Mortgage investment corporations (MICs) lend to borrowers that banks generally don’t touch. For that additional risk, they charge higher interest rates. Those above-average rates, in turn, help MIC investors earn mouth-watering yields (high single digits or greater).
But there’s a lot to consider when investing in MICs. For tips we spoke with Andrew Jones, Managing Director, Debt Investments at Timbercreek Asset Management (which runs two public MICs). Among other things, he explained the differences between public and private MICs (very relevant for investors), MIC performance when rates increase and risks to watch when investing in these things.
Here’s that interview in full…
CMT: What’s with all the new public MICs lately?
Andrew: Raising capital for a mortgage investment vehicle through the credit crisis was difficult. As time progressed, however, we were able to demonstrate that [our mortgage] investment strategy provided a great source of stable cash flow. It therefore became easier to subsequently raise capital in the retail channels.
We believe other MICs and mortgage investment funds saw [our] success and were attracted to the public markets for a variety of reasons:
- Some needed to replace institutional capital exiting their funds.
- Some needed to provide their investors with the liquidity of public market trading because they were unable to satisfy redemption requests.
- Some were just attracted to the popularity of the asset class within the retail markets.
Also, once investors were given the option to invest in publicly traded MICs, it may have become difficult for some MICs to raise capital as private structures. A public listing ensures the MIC is regulated, transparent, and offers improved reporting for investors. Additionally, there is daily liquidity for investors.
CMT: How many public and private MICs are there?
Another company has filed a preliminary prospectus for its IPO. There are also four public mortgage investment funds that invest in mortgages but are not structured as MICs.
In terms of private MICs, there are hundreds that come in all shapes and sizes. However, there are only a handful of MICs in Canada with a portfolio over $100 million.
CMT: How do public and private MICs differ in terms of risk and liquidity?
Andrew: The primary differences between public and private MICs are the level of transparency and liquidity. Private MICs generally do not disclose whether lender fees are being paid to the manager. We operated a private mortgage fund for a short while before going public and can attest to the fact that audits on public companies are much more sophisticated than audits conducted on private companies.
Public companies are also scrutinized by the agents raising the capital and their counsel. Liquidity in a public MIC is also daily, versus private MICs that typically only offer liquidity quarterly (which can be suspended by the manager).
As for risk, it would be difficult to generalize. It’s more important for investors and financial advisors to realize that not all MICs are created equal; they need to assess the investment strategies of the MIC and look at the underlying portfolio of loans, and determine what level of risk-return is most appropriate for their situation.
CMT: What would you consider a large MIC? What limits do you see to growth?
Andrew: At the end of last year, the companies I listed above held a total of over $3 billion in mortgage assets, I believe ($375 million each, on average).
The appropriate size completely depends on the investment strategy. For example, our original MIC targets higher yielding loans with higher loan-to-value thresholds (average LTV is 64.6% currently; maximum 85%). We have elected to keep this vehicle under $450 million, as we don’t believe enough demand exists for the type of loan that fits our investment objectives and quality standards.
On the other hand, our Senior MIC targets bank-like loans (all first mortgages, max LTV of 70% and average LTV is 47% currently) where the demand is much higher, so we believe this MIC could grow to upwards of $1 billion.
CMT: Roughly speaking, what ratio of your MIC’s revenue comes from interest payments versus lender fees charged to borrowers?
Andrew: In our case, we push all of the fee revenue to the MICs and this represented approximately 12.5% of the income generated by our original MIC in its first five fiscal years. Other managers of MICs keep a portion of that fee revenue as part of their compensation. This is common industry practice, but we believe that in order to ensure alignment of interest between manager and investor, all lender fees should be pushed through to the investor as additional income. This ensures we as the manager don’t have any financial interest in structuring financing so that the borrower pays higher upfront fees but a lower interest rate on the loan.
CMT: How and how much do large MICs use leverage? And how much extra risk does that create?
Andrew: It depends on the strategy. Our original MIC does not use leverage because it is targeting higher-yielding loans. Our Senior MIC targets around 20% (leverage) because it is focused on lower risk mortgages. Where leverage gets quite material is in the U.S. mortgage REITs where some may be using 10-to-1 leverage ratios.
As for risk, leverage should be considered but it is important for investors to also evaluate the underlying loan portfolio, including the security for the loans. We believe those MICs with a high concentration of land/construction loans are riskier investments than those that invest in loans secured by income-producing assets. Loans secured by actual income producing properties as opposed to raw land or projects under construction are less exposed to fluctuations in market conditions. The reason being, properties with rental or lease income have cash flow to service loans if borrowers were unable to refinance when their loan matures.
Mortgages secured by non-income-producing assets, on the other hand, generally rely on a development or construction project moving forward, which requires sales of the end product to be in place. Such sales can be heavily dependent on market conditions.
Other factors to consider when assessing risk include:
- The average LTV ratio (It’s the equity buffer in case prices decline);
- Diversification of the portfolio (including by geography and borrower); and,
- The track record and lending platform of the MIC’s manager, including whether there is an independent body that reviews and approves the loans sourced by the manager before the MIC can invest in them.
CMT: The yields offered by some big MICs have fallen significantly in the last five years. Is there too much competition now among MICs?
Andrew: Not in terms of capital chasing mortgage investments. Although there have been a number of new entrants into the public markets as of late, many previously existed as private companies and therefore the amount of capital raised in relation to the size of the lending market is pretty insignificant.
The demand for customized mortgages by experienced commercial real estate investors remains healthy, real estate transaction activity is strong and there continues to be a lack of capital available from institutions. Moreover, the $4+ billion commercial mortgage-backed securities (CMBS) market – an important source of commercial real estate financing, which essentially dried up in 2007 – has not bounced (all the way) back.
The MICs in the market today have very different investment strategies so they’re not all competitors. For example, we focus on lending against income-producing real estate. Others lend against land, construction, condo development, and even single-family residential homes. So there are different options for investors to choose from with different risk profiles.
CMT: What has been, and will be, the impact of rising interest rates?
Andrew: So far it has not had a material effect. Rising interest rates that are tied to inflation would spur more real estate activity. That’s good for those providing financing, as real estate investors seek to capitalize on growth in real estate values.
Additionally, many MICs have built-in protection and can increase cash flow in a rising interest rate environment. That’s true for a couple of reasons:
- The loans are typically of short duration. The average remaining duration in our loans, for example, is relatively low (between 18-24 months). And portfolio turnover is fairly high, with maybe half the loans expected to be repaid each year. Therefore, as this capital is repaid we are able to redeploy it at higher interest rates which in turn provides more cash flow to the MIC and therefore a higher yield for investors.
- The loans often include floor rates. For example, a prime-based loan with a floor rate means that if rates go up, the MIC captures that interest hike. But if rates go down, the MIC’s rate won’t drop below the floor rate.
CMT: How did MICs perform during the last housing selloff of 15-20%+?
Andrew: Some of the land players—particularly those exposed to land in B.C. and Alberta—did very poorly but some lenders did okay. Generally, the ones led by good managers did well. At that time it wasn’t beneficial to be huge or too small. The larger lenders were doing tough deals because back then they wanted to pay out 10%+ yields. The ones that were too small were fighting to stay invested when there was a lot of competition. For these reasons, it’s important for investors to consider the track record of the manager, its lending platform, and its history of loan losses, as well as how well it works out loans in arrears, the quality of its governance, and its transparency.
CMT: Could MICs of the future ever be single-family mortgage lenders at highly competitive rates (i.e. lend capital generated from investors as opposed to generated through deposits or securitization)?
Andrew: Currently, (our) mortgage investment funds provide distributions with an annualized yield to investors of anywhere from approximately 5% to 8%. Therefore, interest rates on the mortgages they invest in, typically commercial real estate mortgages, are higher than you would see for prime single-family residential mortgages.
[Single-family lending] is a highly competitive space dominated by the major banks and top monoline lenders. MICs typically pay out all taxable income to investors through dividends. So, if the interest rates on the loans provided by MICs were highly competitive, say 3% or less, the spread would be extremely small and you still have to cover your expenses. Therefore, at the end of the day, unless the investors were willing to take a VERY low yield, I don’t believe this is a viable investment strategy.
MCAN already provides uninsured single-family loans, but it is a “Deposit Taking Institution.” [It uses] leverage by issuing term deposits which are insured by CDIC in order to generate a yield that is attractive to investors, and it has securitized mortgages.
Eclipse Residential MIC, the newest public MIC, will focus on non-conforming single-family residential mortgages (conforming single-family residential mortgages often receive the best interest rates from mortgage lenders).
It expects to use subordinate financing where about 85% of its portfolio will be junior tranches or second mortgages. With tranching, the senior position in the mortgage can be acquired by a financial institution like a bank, life insurer or credit union and it is entitled to a lower interest rate than the entire mortgage rate; this enables the holder of the junior tranche to earn an increased yield on its investment.
Side note: MCAP launched the Eclipse Residential MIC to provide it with a source of funding for its Eclipse
mortgages. Don Ross, SVP, Investor Marketing for MCAP, tells CMT: “MCAP borrowers
pay interest in the 5 to 5.5% range for Eclipse mortgages, assuming that they
qualify under our credit guidelines. We then divide this mortgage into two
components. One of those components will be sold to a bank or other type of
regulated financial institution at a yield of 3 to 3.5%. The excess interest (above that 3 to 3.5%) helps Eclipse Residential MIC earn a gross yield
of 10%. After costs and reserves we have a comfortable target yield of 6% (to
CMT: What are the three most important questions you’d ask if you were investing in another MIC yourself?
Andrew: I would ask:
- Are the loans secured by income-producing assets?
- What is your portfolio diversification strategy to mitigate risk?
- Does all of the fee income generated by the lender flow through to investors as cash flow or does management keep some of it as compensation?
CMT: Thanks Andrew.
Rob McLister, CMT