Casting mortgages in a new light
Roy Prasad looks at the benefits of a contributory mortgage fund such as income and capital stability, control over the investment, and credit quality.
Contributory mortgage funds have addressed the problems which affected the pooled mortgage funds of the past and now offer excellent income opportunities for investors.
Prior to the global financial crisis (GFC), there were more than 150 non-bank lenders in Australia. By 2013, that number had dwindled to around 40. The problems that beset the mortgage funds industry during this period are well-known and well-documented.
For many of Australia's large pooled mortgage funds, the ensuing crunch came in October 2008. Put simply, the types of assets held by these funds did not match the liquidity that was on offer.
This asset/liability mismatch meant that when investors came en masse in search of their money, the funds were unable to facilitate the withdrawals and many were forced to freeze and subsequently terminate.
This caused a great deal of pain for many investors and their advisers. And not surprisingly, many have avoided investing in mortgage funds since.
However, the industry has come a long way in addressing its past issues: redesigning products to avoid an asset/liability mismatch; giving investors greater control over where they invest; and clarifying and effectively quarantining the risks involved.
Best of all, it has been able to successfully create some very high quality, niche opportunities for investors looking for strong, stable income payments.
Opportunities for lenders (and investors)
The chart below highlights the dramatic change in Australia's corporate lending environment as a result of the GFC.
Chart 1: Lending in Australia (2008–2013)
Source: Balmain Corporation
Between 2008 and 2013, the number of ‘first tier' banks didn't change. However, the majority of ‘second tier' banks, commercial mortgage-backed securities providers and mortgage funds simply evaporated.
But over the same period, as the chart below shows, growth in household lending was solid. The big banks chased home loans (and term deposits, which were Government-guaranteed). There was a small decline in commercial lending over the period. In 2016, our view of the Australian debt market is that it presents a number of improved risk-reward trade-offs, including:
- Lower loan-to-value ratios (LVR) compared to pre-GFC levels;
- Improved debt service requirements; and
- Stronger loan covenant conditions.
Chart 2: Growth in lending in Australia (2008 – 2013)
Source: Reserve Bank of Australia
In addition, loan margins on offer are two to three times higher than long-term averages. For lenders, and therefore for investors with these lenders, this is an attractive proposition.
In summary, we see tremendous potential to learn from the past and take advantage of the present.
Regular income, fixed terms and focus on capital stability
A contributory mortgage fund can provide investors with the best of both worlds — the ability to select an individual investment that suits their own risk and return requirements, and professional mortgage management from an experienced team.
A contributory mortgage is when one or more people contribute, as lenders, to the loan. Rather than having all investors registered on the certificate of title to the property, the mortgage is usually registered in the name of a trustee (or its custodian) on behalf of all investors to that loan. Each investor has an exposure to the loan in the proportion that each contributed capital.
Investors in a contributory mortgage fund have the choice to invest in a general investment authority or a specific investment authority.
Those who select a general investment authority hand over the choice of investment to the mortgage fund provider, who invests the funds in one or multiple loans selected by the fund manager.
Those who select a specific investment authority have the option to put money into discrete syndicate funds of their own choosing, giving them greater transparency and control over their investment.
Investment in a first mortgage loan is generally a capital-stable investment, offering monthly interest payments that are typically higher than those payable by retail bank deposits.
Some of the benefits of a contributory mortgage fund include:
- Income stability: Monthly interest income provides investors with a high degree of cash flow certainty. As an example, for the Australian Unity Select Mortgage Income Fund, interest rates offered currently range between 6.5 and 9.5 per cent per annum, depending on the date, type and term of the loan and security provided.
- Control over where to invest and for how long: Using the option for specific investment authority, investors can choose to invest in a single, individual first mortgage or spread their investment across a diverse portfolio of mortgage loans to suit their own risk/return profile. Alternatively, investors can choose a general investment authority and the fund manager is able to select one or more mortgage loans on the investor's behalf.
- Capital stability: Each individual investment (or syndicate fund) is secured by a registered first mortgage over real property assets, generally geared to a maximum of 70 per cent.
- Credit quality: Each investment opportunity for the mortgage fund must receive credit approval from the fund manager before being offered to investors. Investors and their advisers should ensure they select a fund with an expert mortgage team with a long history of successfully sourcing and managing first mortgage loans.
Investors in mortgage funds need to ensure the withdrawal arrangements suit their circumstances.
Once an investor has invested in a syndicate fund, the right to withdraw only occurs when the first mortgage loan has been paid.
The investment term for a syndicate fund is generally 12-24 months. On repayment of the first mortgage loan, the syndicate fund investors will receive the return of funds once all secured assets are realised and expenses paid. Investors may then withdraw from the fund or choose to invest in another syndicate fund.
We believe the marketplace for commercial mortgages is at an exciting stage of transformation, becoming more efficient, transparent and user-friendly.
The advent of investment professionals skilfully sourcing first mortgage loans for a contributory mortgage fund (which serves as a hub for matching investors' requirements to borrowers' needs) is a welcome development.
There is genuine opportunity to deliver real value by operating more efficiently than traditional banks in terms of sourcing, approving and settling loans, and passing these gains on to both the borrowers (in the form of quicker turnaround times for loan approvals and settlements), and to investors (in the form of solid and consistent returns).
Roy Prasad is head of mortgages with Australian Unity Real Estate Investment, and manager of the Australian Unity Select Mortgage Income Fund.
AUTHOR
Industry Expert
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