Friday, 12 April 2013

Ways to Get Steady Dependable Income from Mortgages

Every adult Canadian knows what a mortgage is and understands that it is a loan against property on which interest must be paid regularly without fail or else there is risk of having the property taken over by the lender. Many of us are mortgage borrowers to buy a home at some point in life. If we put the shoe on the other foot as investors, mortgages can have a definite appeal as a steady income-producing investment that should be quite secure (how many people would easily or willingly default and lose their home?).

Let's look at the alternative ways a Canadian investor can buy into mortgages. Here is a comparison table of the key features of the alternatives we review below.
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Mortgage Investment Corporations
MICs are specialty funds to pool investor capital for lending out as mortgages, primarily for residential buildings but with a portion allowed for commercial properties. MICs have a long history going back to the 1970s when the federal government modified the Income Tax Act (in section 130.1) to allow income from mortgage interest to be passed through tax-exempt in the MIC to individual investors for taxation in their hands. Average Joe, instead of paying interest on a mortgage on his home, can turn the tables, invest in a MIC, and collect interest instead.

More detail:
1) CanadianFinancialDIY's Ins and Outs of Mortgage Investment Corporations,
2) Interview about the origins and workings of MICs with Wayne Strandlund, CEO of one of the biggest private MICs Fisgard Capital Corporation on the Canadian Mortgage blog,
3) Regulatory restrictions on who can invest in private MICs, which varies by province, also on Canadian Mortgage
4) PIC-a-MIC, Fisgard's more-than-thorough 27 point due diligence checklist for investors. This checklist serves very well for any of the types of mortgage investments we discuss now.

Four MIC flavours - The tax-exempt MIC status can be, and is, available in four different types of corporate structures and investor vehicles.
  • Private MICs - The investor deals directly with the MIC and are thus not available to the online investor. They are subject to the provincial regulatory restrictions. Private MICs tend to be smaller and more narrowly focussed on a province, or even a city. With private MICs you basically expect to get your original contribution back, unless there are bigger losses on the mortgage portfolio than the reserves the the MIC management (should) put in place. Your status is that of providing equity to the MIC, not a loan, so it's not like a GIC. The expectation is interest income/return only. There are dozens of private MICs across Canada, some of which CanadianFinancialDIY lists.
  • Closed End Funds - There are only a few of these around - we found only two, the Timbercreek MIC (TSX symbol: TMC) and the Timbercreek Senior MIC (MTG) which holds an even safer bag of mortgages albeit at a lower return. CEFs are very convenient to the online investor since they can be bought on the TSX just like any other stock. They are subject to fluctuations in market price and so can create capital gains or losses in addition to the interest income.
  • Investment Fund - Almost a CEF except it isn't redeemable, the First National Mortgage Investment Fund's (FNM.UN) days appear to be numbered after the recent federal budget which announced an intention to prevent the transformation of interest income into lower-taxed capital gains by funds such as this one. First National issued a press release denying FNM.UN will be affected so we will have to wait and see the final outcome.
  • Public Corporations - There aren't many of these either. We found only three - Firm Capital MIC (FC), MCAN Mortgage Corp (MKP) and Atrium MIC (AI). They also trade like any other stock with capital gains/losses results too.
Public Corporation but not a MIC
This publicly-traded company concentrates on mortgages but does not have the tax status of the MIC.
  • First National Financial (FN) - This is the same company that created FNM.UN. FN, however, isn't about to disappear anytime soon judging by its claimed status as Canada's largest non-bank mortgage originator and lender. Its business model is quite different from the MICs above. It doesn't just lend and collect interest, it sells on many mortgages while continuing to collect fees for administering them. Consequently its capital structure has lots of leverage but isn't necessarily more risky. Unlike MICs FN distributes dividends and possible capital gains to investors.
Mortgage Mutual Funds
There are several dozen (37 were found in GlobeInvestor Fund Lookup by typing in "mortgage" as a fund name search term). Such funds typically buy mortgages created by other companies and have a lot of lower yield guaranteed mortgages along with some short term bonds so their yield is less overall.

Mortgage REITs in the USA
The attraction of such funds within registered retirement accounts (RRSPs and the like but not TFSAs or RESPs) is that no tax is payable, not even US Witholding tax). These funds sport very high 12-18% cash payout yields at the moment which looks great but is a strong clue of much higher risk. That risk comes from a business model (see description in the Wall Street Journal) much different to any of the Canadian options above. The mortgage REITs rely on the return boosting effect of borrowing at very low short-term rates to buy mortgage backed securities (basically bundles of mortgages originated and sold on by other firms). Are these yields sustainable? One Seeking Alpha article thinks yes, for some. In addition to the many individual mortgage REITs, ETFdb lists US ETFs that hold mortgage backed securities.

Portfolio Considerations
Mortgage interest-producing investments fall into fixed income and their current relatively high yield compared to GICs or short term bonds can make them an attractive alternative.

All but one - the exception being First National - of the securities produce income that is taxed as interest despite the misleading name of dividends attached to the distributions. Therefore the best place to hold such mortgage securities is in a RRSP, TFSA, RRIF, LRIF, LIRA or other tax-favoured account.

Payout Stability and Yield
As our table below shows, the cash payouts of the MICs with a longer track record have declined along with interest rates. That's not necessarily a bad thing since they still compare favourably with other short term fixed income as we have already noted. 
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The key to the future is the skill and judgement of the mortgage management team in properly adjusting the risk of the mortgage lending to the interest rate charged while controlling costs and the risk of leverage. To assess that and other factors that can affect the success of a mortgage, it is a wise idea to use the checklist we mentioned above. As usual, the return to be expected, whether it is interest or dividends and capital gains, will be related to the riskiness of the investment. 

Is now a bad time to invest in mortgages?
That's a natural question given the slowdown in sales in a number of markets and some reports of impending doom in the Canadian market akin to what happened in the USA and other countries. Of course, the companies say they are still expanding profitably within acceptable risk parameters due in part nowadays to some pullback in lending by the big banks. In our opinion it's too hard to tell if mortgages are a better or worse investment than anything else right now. The best protection lies in the due diligence to pick the solid companies who can survive in bad times as Canada's banks did through the 2008-09 financial crisis.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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