A Simple Guide to Mortgage Funds and Investments
Mortgage funds are a popular form of investment for new investors as well as those that are experienced and looking to diversify their portfolios. This article dives into the intricacies of investing in mortgages and is a worthwhile read for anyone looking to invest in mortgage funds.
What is a mortgage fund?
A mortgage fund is a type of investment product. In Australia, mortgage funds come in the form of a managed investment scheme (MIS), also known as a mortgage scheme or a mortgage trust. Mortgage funds have, and continue to be, 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 Fund (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.
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. Borrowers take out loans funded by investors who have invested their money on agreed terms with the mortgage fund. In some instances, the mortgage fund will fulfill the loan privately before releasing it to investors.
Mortgage funds approve borrowers based on their lending policies and criteria. Borrowers provide real estate security for the loan in the form of a mortgage over their property.
Benefits of a mortgage fund for Investors:
- 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 fewer hassles than applying to the major banks
Benefits of a mortgage fund/ private lending for borrowers:
- Private lending will often say yes when the banks say no, providing you are a creditworthy borrower
- Often they are a direct lender, making the process quicker and easier than working with a big bank
- Fewer hassles than applying to the major banks
- Faster settlements
- Opportunities outside the standard 15-30 year mortgages offered by banks
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. Before 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 often operated by lawyers and solicitors (hence the name).
Borrowers would approach their lawyer for a mortgage loan. The lawyer would then contact another client of theirs that 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. As a result, Lawyers engaged in this mortgage practice were forced to either become licensed under the new regime, operate differently or wind down their mortgage lending businesses altogether.
What is the structure of an investment?
As we mentioned above, there are different types of mortgage funds, each with their pros and cons. The three main structures include a pooled fund, a contributory fund, and a debenture fund.
As the name suggests, a pooled mortgage fund pools investor’s money before lending it out across multiple mortgages. The investor receives a fixed return for a fixed period and has no input into which mortgages the funds are invested. All investors in the pool share the lending risk across a portfolio of mortgages.
Rates of return in pooled funds are typically lower and tend to suit a more passive investor. For example, an investor may choose between the following rates of return and investment periods:
6 months at 5%pa
12 months at 5.25%pa
24 months at 5.5%pa
36 months at 6% pa
Pros of a pooled fund include:
- Source of passive income
- Quite easy to set and forget, as there is little management from the investor needed
- Begin earning interest from day one
- Able to diversify their money across a pool of mortgages
Cons of a pooled fund include:
- Lower rates of return. The fund has to pay investor interest even if the funds have not been repaid, hence lower returns
- No direct control over where the funds are being invested
As an investor, it is essential to read the PDS to fully understand your exposure to assets and the security properties included in the fund (e.g. does the fund include rural properties or development funding?).
Contributory or select funds
A contributory mortgage fund is often called a select mortgage fund or a direct mortgage fund. It allows the investor to select the mortgages they will be contributing to. Investors choose mortgages based on a risk profile that they feel comfortable, with considerations around loan purpose, location, term, and interest rate. The investor’s risk exposure is generally limited to the particular mortgage they choose to invest in.
Here’s an example of contributory mortgages that an investor may choose from:
|Location||Sydney CBD||Brisbane Suburbs||Perth CBD|
|Term||12 months||6 months||9 months|
|Rate of Return||7.5%||8.2%||7.95%|
|Purpose||Bridging Finance||Business Finance||Equity Cash Out|
|Security Property Value||$650,000||$700,000||$825,000|
An investor may decide to invest in one mortgage or spread their funds across multiple loans.
Pros of a contributory fund include:
- Direct control over where your funds are invested
- Slightly higher returns (when compared to a pooled fund)
- Choice in property class exposure
Cons of a contributory fund include:
- Interest isn’t paid until the loan has been fully funded. In many cases (and at Funding), the loan will be privately funded before being listed, so investors can start earning interest straight away, and this is not an issue
- Potential wait times as new investments become available
Contributory funds are becoming increasingly popular, especially with the introduction of online features like dashboard accounts where investors can select mortgages and parameters of automatic investments with the click of a button.
As an investor, you are only exposed to one mortgage per investment, unlike a pooled fund where you are exposed to the risk of multiple different mortgages. With this in mind, when investing in contributory funds, if another loan in the mortgage fund defaults, it will not affect your investment.
Regardless of whether the investment is contributed or pooled, the scheme itself is structured as a managed investment scheme. In other words, this is a Trust, where the investor gets units in the trust that correlate to their rights, whether it is to a pooled or specific mortgage.
In a debenture mortgage fund, the investor provides a loan to the finance company (the mortgage fund), which pools the money and uses the cash in its day to day lending operations and on lending the funds to borrowers. So, instead of receiving units in a trust like you would in a pooled or contributory fund, the investor gets debentures, which are small loan obligations.
The debenture fund style has lost popularity recently, with many notable funds collapsing and closing down. Furthermore, the structure doesn’t fall under MIS regulation.
Direct mortgage investments
When an investor funds the entire loan, and the investor’s entity holds the mortgage, it is called a Direct Mortgage Investment. 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 the loans
- The loan to value ratio (LVR)
- The experience of the management team
The LVR is the percentage of the loan value against the property value. For example, if the borrower is seeking a $250,000 loan on a property valued at $500,000, the LVR is 50%.
To improve the disclosure information about mortgage funds in Australia, ASIC requires lenders to provide information about eight (8) benchmarks. From 30 November 2008, all PDSs for unlisted mortgage funds are required to include the following statements regarding 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 have 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 – Does any of the mortgage scheme’s transactions involve parties with 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 that includes 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 are typically two types of investors of which mortgage funds can offer their investment products.
- Wholesale and sophisticated investors. These investors have a net worth, income, or investment amounts higher than the thresholds set by law. Offering products to these investors is less regulated.
- Retail investors. 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 fund is one that only invests in first mortgages. A first mortgage is the first charge over real estate owned by the borrower; it is not the mortgage on a borrower’s first mortgage, but rather the original mortgage taken on a property.
In contrast, a second mortgage goes behind a first mortgage and comes with certain risks. When a property is sold or realised, the first mortgage ranks in priority and is paid out first. Second mortgages usually offer higher returns; however, they also carry greater risk. As a result, it is suggested that investors should only invest in second mortgages if they are fully educated on the associated risks and potential for loss.
Fintech, peer to peer lending, marketplaces and mortgage funds
Financial technology or ‘Fintech’ is disrupting the finance industry and allowing for necessary change in the mortgage fund industry. New technology and software are positively changing the process and experience for investors and borrowers, as they engage in peer to peer (P2P) lending platforms or marketplaces. From an investor’s point of view, these changes have allowed for a more efficient investment process and greater transparency around loans.
Features of these P2P lending platforms include:
- Online portals to monitor and manage your loan investments
- The ability to pick and select mortgage investments online
- Auto-select features
- Easy account top up and withdrawal
- 24/7 access to your investment portfolio
The underlying structure of these marketplace lending platforms is similar to the contributory style mortgage funds mentioned above and is what is on offer at Funding. We are an online mortgage marketplace, offering investors target returns from 6% to 9% pa*, first mortgage security, and monthly interest payments.
Learn more about our platform, or open an account today to begin investing from $5000.
FYE 2021 Q1 Investor Update
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