Mortgage investing has become more popular in recent years, and for good reason. Mortgage funds have provided steady returns with virtually no relationship to public markets and are additionally secured by tangible assets. Mortgages are a valuable solution for today’s fixed-income investing.
Accessing mortgage exposure can be accomplished in two ways: through a private fund or a publicly traded mortgage company. A public mortgage company provides daily liquidity; however, the shares often trade at a discount to the value of the mortgages, and prices can unfortunately be volatile in response to public market events that arguably have little to do with the value of the portfolio. Private funds offer less volatile, uncorrelated performance, along with independent valuation, and they require advance notice for redemption.
Redemption rules and minimum investment requirements vary for private mortgage funds. Retail-focused offerings have minimums of as low as $1,000 to $5,000, while funds focused on institutional or accredited investors tend to have minimums anywhere from $25,000 to $150,000. The right to redeem funds varies from 1 to 3 months all the way up to lengthy restrictions. These details are an important part of the fund selection process.
Fund management is key
Fund managers demonstrate their credit expertise by valuing properties properly, securing the loan obligation conservatively and assessing the credit strength of the borrowers.
Knowing that bad things can happen to good borrowers, adept fund managers value collateral conservatively and use that valuation as the basis of calculating the required equity cushion, expressed as loan-to-value (LTV). This buffer protects the fund if the borrower stops paying and the collateral has declined in value. The lower the LTV, the better.
Why consider a mortgage fund now?
The critical risk for a residential mortgage fund, in our opinion, is unemployment, not housing prices. Owner-occupied homes are an emotional asset. If the borrower has a job, she or he will prioritize their mortgage payment.
These charts demonstrate the correlation between unemployment and mortgage arrears in Canada (which are a good proxy for defaults). The only time the relationship did not hold was during the COVID-19 pandemic, when mortgage payment forgiveness programs broke the link, and arrears did not rise. At current record low unemployment levels, the prospects for residential mortgage investing are strong.
Mortgage funds that focus on construction and commercial lending rely on collateral that is generally more sensitive to the state of the economy. This sensitivity is a function of the type of property and the regional economy where the collateral resides. Even with the possibility of a recession on the horizon, managers that select properties with care; diversify in terms of property types, regions and borrowers; and manage to a low LTV are likely to continue to perform well.
What about rising interest rates and inflation?
Unlike public fixed income funds, mortgage funds do not mark mortgages to a market price and are instead held until maturity. The majority of mortgage funds lend at fixed rates with relatively short terms and are able to adjust rates upon renewal to reflect the prevailing market prices and thereby pass on the increased return to investors. In other words, there is no immediate impact from increases in rates and a potential positive medium-term impact in a rising rate environment.
Real assets, in this case real estate, are often cited as an effective inflation hedge. The absoluteness of that statement is a complicated question that depends upon the type of property and the local market. For example, it may not be true of Canadian housing.
However, remember that because mortgage funds are debt funds, the critical question is whether a borrower will live up to the payment obligation, further supported by the tangible collateral. The inflation hedge notion may well be true of commercial properties that are in strong markets – such as e-commerce distribution support buildings in urban centres – where landlords may garner higher rents.
What should I look for in a mortgage fund?
Investors must be comfortable with the amount of risk that a manager is willing to take for the proposed target return.
- Type of mortgage (owner-occupied home mortgages are the least risky, while commercial raw land development properties can be the most risky).
- Portfolio LTV.
- Borrower creditworthiness.
- Diversification (geography, loan type, number of loans, loan size relative to portfolio, number of borrowers).
- Loss history.
It is best to dig deeper than other investors might and ask a potential manager for information that they may not furnish up front. Consider current liabilities of the fund starting with audited financial statements: what the current arrears are, what loans are in a work-out arrangement, and what, if anything, has the manager set aside as a provision for future losses? Has the manager ever restricted redemptions, for example during 2020? What terms were imposed on investors who wanted their money back? The results of these inquiries will help you to compare risk across managers and funds.
How can a mortgage fund improve my portfolio?
Mortgage funds are designed to be the turtle in the race. Performing well, they provide steady monthly income and a return that has no relationship with public debt and equity markets. They can provide the ballast to a portfolio that was once provided by long-only traditional fixed-income. Even with a relatively small allocation of 5 per cent to 10 per cent, the impact of diversification and steady returns can significantly enhance a portfolio’s risk-adjusted returns. That is a leading reason why many of Canada’s savviest institutional investors have committed capital to this beneficial investment strategy.
David Burbach is a Partner of YTM Capital and Portfolio Manager of the YTM Capital Mortgage Income Fund. David has spent more than 25 years in financial services as a lawyer and investor. Reach him at David.Burbach@ytmcapital.com.
Kevin Foley is a Managing Director, Institutional Accounts, at YTM Capital. Kevin spent more than 20 years as a managing director in capital markets at a major Canadian bank and he currently sits on three Canadian foundation boards and investment committees. Reach him at Kevin.Foley@ytmcapital.com.
More from Canadian Family Offices:
- High risk, high reward and high interest: Private placements in family office portfolios
- How your business’s transfer pricing set-up can trigger CRA audits
- Domestic bias in investing means missed opportunities
- Shareholder agreements: So critical, yet often a family ‘hot potato’
Please visit here to see information about our standards of journalistic excellence.