In my recent blog, I wrote about realistic expectations on the long term annualized rate of return on stocks. Based on close to 60 years of data on the S&P TSX and the S&P 500 stock indices with 95% likelihood (or confidence) we can realistically conclude that our average rate of return, net of management fees of 1.50% and an annual cash drag of 0.5%, will fall between 5.0% and 9.5% and 5.8% and 10.2% respectively.
Investors with sizeable RRSP, TFSA and or non-registered funds could diversify into private mortgage investments to reduce the risk level of their overall portfolios invested in stocks and bonds and also to potentially enhance their returns.
Table 1 shows the main characteristics of private mortgage investments and the return that lenders can expect. You could invest as little as $5,000 in mortgages through Mortgage Investment Corporation (“MIC”) shares.
Private mortgages usually are 1-year term mortgages, which are typically given to borrowers who don’t qualify for a bank or other financial institutions’ lending. Their principal basis of lending is the combined proposed and existing mortgages vs. the property’s appraised value, called loan to equity ratio, that is the combined existing if any, and proposed mortgage(s) divided by the appraised value of the property. For example, if you have a $450,000 1st mortgage with a bank, the value of your property is around $1 million, and you apply for a $250,000 2nd mortgage your loan to value ratio is 70% ($450,000 plus $250,000, altogether $700,000 divided by $1 million). There is normally much less attention paid to the income of the borrower, and instead, the approval is primarily dependent on the loan to value ratio. The lower the loan to value ratio the lower the risk for the lender and also typically lower the interest rate the private mortgage has, as shown in Table 1. above.
The risk in investing in private mortgages is the risk of the borrower’s inability to pay, combined with the net selling price of the foreclosed property to be short to pay your principal you lent plus the missed interest payments. Using the same example as above, if the previously $1 million appraised property is only sold for $650,000 then if you lent the 2nd mortgage of $250,000 to the borrower you will only receive $200,000 instead of your original investment of $250,000 and none of the missed interest payments, a 20%+ loss for you. For apparent reasons, if the loan to equity ratio is 75% or less the value of the property must fall more than 25% for you to lose money on your investment.
Table 2. shows the largest drops and the recovery period for the Vancouver, Calgary and Toronto real estate market since 1980 (data: Statistics Canada). The data shows that since 1980 none of the major cities of Vancouver, Calgary and Toronto has experienced higher than 33% loss from top to trough. A word of caution, although this is true for the average real estate values, it is still possible that a few particular houses dropped more in value.
The lower the loan to equity ratio is the lower is your risk of losing money on your mortgage investment. In any case, if you do not lend to borrowers with more than 75% loan to equity ratio, your chance of losing any portion of your investment is relatively small. The inherent risk in investing in 1st, 2nd or 3rd mortgages are best shown with some examples in Table 3. below:
Investors can invest in three different ways in private mortgages. They could lend the full sought after funds or they could co-lend with one to three or so other lenders or they can invest in Mortgage Investment Corporations (“MIC”).
MICs are pooled investment “funds” typically invested, in a large number of diversified private mortgages. They are similar to mutual funds in the sense that their managers are responsible for investing in pools of well-diversified mortgages and are paid a management fee of so doing. Due to this and the fact that the lender is not the actual investor in the MIC their returns are considerably lower than that if the investor invests directly in a private mortgage. The main benefits of investing in MICs are the reduction of risk, no requirements of significant investments and no necessary due diligence for the investor. The drawbacks are that there usually are redemption fees in the first few years after investing, lower interest rates and the risk of mismanagement by the manager of the MIC.
Table 4. compares the before and after-tax annual expected rate of return for the S&P TSX, S&P500 and investments in 1st and 2nd and 3rd private mortgages in proportion of one-third, one third and one third:
If you don’t mind to take a bit higher risk with private 1st, 2nd or even 3rd mortgages, with no more than 75% combined 1st and 2nd (and 3rd) mortgage balance to values, you could also get higher returns with acceptable risk levels. As an alternative to investing in individual mortgages, you could also invest in MICs and invest in a pool of 1st, 2nd and 3rd mortgages and by so doing, reducing your risk of high exposure to any one individual mortgage.
Interest on mortgages is taxed at the highest possible rate. If you are in the highest marginal tax rate living in Ontario that is 47.97% for the year of 2019. Return on capital gains only taxed at 50% of the tax rate of interest and that is 24% for an Ontario investor in the highest tax bracket (2019). The significantly different tax rates on interest income compared to those on capital gains or dividends makes the substantial before tax return advantage of investing in private mortgages partially erode, compared to that of stock investments.
Having said this, investing in private mortgages within your RRSP or TFSA is a very attractive choice as there is no tax on their return within your registered investments. Furthermore, if you invest a portion of your total investment in mortgages, for most, the first choice must be your TFSA as high returns in your RRSP/RRIF will generate high taxes at withdrawal as opposed to no taxes on TFSA withdrawals. Keep also in mind that if you want to invest in individual mortgages either by lending the total requested mortgage or even of you co-lend with 2-3 other lenders the amount what you need to invest could be $50,000 to $500,000 if it is for a first mortgage and typically $25,000 to $200,000 for a 2nd mortgage and somewhat less for higher risk third mortgages.
Investing in private mortgages requires investors to work with a lawyer and or a mortgage broker and or real estate agent. In any case, make sure that you trust the professionals who bring the deal to you and that the appraisal is from a reputable and experienced appraisal. Generally, I would shy away from 1st mortgages over a 80% loan to value ratio, 2nd mortgages above a 75% loan to value and 3rd mortgages in excess of a 80% loan to value ratio.
Determining whether investing in private mortgages is the right strategy for you and if it is, what percentage of your investable portfolio you should invest in them needs careful analysis and planning. Fin-Plan can help you in this regard. To ask any question about this article or to book an appointment to look at your particular case, please contact Miklos at nagy@fin-plan.ca. Miklos is a fee-only financial planner, best selling author, finance-related educational course writer, statistician and former Chair of the Canadian Institute of Financial Planners with over 25 years of experience in financial planning for high net-worth and middle-class Canadians. His Fee-Only financial planning website is at www.fin-plan.ca and his Linkedin page is at https://www.linkedin.com/in/miklos-nagy-fee-only-financial-planner/.
Copyright © 2019 by: Miklos A. Nagy
The views expressed in this material are the opinions of Miklos A. Nagy through the period ended October 23, 2019 and are subject to change based on market and/or other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk, including the risk of loss of principal. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.
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