A made-up conversation overheard yesterday at the gym….
“Do you still have your money in the stock market? What are you doing? The market is way too risky. I have all of my money in a mortgage fund and it has been paying me 10% a year for years with no risk”.
With Canada Savings bonds offering 0.4% (yes, you read that correctly), “high-interest” savings accounts paying 0.75% and good quality corporate bonds offering 3%, Canadians are frantically looking to alternatives to the stock market to achieve a sensible return. Many of our clients have asked us our opinion on private mortgage pools or funds that invest in so called low risk first mortgages that pay 8-10% returns. If you are considering an investment in one of these vehicles, please keep the following in mind.
- Do your homework. Investments in mortgages are not low risk, especially ones offering to pay 8-10%. Mortgages invested in bridge loans, construction or pre-development opportunities are deals that are passed over by banks and fraught with many risks.
- Size doesn’t matter. Although this goes against conventional wisdom, the bigger the fund, the greater the risk. As a successful mortgage funds grows it will have to diversify into new geographical areas. Having success in a local market does not guarantee results in another. A diversified pool of high risks mortgages is still high risk.
- Watch the payout ratio. Many funds are required to payout 100% of earnings as distributions. What happens when a deal goes bad, oh that’s right your payout could be in jeopardy.
- So you want your money back? High yield does not guarantee your principal will be maintained. Mortgages funds are illiquid. The money you invest is lent out to borrowers so the fund can get a return to pay its investors. What happens when you want some or all of your money back? Many funds will allow you to redeem your investment but only at a discount or given a significant waiting period.
- Fees can be outrageous. The partners or managers of the mortgage funds may pay themselves a reasonable 1% to 2% management fee and then go ahead and charge the borrower of the mortgage another 2% to 3%. You could be paying a management fee of up to 5%!!! Think about this for a second. Does it sound fair that the manager of the mortgage fund not only charges you a management fee but also charges the borrower of your money a fee as well? To generate an 8% return to pay you, the mortgage fund will have to find borrowers willing to pay at least 12% for a loan. Remember these are borrowers that the banks have passed on due to the high level of risk.