-term because of their plan to sell, and they didn’t know how long that sale process would take.”

With a bank loan, borrowers are typically locked in to a five- or 10-year fixed-term and there are substantial penalties for closing the loan early.

The building was on a land lease, meaning the developer didn’t own the land; the City of Windsor did.

This would have made it even more difficult for the owners to sell because a buyer would consider the terms of the lease. If the lease expires soon, it’s a problem because the city could rezone the land and force the owners to tear down the building.

“Dealing with the economics and the legalities of a land lease deters banks.”

The auto industry was (and still is) coming out of a recession, making it even more difficult to get a traditional loan.

“So we provided them with a $26-million first mortgage, with a one-year term. And we said you can repay the mortgage without penalty anytime after six months, providing them flexibility.”

Why did Nisker’s team extend the loan? Their research showed Chrysler was trending better than other automakers. “So we took a calculated risk that, over the course of the 12 months that the loan is outstanding, they’d continue to trend in a positive fashion. This is a big part of our business—it’s something that banks don’t look at because they aren’t set up to make those types of judgments, and just look at the numbers.”

Within six months, Dundee, an office REIT, bought the property. “We were in at about 65% loan-to-value, but based on the higher actual sale price that Dundee paid, our loan was at about 55% loan-to-value.”

He adds, “Our investors earned between 7% and 8% on the fund that included this loan.”