Typically, when people need mortgage financing to buy a home or a commercial property, they borrow from conventional lending sources such as banks or credit unions. For those people that are not able to obtain a loan from these traditional sources, they often turn to alternative types of mortgage lenders. These non-bank lenders or private lenders can include mortgage investment entities, or MIEs.
An MIE is a mortgage-financing business that pools together money from investors to lend to people as mortgages. Each mortgage is secured by a real property such as a house, strip mall or a piece of land, but the MIE investor doesn’t own a piece of that land or house.
MIEs provide loans to people or companies which are generally financed from the pooled investors’ money. Borrowers who can’t qualify with traditional lenders or who want more flexible mortgage terms commonly pay a higher interest rate with private lenders since these are typically higher risk loans. People are often willing to pay higher interest rates to get a loan from an MIE because they can get approved quickly by the MIE manager and sometimes without their income or credit history even being verified. These loans form the portfolio of an MIE, and can include residential mortgages (e.g. single detached houses, townhouses, condominiums), commercial mortgages (e.g. office building, industrial, retail real estate) or land mortgages. An MIE earns its income from the mortgage interest, financing fees, mortgage renewal fees, cancellation penalties and other fees that it charges to the people who borrow the money.
An MIE will have a manager who sets up the MIE and originates and administers the mortgages. This mortgage portfolio has to be continuously managed so as to handle funding new mortgages and discharging existing mortgages in the portfolio. They are also responsible for collecting mortgage payments. The manager of the MIE will be paid fees for performing these management services from the money you have invested and from the people who are borrowing.
As an investor, you purchase a security issued by an MIE, typically in the form of shares of a corporation, limited partnership units, promissory notes or trust units. The security’s value is derived from the value of the underlying pool of mortgages. Investors may earn dividend or interest income generated from the interest earned by an MIE’s portfolio of mortgages.
Generally, the goal of an MIE is to lend out money and charge an interest rate that is high enough to cover the expenses of operating the MIE, the fees charged by the manager for its work, and the income payouts (if any) to investors.
1. Lack of liquidity. Private MIEs are illiquid investments and are not listed on a stock exchange, meaning that you may not be able to sell your investment when you want to (or at all). In most cases, the only way to get your money back is to sell your security back to the MIE, commonly referred to as a redemption. When purchasing an MIE security, ask about what the redemption terms, lock-up periods or other penalties are if you want to sell your investment – some MIEs charge early redemption fees up to 10% of the value of your investment. While some MIEs may offer redemption terms, there are generally restrictions because most investors’ money is tied up in mortgages or development projects. Ask if there is a waiting list for people looking to redeem their investment.
2. No guarantee of a return. Some MIEs claim to offer high and steady annual yields and promote investments that are “secured by real estate” or that “preserve your capital.” The name “secured” means that the MIE requires something as security in case the borrower cannot pay the loan back. “Secured” does not mean guaranteed and while the mortgage may be backed directly by the real estate, your investment is not secured and you have no rights to the home or property that secures the mortgage. If a borrower is unable to make payments on its mortgage in the MIE’s portfolio, this can affect the ability of the MIE to maintain payments to investors and the value of your investment. An MIE can shut down or go bankrupt like any business, particularly if there is a downturn in the real estate market or a recession.
You may also see the investment marketed as a “high-returning GIC alternative.” GICs and MIEs are two very different products with different risk profiles. Unlike a GIC, an MIE cannot guarantee that you will earn any income or that you will receive your original investment back. There is also no insurance program for MIE investments similar to the Canadian Deposit Insurance Corporation (CDIC) which covers against the loss of eligible deposits to a maximum of $100,000 in the case the CDIC member were to fail (e.g. bank or other financial institution). For example, savings and chequing accounts and guaranteed investment certificates (GICs) with terms less than five years are covered by CDIC.
3. Low priority of rights. MIE’s portfolio holdings can consist of first mortgages, second mortgages or third mortgages. First mortgages are generally less risky because they are the first to get repaid and the first to claim any property provided as collateral on the mortgage in the event that a borrower is unable to make its payments or has defaulted on the loan. A second mortgage only gets back whatever money is left over after the first mortgage lenders are repaid in full and might not be able to exercise its rights to foreclose a property if the first mortgage is not in default. Some mortgages can be third or fourth behind other lenders. Keep in mind that even if the MIE is first in line to get repaid, it can take a long time to collect on a bad mortgage which can affect the ability of the MIE to maintain payments to investors and the value of your investment.
4. Mortgage portfolio composition and concentration. An MIE typically holds a number of mortgages in its portfolio, reducing the potential risk to investors compared to holding a single mortgage. However, the mortgages typically provided by an MIE are higher risk than those provided by a conventional lender, such as a bank. It is important for you to understand the composition of mortgages that the MIE holds including the (i) types of mortgages, (ii) geographical location of the properties, and (iii) terms of the mortgages. Be wary of high concentration in any of these because it exposes you to more risk.
Typically, the interest rate that an MIE charges a person who borrows is directly correlated to the level of risk of the mortgages – the higher the risk of a person defaulting on their mortgage loan, the higher the interest rate they will be charged.
(i) Types of mortgages. MIEs can lend money for first, second, or third mortgages on different types of real estate like residences, commercial properties or land development. An MIE composed of first mortgages, is typically less risky than an MIE holding second or third sub-prime residential mortgages or construction loans. Loans to buy houses are typically secured by the house and typically have a lower risk profile, depending on where the MIE stands in line to be repaid if a borrower fails to pay, commonly referred to as a default on its loan payments. Conversely construction loans are riskier if the development hasn’t started yet and the loans are not backed by any monthly income from the development. If the construction loan defaults, it may also be harder to sell because it is an unfinished project.
(ii) Geographical location. You should be wary of MIEs that have high concentration of mortgages in one geographical location. An MIE that is concentrated in one geographical location will be riskier because it is more sensitive to adverse local economic and real estate conditions.
(iii) Terms of the mortgages. MIEs are typically more flexible in their lending terms and will provide shorter term loans, generally ranging from 6-36 months, than those offered through traditional sources. It is because of this flexibility and the higher risk of these loans that they charge interest rates that are significantly higher than prime rates used by banks. While the loans may be initially structured as a short term loan, they typically get renewed multiple times turning into multi-year mortgages.
Under normal market conditions, diversification is an effective way to reduce risk. For example, if the MIE holds a single mortgage and the borrower defaulted, you could lose all of your money. If it holds a variety of different types of mortgage loans, for different types of properties and in different geographic locations, it’s much less likely that all of the mortgages will default at the same time.
5. The valuation of the loans is important. Since private MIEs are not traded on an exchange, it is the manager that determines the value of the investment. The loans’ valuation is critical because it primarily determines the value of your investment.
6. The Loan-to-Value of the mortgage portfolio is important. This is the ratio of the mortgage amount to the market value of the property, which is typically used to support the loan as collateral. You should ensure that the value is being calculated using the “as is” market value and not the future value, which can understate the actual risk.
Generally, riskier loans will have a higher Loan-to-Value ratio. For example, if an MIE has lent a borrower a mortgage of $600,000 for a property valued at $1,000,000, then the loan-to-value is equal to 60%. This figure is important to ensure there is enough equity in the property to pay investors back if the borrower defaults and the property needs to be resold. The lower the Loan-to-Value ratio the better because it gives some protection against the risk of a decline in property or home values (prices) which can adversely affect the MIE if it has to pay for expenses associated to selling the property that has been used as collateral such as legal fees, realtor commissions and other associated fees.
A portfolio made up of a high percentage of first mortgages with a low loan-to-value ratio can protect against a decline in housing market.
7. Understand all Fees. Private MIEs sometimes pay higher fees that can reduce the payout amounts to you. Fees paid to the manager can be high and can include management fees, performance fees, and mortgage origination fees. On top of these fees, the operating expenses of the MIE are also funded from investor money. This means that a manager can earn a higher return than investors through the different types of fees.
Ask how the manager is earning money, how much of your money is going to pay fees to the manager and how much is going to be lent out as mortgages. You also want to understand if the manager lends to related parties – this may create a conflict and puts your interests at risk because the manager’s interests may not be aligned with yours.
If a manager claims to earn no fees, you should question how they earn money. You may want to ask whether the manager collects fees directly from the borrower – as a broker fee for arranging the loan – and if so, why the fees don’t go directly to the MIE for the benefit of investors.
In addition to the expenses of operating an MIE, the manager charges different fees and most of these fees are not impacted by the performance of the MIE, so even when the MIE loses money, the fees to the manager will still need to be paid.
8. Check before you invest. Individuals and businesses need to register with their local securities regulator in order to offer investment products, services or advice to Canadians.