Yield investors need to actively manage risk while seeking returns

Mortgage funds may be a solution to the income generation challenge as they avoid an asset/liability mismatch and allows investors to tailor risk and return, Roy Prasad writes.

While investors may believe they are managing risk by taking a cautious approach to investment opportunities, they are not always considering the full range of risks.

One of the biggest risks facing investors in the current environment is opportunity risk.

This can be defined as the risk taken, when choosing one opportunity, that another, better, opportunity may arise.

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This is particularly true of investors chasing yield in the current environment. The recent and on-going cycle of rate cuts by the Reserve Bank of Australia means that investors are finding income generation more challenging. This situation is not likely to change any time soon. We are set to be in a low interest rate environment for some time so investors need to accept this fact and make investment decisions accordingly.

Achieving adequate portfolio diversification is also an on-going issue for advisers and their clients.

Many yield-seeking investors are keeping their capital in term deposits and equities. But those who keep all their savings in term deposits believing it to be a risk-free strategy are in fact subject to a number of risks, including opportunity risk.

A sensible strategy when seeking yield is to balance low returns from fixed interest investments with a mix of higher yield investments, which also manages risk through diversification.

This means keeping an appropriate position in secure, but currently low interest producing, fixed interest investments, while spreading investments across a number of other asset classes, including domestic and international shares and different types of property, i.e. commercial, healthcare, or industrial etc.

The role of mortgage funds

Before the global financial crisis, mortgage funds were seen as an important part of the yield and diversification solution, but the worldwide credit collapse meant the structure utilised at that time was found wanting.

This has meant that many investors are missing a potentially useful tool in their investment portfolio tool kit.

We have spent several years looking at ways to develop and improve the model to mitigate investor risk but still provide the yield benefits that investors once found so attractive.

The approach we have adopted is a Contributory Mortgage Fund that gives investors control over which mortgage funding opportunities they invest their money in.

The fund has been purposely designed to avoid an asset/liability mismatch, and allows investors to tailor risk and return, geographic location, and the duration of returns to suit their own circumstances and preferences.

In short, the investor is in control of their investment decisions.

An investment in the fund, when it is part of a balanced portfolio, offers a number of advantages for investors.

When correlated to other asset classes it offers potentially high returns relative to other floating-rate investments, low volatility, with low levels of default and well managed levels of loss ratios. Investors receive a fixed rate of return paid monthly for the duration of the loan term.

Understanding contributory mortgage funds

A contributory mortgage fund is when one or more people contribute, as lenders, to a 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 custodian on behalf of all investors to that loan.

Each investor has an exposure to the particular loan in the proportion of their contributed capital. Investors are entitled to interest income and the return of their initial investment amount from a specific syndicate fund, not from a diversified pool of mortgages.

Because the investment is in a first mortgage loan, it is generally a capital stable investment, offering investors competitive monthly interest payments. These are useful attributes when interest rates are at record lows and look likely to stay that way.

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 gaining popularity with advisers and investors.

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 potentially solid and consistent returns).

Key benefits

When used in a portfolio of investments designed to produce income, the benefits of well managed contributory mortgage funds include:

Income stability — monthly interest income provides investors with a high degree of cash flow certainty.

Control over where to invest and for how long — 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.

Capital stability — each individual investment (or syndicate fund) is secured by a registered first mortgage over real property assets.

Credit quality — each investment opportunity must receive credit approval from the fund manager before being offered to investors. In line with this 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. This includes a thorough and proven due diligence process and robust credit procedures.

Defined term investment — investors can choose the term of the investment, and know their money will be returned at the end of that term.

‘Hands-on' approach

One of the key advantages we bring to the table for investors in managing our contributory mortgage fund is a "hands-on" style of lending.

For example, when funding developments our initial validation and our intimate involvement during each and every stage of the construction process is vital.

In our experience being committed to the "on schedule" completion of the project is the key to getting the best outcome for investors.

We also exercise high levels of due diligence to help manage any risk, when assessing a potential property to include in the contributory mortgage fund.

This includes thoroughly reviewing the financials to determine whether the project will be profitable and that there is a clear financial reason for the developer to be undertaking it.

The development margin should be appropriate and developers must have a strong level of pre-sales to support the project.

From the borrower we also ask for at least three years of financial information, a certified statement of assets and liabilities, perform title checks and credit checks, and ensure all the facts stack up.

We need to be completely satisfied that the counterparties we are dealing with are people we want to work with and who will comply with the terms of the loan.

In addition, we only work with borrowers who have an established and successful track record of completing developments on time and on budget. We ensure they have the requisite level of experience by seeking testimonials and references, and once they have passed these tests, we drill down to four key fundamentals:

• The proximity of the development to public transport and other services;
• The attractiveness of the development to the end purchaser e.g. any unique selling point;
• The suitability to the existing demographic ; and
• The price point of the completed development must have broad buyer appeal suiting both owner-occupiers and investors.

Managing risk

Perhaps the biggest risk that faces any development is if the builder were to fail, so a successful track record in the type of project they are undertaking is very important.

It is also vital to investigate factors such as the building licence and whether there have been any claims on it, as well as the builder's insurance cover and history.

Settlement risk is also a very real issue so it makes good business sense to do smaller scale developments with no more than thirty apartments coming onto the market at the same time.

This risk can be further mitigated by ensuring an appropriate mix of owner occupier and investor buyers.

Monitoring and assessing all these factors can helps manage the risk levels of the contributory mortgage fund.

Roy Prasad is head of mortgages at Australian Unity Property.