Mortgage funds, commonly referred to as MICs, have grown in popularity as investors look for alternative ways to generate stable income. These funds earn interest by lending money, secured against real estate, to borrowers who don’t fit the increasingly rigid requirements of the bank.

While we believe mortgage investing can be a great way to add income and stability to a portfolio, not all funds are created equal. Below are three key concepts to understand when considering a mortgage fund investment.

Loan-to-Value (LTV): How much security do you have in case of a market drop?

The first is the loan-to-value (LTV) ratio, which is calculated by dividing the mortgage amount by the property value. For example, a property with a $50,000 mortgage and a $100,000 value has an LTV of 50%.

Understanding LTV ratios is important in determining the probability that the lender will lose money if a property decreases in value. In the example above, one could estimate that the property’s market value would have to drop by 40% before there is significant risk of capital loss, assuming foreclosure costs of 10% of the asset value. From the perspective of an investor looking to participate in a mortgage investment fund, a lower LTV signals a more robust fund that might be able to withstand a market downturn better than others.

An important detail to keep in mind is whether the LTV ratio advertised by a fund is calculated as a weighted average. In a simple average, small mortgages with very low ratios might skew the numbers, potentially hiding problematic large mortgages. Consider a fund with the following mortgage pool:

While the average LTV is relatively low at 50%, the weighted average LTV is almost 80% due to the large $8,500,000 mortgage at 85% LTV. While the fund might appear diversified, a market downturn could severely impact the whole fund due to the potential loss of capital from that single loan.

Considering this, we looked to partner with a mortgage fund with a weighted average LTV of 60% or lower, with a larger pool of smaller mortgages to ensure sufficient diversification. As such, the fund would be well positioned for market turbulence and can serve as a stabilizing presence in our clients’ portfolios.

Asset Type: What type of property are the mortgages being secured against?

Another component influencing the risk profile of a mortgage investment fund is the asset type lent against. The main categories include residential, commercial (which consists of multi-family, retail, office and industrial), land, and construction financing.

Mortgage funds vary in their composition of each asset type due to their portfolio strategy and regulatory requirements. As a general statement, residential mortgages (and to a degree commercial mortgages) are viewed as lower risk than land or construction mortgages. Funds heavily involved in construction financing usually offer a higher return to reflect the higher risk nature of the projects. These risks come primarily from two different sources.

The first source is mortgage size. Commercial properties and land deals typically require much larger mortgages than an individual residential property. Depending on the size of the fund, the available capital might be overly concentrated in only a handful of mortgages. This lower diversification means the impact of one mortgage going sideways would be significant, in a similar fashion to our mortgage pool example above.

The second source of this risk is the ability to sell the property for the desired price in the event that the lender has to foreclose on a property. Residential properties, particularly in larger urban centres, are relatively quick and easy to sell due to a larger buyer pool and shorter closing period. On the other hand, commercial real estate and construction deals can be more difficult to sell with a smaller buyer pool and longer transaction times, potentially straining cash flow for the fund.

One final point on construction financing is that there are far more variables involved with development than existing buildings. Construction costs can change, timelines are often extended and market values can change while the project is under construction, making it economically unfeasible. This means that not only is it more difficult to recoup your capital when a deal goes awry but the probability of it going askew in the first place is also higher.

Hawkeye Wealth has chosen to focus on funds that have a majority (90%+), if not the entire portfolio, composed of residential properties. This avoids construction risk and means the debt is being lent against an asset that already has its value in place on top of the value of the land. Giving preference to residential properties also means you are lending to a profile of borrowers more likely to make payments, since a large number will be homeowners refinancing or purchasing their principal home, which carries strong financial and cultural incentives for individuals to make payments.

This isn’t to say that investing in commercial or construction loans is a poor strategy. This is meant to highlight some of the risks so you can make a decision as to whether you’re being properly compensated for them.

Fund Size: Being big enough but not too big

Lastly, one commonly overlooked factor is the size of the fund itself. Just like any other business, mortgage funds benefit from economies of scale up to a certain point. To illustrate this, let us consider two extreme examples—a $5M fund versus a $1B fund.

In the smaller fund, depending on the market being invested in, there will only be enough capital for a handful of mortgages. This over-concentration exposes the fund to cash flow problems should even a single borrower stop making payments. The fund will likely not earn enough fees to hire good underwriters, establish effective business operations and have the marketing and business wherewithal to source the best mortgages. The only advantage is how nimble it may be as a small business to find fringe opportunities that others may have overlooked.

Conversely, looking at the larger fund, one can expect a stronger team in place with different individuals dedicating their entire day to mortgage origination, underwriting, accounting and so on. This fund will likely have the reputation and capital to be in a favourable position to source optimal mortgage opportunities. With this much capital, it will also be able to diversify in a variety of markets across the country. The potential issue that comes with funds of greater magnitude is the difficulty of continuously lending out the capital available. This might lead to reckless underwriting and/or low-yielding mortgages.

Final Thoughts

There are many other factors that will influence the risk and reward profile of a mortgage investment fund, many of which can be a deal maker or breaker depending on your personal preference. Other components not covered in detail here include the borrower profile, how frequently distributions are made back to investors, the seniority of mortgages, how easily you can exit the fund and the eligibility for registered funds (TFSA/RSP). All of these will play a role depending on your capital available, your time horizon and liquidity needs.

If you would like to learn more about mortgage investing and how to participate in Hawkeye Wealth’s vetted opportunities, you can access our webinar and investor package here.

*This article is for informational purposes only and does not constitute investment or tax advice.