Canadian retail investors love their real estate.
Their fervour sent real estate investment trusts soaring over the past few years, but lately a different type of investment has gained traction: mortgage investment corporations.
Unlike REITs, which buy income-producing properties and then use the rents to pay distributions to investors, MICs, as they are known, are keen on funding land development and real estate construction, and they attract retail investors by paying juicy yields.
I've raised questions about these vehicles before, arguing that investors must remember that these vehicles pay high yields because they come with the higher risks inherent in construction financing. Rob Wessel at Hamilton Capital Managers remains concerned and just released a new report outlining his worries.
Mr. Wessel's main argument: Though there aren't signs of a hard landing for Canadian real estate yet, "if there is a downturn in credit, it is possible that the first evidence of losses in the Canadian financial system could emerge within certain lower-quality mortgage investment corps."
"In a falling home-price environment, the first credit losses tend to emerge in low-quality/junk residential mortgages, as well as land development and construction loans," he added.
Mr. Wessel invests in U.S. banks, and history taught him that "after a multiyear period of essentially zero losses, U.S. construction-heavy banks began to experience a decline in credit quality at almost the exact same time as home prices began to decline."
His worry, then, is that if there is a hard landing in the Canadian housing sector, the losses that MICs experience could be material.
First, they argue their track records have been strong, suggesting that past performance is likely to persist in perpetuity.
Second, they refute the financial rule that a higher yield equates to higher risk. They argue that even though they pay higher yields, they ensure they diversify their portfolios.
Mr. Wessel remains skeptical. "We have seldom seen such high credit risk loans in any vehicle so casually dismissed by so many as we see with MICs, a part of the market that desperately needs to avoid a hard landing in home prices," he noted.
Yet he remains realistic, noting that if there is a soft landing, the MICs will likely experience higher than normal losses, but they should be manageable.
(Tim Kiladze is a Globe and Mail banking reporter.)
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