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Alternative to REIT sector has eye-popping yields

Miroslaw Pieprzyk/Getty Images/iStockphoto

Investor skepticism toward mortgage investment corporations (MICs), while understandable, may obscure an opportunity to combine stable income with capital preservation at good prices.

By combining real estate development and eye-popping yields, the MIC sector has generated both attention and apprehension in equal doses.

Now, less than two years since a wave of Canadian MICs went public, some of these companies have established good mortgage portfolios while paying stable dividends, at a time when yield is scarce, said Paul Gardner, a portfolio manager at Avenue Investment Management.

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"It's not perfect, but I think you're getting paid for the risk," Mr. Gardner said, pointing to his top pick in the sector, Timbercreek. "The problem is, show me anything else in the bond market that has value."

These lending corporations provide short-term mortgages on commercial and residential properties, distributing all net income as dividends to shareholders. These stocks bear some of the qualities of bonds, and might be considered good investment alternatives to real estate investment trusts, whose assets are tied to the properties themselves, not the mortgages.

Historically, the sector has yielded close to a whopping 8 per cent on average, which alone is enough of a warning sign for some.

To pay that kind of yield, these MICs distribute loans on which they charge double-digit interest rates. At a time when banks lend at, in many cases, far lower rates, MICs must be engaging in far riskier lending practices than the banks, the argument goes.

On the other hand, Mr. Gardner argues that real estate developers and construction companies are willing to pay a premium to access the kind of financing that is otherwise in short supply. "It just gets these companies quick funding. They need that money so they can start putting shovels in the ground," he said.

Canada's big banks, meanwhile, have chosen to largely ignore this market. "They prefer to devote their resources to larger 'vanilla' loans that are outstanding for a longer term, leading to a smaller pool of lenders," GMP Securities analyst Jason Kepecs said in a note.

Mr. Kepecs recently initiated coverage on two MICs managed by Timbercreek Asset Management: Timbercreek Mortgage Investment Corp. (ticker TMC; yield 8 per cent) and Timbercreek Senior Mortgage Investment Corp. (MTG; yield 6.6 per cent).

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On TMC, Mr. Kepecs issued a "hold" recommendation and a $9.25 price target, while MTG he rated a "buy" at a target of $9.90. The only other two analysts covering MTG also rate it a "buy" at an average target price of $9.97.

"While MICs are unlikely to appreciate materially in value, they offer investors a stable and attractive return with a low probability of capital impairment relative to REITs," Mr. Kepecs said.

MTG is the more conservative of the two Timbercreek offerings, focusing only on first mortgages, which tend to be larger and less risky. As a result, MTG has a loan-to-value (LTV) ratio – a measure of the riskiness of its mortgage portfolio – of 44 per cent, compared to an average for the sector of 58 per cent, according to Raymond James.

That low LTV gives the company a buffer against a possible decline in the real estate market. "You'd have to have a pretty sizable drop in valuation for them not to recover all of their money," said Lee Goldman, portfolio manager at First Asset Investment Management, which owns shares of MTG.

As a shorter-term lender, Timbercreek also has some additional protection over longer-term lenders in terms of exposure to rising interest rates.

Because MICs focus on loans of one to three years in duration, their portfolios turn over much more quickly. When rates are on the way up, repaid debt can be lent back out on more profitable terms. "If investors feel that rates are going to rise, this is probably a good place to be," Mr. Goldman said.

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And yet, even if the exposure of MICs to changing market conditions is different from other lenders, these stocks may be collectively punished should real estate prices begin to fall.

"If the housing market does fall off, it's going to hit MICs badly," Mr. Gardner said. "The danger is the perception: 'They're in the housing market, and housing is falling.'"

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