Look to mortgage market for consistent yield

Today’s tighter correlations make it difficult to diversify portfolios.

To find strong-performing assets untied to equity and bond markets, Craig Machel, portfolio manager and investment advisor at Macquarie Private Wealth, suggests mortgage investment corporations (MICs).

Not your ordinary mortgage

Banks control about 90% of the Canadian mortgage market. Asset management companies like Timbercreek, Morrison Laurier and HarbourEdge underwrite and bundle a portion of the remaining 10%.

Those companies extend loans to high-quality borrowers for multi-residential building projects, like luxury homes situated around private golf courses, or row houses on large urban lots.

Machel says these funds work for investors wanting capital preservation and consistent income. Returns are distributed and taxed as interest income. This structure, he says, means it’s preferable to place them inside RRSPs.

Timbercreek’s funds are TSX-listed and have generated average yields of 6% per year. Morrison Laurier and HarbourEdge offer higher yields—6.5% and 8.2%, respectively, as of April 2013—but aren’t publicly traded. They’re less liquid, so Machel typically uses them “for larger chunks of money that aren’t needed in the short term.” Clients must be accredited investors to use private funds (see “Accredited investors defined,” below).

Accredited investors defined

In Ontario, B.C. and Alberta, a person must have:

• financial assets worth more than $1 million before taxes and net of related liabilities, or net assets of at least $5 million;
• more than $200,000 in gross income in both of the last two years and going forward; or
• combined with a spouse, more than $300,000 in gross income in both of the last two years and going forward.

Machel tells clients that yields fluctuate with interest rates, and may dip below the expected 6% to 8%. And he makes it clear that reaching for higher returns would involve loans on real estate projects with more risk.

He allocates as much as 15% to MICs for clients who need income. People who don’t need as much cash flow would be at 10%, and he’d reinvest dividends to compound growth.

Bases covered

Machel’s due diligence includes examining the MIC’s financial statements. “There’s a line for bad loans and we make sure it’s a very low number—one or two every five years,” he says.

Advisors should also check if “the work that loans are funding is being done properly and in a timely manner,” Machel says. This means the MIC should have a dedicated team for job site inspections. “As part of my due diligence, I do these inspections myself.”

That pays off. He cites one case where a contractor siphoned off building materials to a different job not funded by the loan. The MIC’s team counted the lumber and realized about half wasn’t there. They halted the project’s funding and went to court to take possession of the property. The MIC then transferred the work to another contractor.

“No money was lost so clients weren’t affected,” he says.

3

Risk

As a point of reference, high-quality corporate bonds are around 3.5, equities around 7.5.

If loan payments are late—which happens fairly regularly—the borrower arranges what’s called a work-through. The MIC modifies the loan terms and there’s no disruption to client returns, he explains.

If a borrower goes belly up, a court would ask it to liquidate the property. The lender gets back its principal, plus interest and legal costs. The borrower keeps what’s left.

Dean DiSpalatro is the senior editor of Advisor Group.