Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
It doesn’t take much to make an informed decision in real estate these days.
The market is cooling fast, buyers are on the sidelines and sellers are starting to worry. Not a great time to be long, in other words.
But that doesn’t stop mortgage investment corporations from tumbling off the financial-product assembly line. MICs, as they’re known, are doing just fine, even though they’re engaged in real estate, including residential. The industry, which operates in both the listed and unlisted realms, is growing briskly.
MICs can be perfectly fine investments, but investors should be careful, because this growth doesn’t jive with what seems to be happening in real estate.
MICs are pretty simple: They pool money and lend it out to borrowers in mortgages. Effectively, they turn your equity into someone else’s debt, and send you a cheque every month as they collect interest and principal.
You start raising your eyebrows soon into your due diligence on some of these things.
For starters, given that some of them yield 8 per cent in a world where one can borrow from a bank at 3 per cent, what kind of loans are these corporations making?
They are clearly more risky than loans a bank might make. And that’s fine, because risk goes with return. But is the return compensating for the risk?
Consider that to get an 8-per-cent yield on money raised, the MIC has to earn a lot more than that.
The costs of raising money will typically eat about a nickel from every dollar investors put into these vehicles. So to earn that 8 per cent, the MIC has to make close to 8.5 per cent. That’s just to compensate for the financing cost.
On top of that, these corporations often pay about 3 per cent in total fees to the managers. So now the hurdle is almost 12 points. A 12-per-cent loan is, by definition, significantly riskier than an 8 per cent loan, but investors are only getting 8.
That might arguably be okay, given the benefit of liquidity and exposure to an asset an individual investor would have trouble creating on his own. But there are other issues.
First, competition. MICs are proliferating rapidly. New ones appear seemingly by the week, and existing one are raising more and more money with the promise of attractive distributions.
But competition at the best of times is not good for the investor. Competition means lower prices. Competition means you have to move faster when you make a loan (i.e. less time for due diligence) for fear that your rival will get the deal. Competition erodes the risk-return proposition.
And as mentioned, these are not the best of times. The economy is shaky and likely weakening, and housing is deflating. Increased competition in the teeth of a faltering market is doubly bad.
Finally, there are the usual hazards of management alignment. I’ve heard of MIC managers who pay themselves the brokerage commission for loan origination, rather than paying them, and the interest, to the company.
The problem with that is that the borrower may not care much how his borrowing costs break down between interest and commission. If it’s 10 and 2, he sees 12. But the investor does, because he only gets the interest. The manager has an incentive to charge more brokerage fees and less interest.
MICs can be perfectly fine investments even today, but it’s highly debatable that they should trade at a premium to their net asset values, as many do.
Investors should take the time to really understand what they’re buying – and who they’re lending money to.
It’s not much fun to read a prospectus but it’s almost always worth it – and probably more so in this case.