Is it safe to invest in Mortgage Investment Funds?
Investing in Mortgage Investment Funds can be daunting for some investors. Although popular with those more experienced, they aren’t the typical “go-to” option for everyday investors.
But just because they’re a lesser-known investment option doesn’t mean they shouldn’t be considered. And for many investors, Mortgage Investment Funds have e been a consistent and secure investment choice.
Like all investment options, there are risks. Weighing up the risks of a mortgage fund investment should take into account your personal situation and the individual fund you are investing in.
Taking the time to do a little research, knowing how to identify trustworthy funds, understanding how the fund managers mitigate risk and being realistic about your risk profile is the best way to determine if a mortgage fund investment is right for you.
But once you gain some knowledge of how they work, you’ll likely find that mortgage fund investments can play an important part of your wealth creation strategy.
What is a mortgage fund?
Mortgage funds are a type of investment fund where investors’ money is loaned (as mortgage loans) to borrowers. Those borrowers use the money to buy or develop properties and pay interest on the money borrowed which is delivered to the investor in the form of regular distributions.
Not all mortgage funds are the same. In recent years there has been an influx of varying product types on the market. And while this means more choice, it also means you need to be diligent when choosing the best fund for you.
Types of Mortgage Funds
There are different types of mortgage funds, each with their pros and cons. Below outlines the two main mortgage fund types:
Pooled Funds
Pooled mortgage funds, as the name suggests ‘pools’ investor’s money before lending it out across multiple mortgages. The fund manager finds the borrowers, conducts all the due diligence and manages the loan until the return of capital and payment of interest. All investors in the pool share the lending risk across a portfolio of mortgages.
Pooled funds typically have lower minimum investment amounts (usually starting around $10,000) and tend to suit a more passive investor.
Direct or Contributory Funds
A direct mortgage fund (also known as a contributory mortgage fund or a select mortgage fund) allows the investor to select the mortgages they will be investing in. Investors choose mortgages based on a risk profile they’re comfortable with. They can consider things such as loan purpose, location, term, and interest rate.
The investor is invested for the term of the loan (usually 6-12 months) and receives all their capital and interest once the loan has been repaid. Many direct investors choose to invest in multiple direct loans so that they can diversify their risk and their ‘pay day’ isn’t relying on a singular investment.
Direct mortgage investments are more suited to experienced investors as the investor has to make the decision on which loan to invest in. The minimum investment amount is usually higher than that of a pooled mortgage fund, usually starting around $100,000.
What are the risks when investing in a mortgage fund?
Some mortgage funds have stood the test of time, delivering consistent returns to investors through the bumpy economic periods we’ve experienced in recent years. But there are things to consider before investing in a mortgage fund.
The risks of investing in mortgage funds depend on a number of things, like the types of loans and borrowers that funds are being used for, how much experience the fund manager has, the loan-to-value ratio of the loan, diversification and the term of the investment.
Here’s some questions you might like to ask when deciding to invest:
Does the fund invest in first or second mortgages?
In terms of risk there are a number of differences between first and second mortgage investments. First mortgages offer less risk but with a lower return. Second mortgages usually have higher risk but with more attractive returns.
First Mortgages
In the event of a borrower defaulting, the first mortgagee has first right to receive the return of their principal, interest, and costs.
As an investor, investing in first mortgages is less risky because there’s a higher chance of you receiving your money back, plus interest and because of this the rate of return is usually lower.
Second Mortgages
A second mortgage sits behind the first. If the property needed to be sold, the first mortgagee would receive their principal, interest and costs before the second mortgagee would receive any.
Because of the higher risk associated with second mortgages, they usually offer a higher rate of return.
Some mortgage funds, like Active Property Group’s pooled mortgage fund, invest in both first and second mortgages in order to provide a balance between risk and return.
How diverse is the fund?
Ideally, a fund should be invested in a large number of loans at any one time so that if one borrower goes into default, the rest of the loans will continue to provide the investors with a consistent return. The fund should also have diversity in relation to the location of the security property. If all security properties are located in one area and property prices start to plummet in that location then this could have adverse effects on the fund.
How important is liquidity to you?
An investment in a mortgage fund should be considered a longer term investment as instant return of investor funds is not always possible (a fund manager can’t just take back the funds from a borrower at any time). In saying that, well-managed funds retain some cash to meet liquidity requirements so that redemptions are possible at regular intervals throughout the year.
What’s the loan-to-value ratio (LVR)?
The LVR is the percentage of the loan value against the property value. The higher the LVR, the riskier the loan.
For example, if the borrower is seeking a $400,000 loan on a property valued at $800,000, the LVR is 50%.
The higher the LVR the more risk to you if a borrower defaults, and the security property needs to be sold. So, for example if the LVR was 90 per cent, a drop of 10 per cent in value of the security property could mean it is difficult to recoup the loan amount. Check that the fund has conservative LVRs and that the borrowers have solid exit strategies so that there’s a higher chance the loan will be repaid.
How can investors minimise the risk when investing in mortgage funds?
There are a few things potential investors can do to help them choose a quality mortgage fund that delivers consistent high returns:
Professional advice
Getting help from an adviser to understand what constitutes a good quality product is recommended. They can help you differentiate between the various mortgage funds on the market and can advise if a mortgage fund suits your individual risk profile.
Funds manager
How a fund is managed and by who, can play a big part in how well it performs. Experience, performance and commitment of the fund manager should be checked. Are the directors of the fund invested themselves? If they’ve got skin in the game then they’re clearly happy to put their money where their mouths are. Also, make it your business to find out about the loan security, diversification of the portfolio, and risk management processes used by the fund manager.
Product Disclosure Statements
Each fund should document its policies through a product disclosure statement. Yes, it can make for some tedious night-time reading. But a full description of the risks is there for you in black and white in the product disclosure statement.
Don’t just focus on returns
We can all get dazzled by the high returns promoted by glossy advertising. But it’s important to remember returns are just one piece of the mortgage fund puzzle. And remember if it sounds too good to be true, it probably is.
Check for licences
Fund managers need to be of good character. The Australian Securities and Investment Commission (ASIC) sets the standards, so check if they operate under an Australian Financial Services Licence.
Know your risk to reap your reward
Getting good advice from experts is the best way to ensure you have the information you need to make good decisions. Talk to the people who know mortgage funds well and how they function.
There’s no cookie-cutter approach with Active Property Group. We consider the best investment options for you specific to your situation. So whether you’re just starting out or ready to invest we’re here to help. Get in touch and we’ll help you navigate mortgage fund risks and rewards.
This information is of a general nature and does not constitute professional advice. You should always seek professional advice in relation to your particular circumstances
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