Mortgage Funds and Investments
What is a mortgage fund?
A mortgage fund is a type of investment product. In Australia it is commonly in the form of a managed investment scheme (MIS) also known as a mortgage scheme or a mortgage trust, however can take other forms. It has and continues to be quite a popular investment choice for all types of investors including retail “Mum and dad” investors, sophisticated investors, wholesale investors and more recently Self Managed Super Funds (SMSF) Investors.
What is a mortgage?
A mortgage is a lien or encumbrance over real estate property. It secures the loan to the borrower and if the borrower defaults, the property can be sold to recoup the loan. It’s exactly like getting a home loan from the major banks.
Benefits of a mortgage fund:
- Fixed regular income.
- Attractive rates of return.
- Fixed term investments (typically short to medium term).
- Underlying real estate security.
- Borrowers also benefit as they find it as a useful, convenient source of funding with less hassles than applying to the major banks.
How does a mortgage fund work?
A mortgage fund is a finance company or institution. There are two sides to every Mortgage fund, the investors and the borrowers. Investors invest their money on agreed terms with the mortgage fund and those funds are then utilised to fund loans to the borrowers. Mortgage funds approve borrowers based on their lending policy and criteria. Borrowers provide real estate security for the loan in the form of a mortgage over their property.
How long have mortgage funds been around?
The current form of the Managed Investment Schemes was introduced under the legislation Managed Investments (Act) (Cth) in 1998. Prior to this there were different types of mortgage schemes and investment vehicles. A popular setup was what’s termed “solicitor loans” or “solicitor funds”. This form was was often operated by lawyers and solicitors (hence the name). Borrowers would approach their lawyer for a mortgage loan and the lawyer would approach another client of theirs they knew who invests in mortgages. This practice was phased out due to the potential conflict situations solicitors could end up in acting for both the borrower and the lender/investor. The Managed Investments Act was introduced to assist in regulating the industry and Lawyers engaged in this mortgage practice were forced to either become licensed under the new regime or operate differently or wind down their mortgage lending businesses.
What is a structure of an investment?
As mentioned above, there are a few different forms of mortgage funds, each with their own pros and cons. The 3 main structures include a pooled fund, a contributory fund and a debenture fund.
A pooled mortgage fund, as the name suggests, pools investors money and then lends it out across multiple mortgages. The investor receives a set fixed return for a fixed period or term and makes no decisions as to which mortgages the funds are invested in. The rate or returns on this form are typically lower and suits a more passive investor. The investors usually all share in the lending risk across the entire portfolio of mortgages.
For example pooled options would look something like this:
6 months, 5%
12 months, 5.25%
24 months, 5.5%
36 months, 6%
Whilst it depends on the fund investors often enjoy:
- Passive income.
- Set and forget.
- Interest from day one.
- Diversification across a pool of mortgages.
- Slightly Lower returns (the fund has to pay interest to investors even when the funds have not yet been on lent resulting in lower returns).
- No direct control of where funds are invested
As an investor, is important to read the PDS to in sure you understand the exposure to assets and the security properties of the fund (i.e. you may not rural properties or development funding etc.
Contributory or select funds
A contributory mortgage fund or what’s often called a select mortgage fund or a direct mortgage fund, allows the investor to select the mortgages they will be contributing to. They normally can select mortgages taking into consideration things like loan purpose, location, term and interest rate. The investors exposure is usually limited to the particular mortgages they choose.
For example a contributory mortgage would look something like this:
Rate of return 7.5%
Purpose: bridging finance
Total loan amount$350,000
Security property value: $650,000
Rate of return 7.95%
Purpose: business finance
Total loan amount $250,000
Investors contribution: $500,000
Investors can choose multiple mortgages they feel comfortable with and spread their funds across multiple loans.
- Direct control over where your funds are invested.
- Slightly higher returns.
- Choice in property class exposure.
- Interest from start of investment.
- Wait times for investments to become available.
With online features including dashboard accounts where you can select mortgages or set parameters for automatic investments this is increasingly popular.
As you can see select investments are stand alone investments which means there is no exposure to a pool of mortgages. If another loan to the mortgage fund defaults it won’t affect your loan. Whether contributed or pooled, the scheme is structured as a managed investment scheme. This is a trust where the investor gets units in the trust which correlate to their rights whether pooled or to a specific mortgage.
The other form of of a mortgage fund is a debenture mortgage fund. This is where the investor provides a loan (rather than receiving units) to the finance company (the mortgage fund) which then pools the money and uses the cash in its day to day lending operations by on lending the funds. It’s similar to the pooled scheme mentioned above however the investor normally gets debentures (small loan obligations) instead of units in a trust. This debenture fund style has lost in popularity with notable collapsed funds that have closed down. This structure doesn’t fall under the MIS regulation and more information on debentures can be found here on ASIC’s money smart website (https://www.moneysmart.gov.au/investing/investments-paying-interest/unlisted-debentures-and-unsecured-notes)
Direct mortgage investments
Another type of mortgage investment is a direct mortgage. Direct mortgage investments are where the entire loan is funded by the investor and the investor’s entity holds the mortgage/loan. These are suited to larger investors.
How do I compare mortgage funds?
- When comparing mortgage funds, an investor should look at a few key things:
- The form of investment (pooled, contributory, debenture).
- The type of security being lent on.
- The size of loans.
- The LVR on loans.
- The experience of the management team.
The loan to value (LVR) or loan to value (LTV) is the percentage of the loan value against the property value. Ie a loan of $250,000 on a property to the value of $500,000 is a 50% lVR.
To improve the disclosure information about mortgage funds in Australia, ASIC requires us to provide information about eight (8) benchmarks. From 30 November 2008, all PDSs for unlisted mortgage funds
are required to include the following statements in respect of each benchmark:
•• that the Fund meets the benchmark; or
•• that the Fund does not meet the benchmark, and an explanation of how and why the Fund deals
with the business factor or issue underlying the benchmark in another way.
“The eight benchmarks and disclosure principles focus on the following:
- Liquidity – What is the scheme’s policy on managing liquidity and does the scheme has enough cash and liquid assets to make regular distributions and pay back its investors?
- Scheme borrowing – Does the scheme have any current borrowings, or intention to borrow? How will it repay any debts, in the short term and over the life of the scheme?
- Loan portfolio and diversification – What is the scheme’s policy on diversification and has the mortgage scheme spread its risk between different borrowers and investments?
- Related party transactions – Do any of the mortgage scheme’s transactions involve parties that have a close relationship with the responsible entity? What are the details and risks of these transactions and relationships?
- Valuation policy – How are the mortgage scheme’s underlying assets valued and how often are the valuations carried out?
- Lending principles (loan-to-valuation ratios) – What is the size of the loans compared to the value of the assets used as security for the loans? The higher the ratio, the higher the risk of losing your money.
- Distribution practices – Are current distributions being paid with borrowings? How often are distributions being paid?
- Withdrawing arrangements – Whether you can withdraw from the mortgage scheme, what conditions must be met and how long it will take to get your money back.”
There are numerous layers of regulation and compliance with mortgage trusts including:
- The Corporations Act is the key governing legislation which include the managed investment scheme provisions.
- Australian Financial Services Licence (AFSL) requirement. The Responsible entity who acts as trustee of the fund typically holds an AFSL.
- An independent Custodian is used to hold the assets of the fund.
- An independent Auditor is used to conduct yearly audits of the fund.
- ASIC – The Australian Securities and Investment Commission is the regulatory body and watchdog of the investment industry.
Investors, wholesale and retail mortgage funds
There a typically two types of investors of which mortgage funds can offer their investment products to.
The first is wholesale and sophisticated investors. Simply put, this is an investor who has a net worth, income or investment amount higher than thresholds set by law. Offering products to these types of investors is less regulated.
The second type is a retail investor. This is anyone who is not a wholesale investor.
Some funds are available to all investors, others only wholesale.
What is a first mortgage fund?
A first mortgage is one that only invests in first mortgages. A first mortgage is the first ranking charge over the property. In contrast a second mortgage goes behind a first mortgage and comes with it certain risks. When a property is sold or realised the first mortgagee ranks in priority and is paid out first. Second mortgages usually offer higher returns however carry with it greater risk and therefore it is often suggested investors should only invest in second mortgages if they know what you are doing and are educated on this type of investment.
Fintech, peer to peer lending, marketplaces and mortgage funds
Financial technology or “fintech” is disrupting the finance industry and with that the mortgage fund industry is changing. You may or may not have heard new terms like fintech, peer-to-peer, P2P lending or marketplace lending. In a nutshell these are the terms for new online websites and software that is changing the process and experience for both investors and borrowers in a positive way. From an investors point of view, changes are positive with more efficient investment processes and more transparency relating to loans.
- Features Include
- Online portals to monitor your loan investments.
- Pick and select loans online.
- Auto-select features.
The underlying structure of these new marketplace lending is a similar to the Contributory style of mortgage fund.
Funding Quarter Update
In Q4, all completed loans achieved their target return or higher, with an average target return of 7.08% and loan term of 8.75 months.
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