INVESTING IN MORTGAGE FUNDS

A mortgage investment fund lends money (secured against real estate) to borrowers that may not qualify for conventional bank financing. The borrowers typically pay higher interest rates with a mortgage fund than they would with larger banks or lenders. It is also common for mortgage funds to allow interest-only payments, lowering the monthly payment amount.

The investors in the fund earn a return on their investment from interest and fees paid by the borrowers on their mortgages. 

Mortgage funds can use various structures, including Mortgage Investment Corporations (MICs), Mortgage Trusts, and Limited Partnerships. While there are nuances between the structures, they are all fundamentally in the same business of providing private mortgages to earn a return for investors.

Canadian Banks have traditionally been known for their conservative lending practices, and have become increasingly cautious since the financial crisis of 2008. This tightening has increased the number of people seeking alternatives to the bank for mortgage financing.

When calculating mortgage risk, banks and mortgage funds need to assess both the quality of the borrower and the quality of the underlying asset serving as security against the loan. As a general statement, bank underwriting is more rigid and tends to focus more on the borrower when deciding whether to lend, whereas mortgage funds are more flexible and tend to focus more on what asset they are lending on, and how much they are lending on the asset (the Loan-To-Value, or LTV). Mortgage funds typically prefer highly marketable properties in high demand areas like major urban centres.

One of the main reasons borrowers do not qualify for bank financing is because their income is deemed too low to service the debt. To determine debt-servicing capacity, banks primarily look at your line 15000 (Line 150 prior to 2019) income on your T1 tax return form. If banks are not satisfied with your line 15000 income, the conversation often ends there, even though there may be many good reasons that the borrower is more than capable of paying the mortgage. This is where mortgage funds often step in, as debt-servicing requirements are relaxed if they have reason to believe the debt will be serviced, and if it isn't, the asset will cover the debt and accrued interest in the event of a foreclosure.  Another reason is that the borrower has inadequate credit due to poor or no credit history.

A few examples of the types of clients mortgage funds serve are:

Business owners that may not meet the debt-servicing thresholds for banks because they pay themselves a lower salary for tax purposes. Some business owners also benefit from the fact that they do not need to increase their personal income to get a mortgage, resulting in lower personal taxes paid. 

New immigrants with significant assets but little/no credit history.

Recently divorced individuals that may have lower income or inadequate credit history but have significant assets that could be sold if required to service debt.

Individuals that are purchasing a new house but have not sold their previous house yet and have difficulties debt-servicing both properties at once. Sometimes these borrowers have access to funds through a line of credit on their current residence, which can serve as a large down payment on the second property being financed by the mortgage fund. These borrowers will typically refinance their new property with a bank after their previous home sells.

Purchasers that may qualify for traditional financing but need to close very quickly. Unlike banks, mortgage funds are known for their ability to fund quickly, which wins them deals that would typically go to the bank. This may include homebuyers with quick closing dates, purchasers who have financing fall through at the last minute, or investors that need to pounce when they identify a good deal. Again, these borrowers often refinance with the banks at lower rates once their private mortgage matures.

Financing property flips as banks don’t like to be short-term lenders and borrowers are okay with the higher interest rates given the short term of the loan.

Mortgage terms and interest rates vary greatly depending on the quality of borrower and perceived risk of the underlying asset serving as security. As a general statement, private mortgages tend to have shorter terms and almost always have higher interest rates than traditional mortgages. For private residential mortgages, a 12-month term is common to give the borrower time to get their affairs in order and refinance at a lower rate with a bank. Private mortgage interest premiums ABOVE bank rates can be as low as 2-3%, or as high as 20%+ over bank rates depending on the perceived risk of the loan.

Risk Adjusted Returns: With very few exceptions, holding the debt on a property carries lower risk than investing in the equity. This is because equity is the first money to be lost if there is a market downturn. To illustrate, consider if you buy a $1,000,000 property and put down a 40% down payment ($400,000), and a mortgage fund lends the remaining 60% ($600,000) required for the purchase. Subsequent to your purchase, there is a 20% drop in the market value of your property. If you are then forced to sell, or the lender forecloses, and the property sells for $800,000 (20% lower than your purchase price), in this circumstance, the lender would be paid their $600,000 plus any accrued interest first, with the remainder going to you, the borrower. In this scenario, the lender invested $600,000, collected interest, and lost no money in spite of the market downturn. You, on the other hand, have lost at least $200,000 of your original $400,000 down payment, if not more after sales expenses and/or foreclosure costs. With this risk profile and with anticipated returns much greater than other fixed income options out there (GICs, Money Market Funds, etc.), many wealthy families and business owners are attracted to mortgage investing for long-term growth.

Low Volatility: Another aspect that attracts investors is the relatively low volatility of mortgage funds. Interest payments to investors are typically more consistent than cashflow from equity investment options and the value of your investment will continue to grow unless a significant portion of the borrowers stop paying AND the sale of assets upon foreclosure does not cover the mortgage amount. If executed properly, mortgage funds can act as a stabilizing presence in a portfolio and be an excellent source of long-term income. Of course, each mortgage fund varies in risk depending on their strategy and underwriting criteria. While higher returns can be achieved with a more aggressive strategy, we focus on what we believe is the lowest risk segment of the private mortgage market. If you'd like to learn more about the criteria we've used to assess risk, please see "What do you look for when choosing a mortgage fund to work with?"

RSP/TFSA Eligible:  Unlike most of our private equity deals we offer, most mortgage funds are RSP/TFSA eligible, which can be a great option from a tax-planning perspective.

Providing mortgages directly to borrowers is a valid option for some investors, however, unless you have very large amounts of capital (multiple-millions) to invest in this strategy, it is hard to get the benefits of scale and diversification that come with having many mortgages and a professional team. A few potential things to consider when managing individually are:

Work: Foreclosure can take much time and effort and if you do not have the team to handle it, it is going to be you. For many of our clients that are starting to enjoy the fruits of their hard-earned wealth, time becomes increasingly valuable, often more so than money.

Security of Cash Flow: Foreclosure stops cash flow and if you only have two mortgages and they are both the same size, your cash flow is cut by 50%. Compare that to the possible scenario of having 100 mortgages, with five in foreclosure, where you are still collecting interest on 95% of the mortgages.

Liquidity: There are no liquidity options until the term ends or the foreclosure is complete. Many mortgage funds offer liquidity options, usually with 30 to 90 days notice (more on this in “Can I exit if I need to?”). While funds vary and there is no guarantee of liquidity with a mortgage fund (more on this in "What are the main risks?"), liquidity is usually easier. 

Access to Best Mortgages:  Since individuals are usually more limited in the number of mortgages they can fund, they may not be the go-to option for mortgage brokers and borrowers. This can make it difficult for individuals to build a sales pipeline to get access to the best mortgage deals.

Investor risk comes from the character and competence of the Mortgage Fund's team, which determines the quality of the mortgages the fund invests in. There are two main risks that mortgage funds want to understand before deciding whether to lend, and at what interest rate. The first is - will this borrower make their payments? The second is -  if the borrower stops making payments, will we be able to recoup our funds through foreclosure? 

In other words, what’s the risk of the borrower, and what’s the risk of the asset?

The main factors used to assess the risk of the asset include:

• The type of loan (from lower to higher risk - Residential, Commercial, Construction, Bare Land)
• The loan to value of the mortgage, which determines how far the market value can fall before the fund will lose money
• Whether it is a 1st, 2nd or 3rd mortgage, as 1st mortgages get paid back first
• The market the property is in, as a desirable market is easier to sell in

The main factors used to assess the risk of the borrower include:

• Their credit score
• Income
• Liquid assets
• Net worth

The potential areas of risk that could impact the above factors are:

General Economic & Real Estate Risks: Factors that may impact real estate pricing and external economic forces are inherently unpredictable and may impact the borrower’s ability to make payments and the fund’s ability to recoup their funds in the event of foreclosure. 

Liquidity Risk: Given that the fund invests in private real estate mortgages, there are liquidity risks that could impact the fund’s ability to make payments to investors should foreclosures happen and the ability to sell the property is not met quickly enough. 

Regulatory and Interest Rate Risks:  The demand for private mortgages can be heavily influenced by the regulatory regime around lending and the interest rate set by the banks. 

This is not an exhaustive list. For more details and a complete discussion of the potential risks of this investment, please refer to the Offering Memorandum. 

Please reach out to us at info@hawkeyewealth.com and request an information package. After discussing whether there is a fit for you to invest with us, we will complete the subscription process.

There are many fee structures but most fall between 1% and 2% of your investment amount per year to manage your account.

Almost all mortgage funds are RSP eligible. If you are not sure, check the offering memorandum document or feel free to reach out and ask us.

The terms around redemptions vary between mortgage funds. For example, one fund we work with has an option to redeem with 90 days notice. However, there may be conditions where redemptions are paused, or "gated." Gating may occur when too many investors are trying to redeem at the same time, potentially causing lower performance or higher risk for the remaining investors in the fund. Some funds we have spoken to have never gated their funds after years of operations, but it is always a possibility, particularly in a severe downturn. 

Our clients like to work with us because we operate independently. We respect and trust the firms we partner with but our ultimate allegiance is to our investors. That's why we always conduct independent due diligence to verify key assumptions and ensure they align with our investor group’s goals. There is usually little to no fee differential between what you would pay working with Hawkeye Wealth versus what you would pay working directly with the issuer. When there is a difference, we will be transparent about it and explain why we believe our service and access to a variety of other opportunities more than compensates for the difference.

We prioritized preservation of capital over return when looking for a mortgage fund to partner with. Many mortgage funds position themselves as low risk options and at first glance many look the same, but looking further often reveals significant differences in risk. Here are some of the things we look at when seeking to understand a fund's risk:

1. Fund Size: If the fund is too small, the benefits from spreading your risk across numerous mortgages is lessened. Size can also impact the quality of mortgage underwriting, mortgage sourcing/origination, service to the borrower and investor communications. Our preference is for funds that are greater than $100M in size.

2. Asset Focus: Residential mortgages are generally regarded as lower risk when compared to lending for land, construction financing or commercial property. 

3. Loan-to-Value (LTV): Most funds have a criteria for what LTV they are willing to lend at, with the lower the loan-to-value, the lower the risk. The lowest risk mortgage funds operate at below 60% average LTV. One thing to be aware of is that averages can be deceiving. A fund with half of its mortgages at 40% LTV and the other half at 80% LTV is more likely to lose money than a fund with all of its mortgages at 60%, even though the average LTV for both funds is 60%. This is because in the event of a market drop, mortgages lent at 80% LTV would be under water far before any of the mortgages lent at 60% would be. A fund may earn a slightly higher return by lending a portion of their portfolio at 80% but they are taking on higher risk. The key is to know that the primary objective of the mortgage fund is to mitigate risk, not just appear like they are mitigating risk for the sake of attracting investors.

4. Percentage of 1st/2nd/3rd Mortgages:  Being in a first mortgage position has the advantage of being paid back first in the event of foreclosure. For this reason, many mortgage funds that have the primary objective of protecting capital predominantly pursue first mortgages.

5. Geographic Diversification:  Many funds focus primarily on one or two markets that they are familiar with and aren't equipped to diversify over many markets. Also, larger cities may be preferential for lenders as they are generally regarded as less risky options because of the ability to sell in the event of foreclosure because there is a larger pool of buyers.

6. Prudent Use of Leverage:  Most mortgage funds have a line of credit that they use as a cash buffer and to increase returns. Higher use of leverage increases risk.

7. Alignment:  Some fund managers and related parties have heavily invested in their own mortgage funds. If these related parties say their objective is preservation of capital, being invested alongside our investors is what we like to see.