People who manage private mortgage pools are tip-toeing around, glancing nervously over their shoulders in the aftermath of the Home Capital crisis. After all, Home Capital's mortgage book was sound and its default rate low, leaving some to wonder why it was driven to the brink.
Home Capital lends mainly to homeowners who don't qualify for mortgage loans from the big banks.
Could the jitters spread to the commercial real estate market where the big private mortgage lenders do business?
Time to separate the wheat from the chaff, investment advisers say. Key to the success of private mortgage pools are management experience and broad diversification, both geographically and by asset type. Operators must be willing and able to step in and manage a project if a borrower defaults.
"We like guys who plan for defaults," says Craig Machel, an investment adviser and portfolio manager at investment dealer Richardson GMP. Mortgage strategies don't come without risks, he notes. "Defaults will happen. We really want to know what they intend to do about it."
To ascertain that, he looks at what the operator has done in the past. "We have to be able to trust them to get through adverse times."
For investors, this might be a good time to take a long, hard look at what is in your alternative investment bucket. Alt investments should be no more than 10 to 20 per cent of your holdings, investment advisers say. That bucket should include a variety of funds, with a couple of different mortgage pools, some private equity, real estate, and perhaps business receivables.
Among the mortgage pools Mr. Machel recommends to clients are those operated by Centurion Asset Management Inc. of Toronto. Centurion does both real estate investment and mortgage lending. The Centurion Real Estate Opportunities Trust, for example, lets investors pool their money to invest in mortgages and growth-oriented real estate.
(Note that mortgage pools are different from syndicated loans, where investors get together and lend their money to a single developer or project.)
Fund managers are mindful of the changing environment. Over the past year, "the number of opportunities to buy has really shrivelled up," says Greg Romundt, chief executive officer of Centurion Asset Management. The lending portfolio, in contrast, is active. "We've made more commitments in the first quarter than the entire year last year," Mr. Romundt says. "The demand is there." Indeed, returns in some cases have been higher than anticipated because the property markets are so strong, he adds.
But has risk risen?
Mr. Romundt doesn't think so. "We're pretty selective in what we'll do," he said in an interview. "We've deliberately shied away from certain transactions we don't find attractive."
Like Mr. Machel, Matthew Ardrey, a vice-president and financial planner at TriDelta Financial in Toronto, has long recommended clients hold some of their portfolio in private mortgage funds.
"I think there's still a market for them," Mr. Ardrey said in an interview. "With the incredibly low yields on bonds, people are looking for yield. Obviously, when you're getting a high yield, there is some risk involved."
Like any asset class, "you have to look at the allocation," Mr. Ardrey says. If alt investments comprise a fifth of your portfolio, anywhere from a quarter to a half might be in mortgages. Lately, Mr. Ardrey has been shifting his glance to the United States because of concern that the Canadian real estate market is overheated.
"Location, location, location also applies to mortgage pools," Mr. Ardrey says. "I wouldn't encourage people to invest in higher-risk Canadian mortgage pools such as second or third mortgages," he says. "Where we do have investments in Canadian mortgages, we're looking at first mortgages, so if some default our clients will be first to be paid out."
His preferred vehicle for mortgage loans is Vancouver-based Trez Capital, which has a number of private pools and funds investing in the short-term U.S. and Canadian commercial mortgage markets. "It's important to have someone in the U.S. with boots on the ground, who understands U.S. laws and regulations," Mr. Ardrey says.
Trez points to its 20-year history in bridge lending via commercial mortgages.
"A unique advantage we have compared to some of our competitors is that we established a strong performance in the United States starting in 2010," says Greg Vorwaller, president of Trez Capital. "We've gone through various cycles, both positive and negative," he adds. "We've had some challenges" but the losses have been "well below industry standards for a lending institution."
A result of those ups and downs is that management has a "wealth of information," research and monitoring systems to help it understand pricing trends in the marketplace "and how to use that to factor into our underwriting."
The firm is looking to identify opportunities in the Pacific Northwest. Not only is the U.S. market much larger, but the lending opportunities are greater because of tighter U.S. banking regulations. Canada, by comparison, is looking fully valued.
"The way we approach Canadian opportunities is with a lot of prudence," he adds. "We are still finding unique opportunities. We're aiming to continue to grow prudently and to be pre-eminent in the marketplace."
Facts and fiction about private mortgage pools
Mortgage lenders who hype their funds do a disservice to investors and themselves because they create expectations they may not be able to meet. Here are a few clarifications:
Those "target" yields outlined in the offering memorandum are usually just that: targets. They could turn out lower. Indeed, looking at the Romspen Mortgage Investment Fund over the past 20 years shows yields that have been stable but drifting steadily lower, from slightly more than 10 per cent a decade ago to less than 8 per cent a couple of years ago. They have since climbed back to the 8-per-cent range. Yields drift down in line with other interest rates.
Don't fret if yields fall
The last thing in the world you would want is for the manager to chase increasingly risky deals just to meet the target payout.
Real estate and mortgage funds do offer portfolio diversification because they are not tied directly to stocks, bonds and mutual funds. As well, they provide access to commercial mortgage markets not typically available to individual investors.
Mortgage pools are not high-yielding GICs. There are no guarantees. They are tied to economic cycles so they do bear risk that some borrowers will default.
Private mortgage pools are less volatile than stocks and marketable bonds simply because they don't trade in the open market. Their value is based on the underlying assets – which can fluctuate – rather than the whims of the financial markets. Which brings up a final, important point.
You can't run to the phone and sell these securities when you see a scary headline. Most require at least 30 days' notice to redeem, and investors who want to sell before a year may have to pay a penalty. In a worst-case situation, the operator could halt redemptions entirely for a time.