Mortgage Investments

before you invest your money...

Mortgages represent one of most common institutional investments in the world. Bankers like mortgages for the same reasons that you will.

Good return on investment.

Good security.

Relatively lower risk than most alternatives.

Of course, there are many different types of mortgages but here I am only going to discuss residential first and second mortgages.

When referring to a “first” or a “second” mortgage what we are referring to is the date of registration of the mortgage relative to any other mortgage placed on the property. Priority of a mortgage, at law, relates to the order in which mortgages are registered. So if I refer to a first mortgage, it means that no other mortgage is to be registered on title in priority to your mortgage. If I refer to a “second” mortgage I am referring to a mortgage that is to be registered behind a previously existing mortgage. Most private investments in mortgages are in “second” position and are called “Second” mortgages.

Second mortgages are generally considered to be riskier than first mortgages, which is why higher interest is charged than on a first mortgage.

The risk involved, however, is relative and varies considerably from one second mortgage to another.

Generally, most private mortgages are considered “equity” mortgages, which basically mean that they lean more on the value of the real estate than on the general credit worthiness of the borrower. However, the better the credit score of the borrower and the borrower’s cash flow position, the lower the interest rate will be, subject to the mortgage investment marketplace and the Loan to Value of the mortgage investment.

Typically second mortgage interest rates currently range from a low of 9% to a high of 18%, or even higher, depending on a number of factors that are balanced by a mortgage broker when he quotes a rate to a borrower.

The rate the mortgage broker will present to a potential borrower will be a market-based rate based on the lowest rate likely to be acquired by an investor.

In southwestern BC, at the current time, most second mortgages range from 12% to 16% subject to various factors including geographic location of the property, loan to value expressed as a percentage, use of the property either as a rental or homeowner occupied asset, etc.

For example, one of our lenders will place a second mortgage on property located in the Lower Mainland of BC, with a Loan To Value of 65%, to someone with reasonable credit, at 10% to 12% per year. Another will place a mortgage on a property located in a declining marketplace outside of urban areas, to a loan to value of 75%, at an interest rate of 16% to someone with bruised credit.

A significant part of the mortgage broker’s work is to determine what rate of interest will attract investment by an investor, and still be within the generally market rates otherwise available to the borrowers. Before we propose a mortgage investment we will have priced the investment based on market conditions, taking into account various risk factors that affect the cost of the money to the borrower, and the rate of return to the investor.

More experienced investors may choose higher risk mortgages, as the investor has had more background in handling an occasional NSF cheque, or isn’t concerned about perhaps having to foreclose on the property to recover their investment. A desire for a higher rate of return is balanced by a higher risk of loss or inconvenience.

The difference in the level of risk between most second mortgages does not mean that there is a significant risk of losing all your money. Rather, higher interest mortgages generally reflect the possibility that you will have to collect your payments actively, or even engage lawyers and extra expense to recover your investment dollars and/or your payments.

As long as the investment in a mortgage is made with reasonable parameters there is little or no risk of losing all your money, but you might have to wait to get paid at the higher risk levels. In declining markets the risk of total loss increases, in rising markets it declines.

Assessing Relative Risk and Reward

When investing your savings in a mortgage it is important to assess the risks involved.

If you put your money into a Canadian bank account, there is virtually no risk of total loss, but you will earn almost no interest income from it, either. At 2% your money is actually losing value every year against the Consumer Price Index and the underlying inflation rate. Government T-bills pay a little better, perhaps 3% or 4%, but using the Rule of 72 your money will double its value ever 24 years at 3% or every 18 years at 4%. Safe but not exactly sensible necessarily, since the value of your money will actually decline if your net rate of interest returns are the same as or close to inflation.

At the other end of the risk spectrum are investments in many different investments, including commodities like coal, corn or futures in metals. Those investments, when managed by skilful experts may result in being able to double your money in a few months or a year or two at the most. However, the risk of loss is extremely high. In other words you will likely lose some or all of your principle making these types of investments.

The same thing is true of investments in stocks and bonds, or even mutual funds based on stocks and bonds. The higher the rate of return published, the more likely the risk of losing some or all of your investment dollars. It doesn’t always have to happen. Sometimes investors do very well indeed investing in stocks on the various exchanges around the world. As many of us have experienced in the past year, one might choose to have some exposure to this marketplace, but one should be cautious about exposing critical retirement money to the risks represented by equity markets where values are based on the buying and selling of volatile stocks.

The last type of investment really available to most investors is debt investments of one kind or another, where the risk of loss is lower, but the rate of returns is also lower. Mortgages are in this class of investments, however, their rate of return in substantially higher than most other equally “safe” or “less risky” investments.

Even within the mortgage investment world there are additional ways to reduce your risk of loss:

Mutualisation of mortgage risk – by investing in a mortgage pooling arrangement, (like a Mortgage Investment Corp.) decreases your risk by spreading it out over a large number of second mortgages. It also slightly reduces your net returns because typically MICs invest in a mixture of lower risk first mortgages and some higher risk seconds and charge the investors for the costs associated with administration.

Investing your money in a number of smaller mortgages instead of one large mortgage. This is the method preferred by most small mortgage investors, since the more mortgages represented in your portfolio, the less likely you are going to find yourself with more than more of them not performing at any given time.

Reliance on competent professionals all the way down the line. Seasoned investment professionals are more likely to successful with you than beginners. Check out some referrals. Ask lots of questions. If your mortgage broker balks at answering your questions at any time, be concerned, very concerned.

Make sure that the lawyers doing the work are always available to answer your concerns and question. Lawyers preparing mortgages for you, have a duty of care to you. Don’t hesitate to ask questions of the law firm preparing the documents and registering the mortgages for you. I use a number of different law firms to prepare documents for private mortgages I broker. The firms I use are all experienced lawyers, with skilful conveyancing staff. What they all share is that they always recognise their duty of care is to the lenders (the investors, you guys).

Review your documents when you receive them from the lawyers, and make sure that what you were told you were getting is exactly what you in fact have received. If there are any doubts or questions, call me (or the law firm) for clarification, or in the event of an error, rectification.

Mortgages are held in your own name, unless otherwise specified in writing. This is important, and the priority of your mortgage should always be consistent with what you have been presented by your broker. The Investor Disclosure sheet provided by him is your statement of intention by the broker. The actual mortgage should conform entirely to what has been disclosed. If there are changes to any of the material facts, the law firm will contact you directly confirm that you still wish to proceed with the investment. The lawyers provide you with assurances that the disclosure form accurately reflects the mortgage reality.

Ultimately, investing in mortgages can be relatively low risk, and mostly requires that you ask suitable questions to determine whether what you are investing in is a lower, medium or higher risk mortgage.

At the end of the day, the higher the rate of interest you seek to earn from your mortgage investment, the more likely the risk of loss of some, part or all of your investment capital in any given mortgage.  This risk is remediated by careful underwriting and allocation of capital, but not eliminated.

All this being said, investments in mortgages are a reliable way to earn a good rate of return in an active portfolio.  It does require some due diligence by the investor/lender. But the rewards are worth it.