Larry Jacobson, a fee-only advisor with Macdonald, Shymko & Company in Vancouver, receives many pitches to sell syndicated mortgage deals to his clients.
These lucrative, private debt agreements for real estate projects often promise attractive annual returns of 8% or higher. Most, Jacobson says, come with risky backing or excessive commissions, and he throws them in the bin.
It’s the solid-looking offers he takes seriously, scrutinizing their details, the project’s prospects and the quality of the underwriting. He visits the land for a literal sniff test.
“I drive to the site. I drive the area. I look at competing properties. I look at the cars and apartment buildings across the street. I get down on my hands and knees and smell the dirt,” says Jacobson, who’s been with MS&C since the mid-’70s. “We really do a thorough job of inspection.”
This may be what’s needed to properly scrutinize syndicated mortgage offers amid surging property valuations and housing sector risks in Toronto and Vancouver. While real estate booms mean more investment, more construction, big commissions and nice returns, they can also mean sky-high valuations and riskier deals.
While syndicated mortgage offers can be great investments, experienced advisors are warning their colleagues to not be tempted by nice-looking commissions or pushy investors who want into real estate. “We find that most of the syndicated mortgages around today are garbage,” Jacobson says. “The underwriting process is really critical in these deals.”
Investors want in
Investors see opportunity in the booming prices in Vancouver and Toronto. Tony Mahabir, chief executive of Canfin Financial Group in Toronto, says he hears from investors who want to invest in property in the Greater Toronto Area, but can’t get in with average homes selling for $1 million. They call him to ask about investing in syndicated mortgages instead.
“They want a piece of the action,” he says. “It’s very attractive when you see a marketing email or a blog that talks about the merits of mortgage syndication.”
Sometimes the investments aren’t suitable, Mahabir adds, yet the investor insists they’ll buy in through someone else if he doesn’t sell it to them. “For those types of clients, we say, ‘Go,’” he says.
“When there’s the perception of a deal of the century, it goes around like wildfire,” Mahabir says. “When you’re selling truth, it moves very slow.”
Browse Kijiji’s real estate section and syndicated mortgage investment opportunities pop up. One such post links to a website listing several projects with attractive annual returns, such as 13.24% for a residential low-rise building in Oakville, Ont. The page, by FDS Broker Services, reads: “Tired of riding the investment roller-coaster? Become a private lender to experienced Canadian home builders.”
“Generally, what’s promised are rates that would make anybody open their eyes and say, ‘Oh my God. […] How is it that you’re coming to me saying I can make 30%, 40%, 60% on my money?’” says Fred Rossi, financial advisor with Sun Life Financial in Guelph, Ont. who’s been pitched on the products, but doesn’t sell them.
Rossi says some mortgage brokers solicit younger advisors who may not know any better. “When the solicitation occurs, it happens as a means of offering wealthy clients an alternative to standard vehicles that the industry offers,” Rossi says.
One issue is investment suitability, particularly for retirees who may be willing to put too much into a risky investment (for most offers, the minimum investment is $25,000). In provinces such as Ontario, the investments can be sold with only a mortgage broker licence — without the more thorough suitability testing required for securities. (The firm and the individual must be mortgage licensed.)
Robert McLister, a broker and founder of RateSpy.com, says most mortgage brokers should not be selling syndicated mortgages.
“I’ve seen too many cases where a broker pushes under-collateralized, overhyped, high-risk investments on unsophisticated individual investors,” McLister says. “Most brokers aren’t trained to properly assess the suitability of these things.”
While many investment opportunities are in legitimate and profitable projects, he’s seen cases where a syndicated mortgage provider took its fees before the project was completed. If the development failed, the syndicator still got paid. In another case, he says, the investor’s security was subordinated to another lender, without the investor knowing and after the money was put in.
“I don’t believe there’s an endemic or systemic issue, that mortgage brokers are selling the wrong product to the wrong investors,” says Paul Taylor, head of Mortgage Professionals Canada. “But there’s been such an increase in the availability [of] some of these investment mechanisms in the last number of years.”
As a result, Taylor is more concerned about referral arrangements between brokers and other business contacts, where the broker isn’t fully aware of the investment details.
Previously, Taylor says, syndicated mortgages were more of an exclusive area for investing. Now, the “investments are turning into more mainstream and RRSP-able funds for mom and pop investors. That’s requiring more stringent regulation,” he says (see “Ontario to toughen syndicated mortgage regs,” below).
High commissions, risky deals
Jacobson, with MS&C, says many “pie in the sky” offers have crossed his desk, proposing to build resort properties or big projects with grandiose value projections. He says he doesn’t even consider those.
Instead, he mostly works with one B.C. developer, Realtech Capital Group, and his checks on this firm’s offers are no different than an unknown syndicator, Jacobson says.
He focuses on the underwriting and commissions, and two main red flags are high commissions offered to the broker and the syndicator, he says. As a fee-only advisor, he doesn’t take commissions, so he looks at what kind of fee is being offered to the syndicator and to the person selling it to the client.
“Often we get calls from syndicators who offer us, effectively, bribes,” Jacobson says, noting that he refuses any deal offering trailer fees to financial advisors. “If a client puts in $100,000 and there’s a 10% or 5% commission [to the advisor], that’s a lot of money going off the top that’s not going into the project.”
Mahabir, who estimates he’s been receiving more syndicated mortgage offers than usual—about seven or eight in the past year—says he knows of six or seven reputable firms that offer good investments, though he doesn’t want to name them publicly.
Even solid investments carry risk. Typically, syndicated mortgages are second-, third- or fourth-lien debt, with the bank usually first in line, likely followed by the builder. The client is somewhere further down the line. “There are [at least] two people ahead of you that, if the property goes sour, get their money first,” Mahabir says.
Taylor calls these “tranches.” The lower your tranche, the higher the risk. “You just have to be placed in the appropriate tranche based on the probability of completion,” he explains. “To be fair, the people placed at the top will probably be receiving quite a high[er] rate of return than the folks at the bottom, who will get a much more modest return.”
Other red flags
As part of his due diligence, Mahabir looks at the developer, the location, and the banks and law firms involved in the project. If there are names he doesn’t recognize—such as key financial backers or law firms—it’s a red flag. Sometimes, he says, the people involved have been suspended from selling securities.
While some advisors may be drawn in by commissions as high as 7% or 10%, selling a risky investment is short-sighted, Mahabir says. “You have to be mindful that the same client you’re saving today can become your biggest investor tomorrow,” he says.
Mahabir also looks at the overhead. Sometimes marketing costs, sales and referral commissions, plus mortgage and broker fees, can account for a third of the money raised, he says. That’s excessive because, if the project hits a snag, it may be short on cash.
Jacobson would recommend investing only if the project has all key elements in place—including architectural plans, underwriting and financing. Perhaps all that’s left is the development permit. He also looks at the terms of the construction mortgage, who’s guaranteeing the mortgage, the project equity coming in, and where the equity is coming from.
The offer should also disclose whether or how the client’s principal can be locked into the project for longer than expected—sometimes with a hefty penalty for an early exit. “They say you’ll earn 30% a year on your money, but if your money is locked up for five years with no access, you may not have bargained for that,” Rossi says. “The other side of it is that sometimes the escape clauses they allow are with significant penalties.”
Given high property values, Jacobson runs a sensitivity test that accounts for possible price declines. He tests a project for a possible price decline that may range from a 3% to 12%. He also stress tests cash flow in the event that units must be rented instead of sold.
Another thing: Is there a quantitative surveyor to do a monthly check on the project, providing an additional layer of budget accountability? Jacobson looks for this due diligence.
“We also tell every [client] in a written letter that, if you can’t afford to lose 100% of your asset, don’t invest in it,” Jacobson says. “We’ve done that for 40 years.”