Contributory Mortgage Funds are those where an investor provides a loan (secured by way of a 1st mortgage over real estate, usually an income producing property) that is sourced and managed by a third party (the Fund Manager). In some cases the investor can provide only a portion of the loan amount – by participating in a consortium of lenders. This is similar to what his generally referred to a ‘peer-to-peer’ lending.
The Expected Return:
Borrowers tend to seek loans from contributory mortgage funds once their applications for a loan from the banks have been declined. These mortgage loans are generally provided at a higher price than the pricing the banking sector charges on similar mortgage loans. After the Fund Manager has deducted its fees and charges (generally 1% + pa), the investor could expect to receive a rate of 5.0% to 7.0% per annum on conservatively geared loans. Loans with higher loan to value ratios attract higher rates, but in most cases the return would still be sub-10% pa. Higher rates can be earned on 2nd mortgage loans and higher still on caveat loans, but the risk increases considerably.
The Expected Risk:
One of the problems I have with contributory mortgage funds is their illiquidity. The prospect of selling your investment for full value would be low and don’t expect much help from the Fund Manager. It would not be in the Fund Manager’s best interest to help you exit – because it can increase its income by encouraging the new investor to invest in a new loan as opposed to refinancing an existing one. In addition to this, it is especially difficult to sell your investment if your tenant’s performance is unsatisfactory.
Another problem I have with contributory mortgage funds is their high concentration risk or lack of diversification. I provided some commentary on this under the peer-to-peer lending sub heading. In short, defaults and bad debts are an inevitable facet of lending. If your loan happens to be one that falls into default or experiences a loss, you might not only lose the return you were expecting but might also lose some of your capital. You don’t get the benefit of all the other loans (managed by the Fund Manager) that perform well.
Under the ‘expected return’ sub-heading above I made reference to 2nd mortgage loans – so I will make a comment about the risk associated with those loans. I will however confine my comments to those 2nd mortgage loans that have loan to value ratios no higher than the banks’ ordinarily go to on 1st mortgages. Some would argue that the risk on these 2nd mortgages is no different to the risk on 1st mortgages at the same loan to value ratio. These people would be wrong – as they fail to take into account the rights of the 1st mortgage lender and the costs associated with exercising their rights, which costs rank ahead of the 2nd mortgagee. The 1st mortgagee in selling the secured property is not concerned about whether the 2nd mortgagee is repaid, only that it is repaid. It would be more inclined to accept a sale price that enables it to be repaid than hold out for a sale price that enables both it and the 2nd mortgagee to be repaid in full.
Expected Return-for-Risk:
I would argue that an expected return of 5% to 7% per annum or even double those figures would not be sufficient to adequately compensate me for the disadvantage of holding an illiquid asset for such a long period (probably at least 7 to 10 years) and for the concentration risk (i.e. the lack of diversification).
Prepared by: Mark Morris