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In 2021, about11 per cent of homeowners in Canada’s largest real estate market – Ontario – borrowed using private channels totalling $22.4 billion, up 72 per cent from 2019, a report found.Sean Kilpatrick/The Canadian Press

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Private mortgage investments are an often-overlooked corner of the markets for many Canadians. Yet, this high-yield asset class is likely to attract more attention from borrowers and advisors of high-net-worth clients seeking to diversify portfolio holdings, even as real estate faces an uncertain future in the near term.

“Mortgage investments have historically provided a stable income stream to investors with low volatility and can offer enhanced returns compared with other fixed-income options,” says Simon Carlsen, senior director and head of mortgage investments at Nicola Wealth Management Ltd. in Vancouver, who leads its $1-billion mortgage investment portfolios.

“But today, there is a lot of talk about less money being available from traditional lenders like the big banks, which is where private lenders can step in to satisfy that potentially growing demand.”

Private mortgage investments’ yields – often at least 200 basis points higher than traditional fixed income – may seem less attractive in the current higher interest rate environment than a year ago.

Yet, the spreads mostly widened between private mortgage yields and traditional fixed income, says Dean Kirkham, president and chief operating officer of Trez Capital, which manages short-term mortgage funds for multi-family and residential development.

“The credit spread expanded over the last half of the year because of perceived additional risk, though the spread is likely to come back in as we see more confidence in the direction of interest rates,” he says.

Either way, private lenders are likely to benefit because demand has been growing for private mortgage financing even before interest rates increased, a recent report from the Financial Services Regulatory Authority of Ontario shows.

In 2021, about 11 per cent of homeowners in Canada’s largest real estate market – Ontario – borrowed using private channels totalling $22.4-billion, up 72 per cent from $13-billion in 2019, it found. The report also predicts the private market will continue growing in 2023 given market conditions.

Traditional lenders limiting loan sizes

Jeff Sparrow, broker and partner with Castle Mortgage Group in Winnipeg, says very expensive real estate markets like Toronto and Vancouver are particularly fertile ground for private lending even after the price declines over the past year.

“There has been a significant jump just due to softening market conditions, falling property values and tightening lending criteria,” he says.

One reason it’s more common for borrowers in these markets to require a second position mortgage is because traditional lenders limit loan sizes, he adds.

“For example, a big bank might fund 65 per cent of the value,” Mr. Sparrow says. As a result, a buyer may turn to a private lender for the remaining funding to get to 80 per cent of purchase price.

Private mortgages inevitably entail borrowers paying higher fees and interest rates, typically starting at 9 per cent to as high as 16 per cent for second position mortgages, and the terms are usually one to two years, he says.

“Most would assume if you’re borrowing in the private space that there are big issues with your financial fitness – like a bankruptcy or divorce – but that’s often not the case,” Mr. Sparrow says.

“Private lenders are often an option for self-employed individuals or new small business owners that may not yet have a strong income history that traditional lenders require.”

In turn, financial advisors refer these clients to brokers, who connect them with private lenders for a short-term, high-interest-rate mortgage, affording them time to build the income history or equity to qualify for a traditional mortgage at a lower rate, he says.

Private lenders like Nicola Wealth are filling that need in the marketplace in return for higher yields, doing case-by-case due diligence to build a diversified portfolio of mortgages.

“The focus for private lenders is typically less on the creditworthiness of the borrower and their income than traditional lenders – although those are still important,” Mr. Carlsen says. “Instead, we also heavily underwrite the underlying value of the property.”

The pros and cons of investing

Rob Tetrault, senior portfolio manager with Tetrault Wealth Advisory Group at Canaccord Genuity Wealth Management in Winnipeg says, the fact private mortgages are backed by a hard asset that “you can touch and feel” can make these investments more attractive than other high-yield fixed income assets.

“For example, if the loan-to-value is 60 per cent, the price of real estate would have to drop 40 per cent for you to lose a penny,” he says.

Still, private mortgages are an asset class requiring niche expertise to build a well-diversified portfolio of mortgages, ideally spanning different types of real estate, geographies and maturities, which help mitigate risk and can provide liquidity, Mr. Carlsen says.

“It’s not a huge private market in Canada and that often means it can be inefficient with a lot of price discovery that goes on, particularly in a volatile interest rate environment” he says.

“But these conditions can lead to risk-return imbalances where experienced lenders can get potentially higher returns than actual risk of the investment, which is obviously very attractive for investors.”

Private mortgage funds and private mortgage investment corporations (MICs), which have a different tax structure, typically have another attractive trait: low volatility.

That makes them preferable, for example, to publicly traded MICs, Mr. Tetrault says.

“When I am buying fixed income, like a mortgage fund, I am trying to reduce portfolio volatility. Otherwise, I don’t want to own it,” Mr. Tetrault says, noting publicly traded MICs saw steep price declines in the pandemic bear market.

By comparison, private mortgage funds his clients hold are largely decorrelated from public markets and weathered tough periods “unscathed, which is a strong sign of durability,” he adds.

Of course, the current environment still entails significant risk for lenders public or private, especially with a recession looming.

But it also presents opportunities given the broader picture for real estate in Canada, Mr. Kirkham of Trez Capital says.

“We are massively undersupplied for the next decade for housing,” he notes. “Layered on top of that, you have 450,000 to 500,000 new Canadians coming into the market each year.”

In turn, private mortgages as an asset class are likely to remain lucrative as the pool of borrowers – both consumers and residential developers – seeking financing from non-traditional lenders will almost certainly expand for the foreseeable future, Mr. Kirkham says.

“As lenders in this space, we see a strong opportunity to step in and fill this growing need,” he adds.

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