Should You Mortgage Your Future? - Nicola Wealth

Should You Mortgage Your Future?


By Michael Taylor, CA

Mortgage Future

You definitely shouldn’t jeopardize your future by overspending or by mismanaging your financial affairs. But, let’s ask the question another way: “Should mortgage loans be part of your future?” Well… that depends!

At Nicola Wealth Management, we provide our clients with a variety of investment opportunities in a variety of asset classes, including two commercial mortgage pooled funds: NWM Primary Mortgage and NWM Balanced Mortgage.

Between these two pools, Nicola Wealth Management currently manages more than $300 million of client equity. For the purposes of this article, we will refer to these two funds collectively as the NWM Mortgage Pools.

What is a mortgage loan and why do we invest in them?

A commercial mortgage loan is not an alternative real estate investment. Mortgage loans are an integral component of the capital invested in real property, but they are the debt/fixed income component of the capital structure as opposed to the equity (which represents the ownership of the property).

Mortgage DefinitionIt is analogous to a corporate bond versus the shareholders’ equity in a corporation; the corporate bond (commercial mortgage loan) being the fixed income security with priority over the equity.

Total commercial mortgage value in Canada is estimated to be $170 billion with approximately $32 billion of new commercial mortgage loans written each year. Most of this is institutional in nature – large loans against premiere properties that are funded by pension plans, banks and insurance companies.

These loans are usually very large and are made with very slim credit spreads. Combined with today’s lower interest rates, these loans are made at low, absolute borrowing rates.

Mortgage loan opportunities that are well suited to the NWM Mortgage Pools tend to fly under the radar of institutional lenders because they do not fit specific underwriting criteria. While each mortgage loan granted by the NWM Mortgage Pools is underpinned by cash flow, each is unique and requires flexible underwriting standards.

As a consequence, and because there is less capital available in this section of the commercial mortgage market, they offer investors the potential for higher returns. While the structural risk of second mortgages is higher than for first mortgages, we consider the investment risk for both NWM Mortgage Funds to be low since they are supported by cash flow and secured by hard asset real estate.

There are two major components to fixed income returns: interest rate risk and credit risk.

Mortgage QuoteInterest rate risk results in mortgages and other fixed income securities dropping in value when interest rates rise. Given Nicola Wealth Management’s macro view of the capital markets, we want to minimize exposure to interest rate risk. Interest rates are inevitably going to move higher and interest rate risk also tends to be more volatile than credit risk.

Credit risk refers to the risk that a borrower will default and not pay back the loan. The credit risk that the NWM Mortgage Pools take on is attractive because it is arguably not correlated to the credit risk we take in other fixed income pools like NWM Bond and NWM High Yield Bond. Because the commercial mortgage market is smaller and private, risk-adjusted returns are more attractive than those found in the publicly-traded debt market.

So what do the NWM Mortgage Pools actually invest in?

NWM Primary Mortgage invests primarily (no pun intended) in commercial first mortgages, and NWM Balanced Mortgage invests mainly in commercial second mortgages.

Loans made by NWM Primary Mortgage have a lower loan-to-value ratio and higher debt service coverage ratio than loans made by NWM Balanced Mortgage. Commercial mortgage loans are made by both funds to owners of multi-family properties (including apartments, retirement facilities and student housing), retail, office, industrial and hotel properties.

The following three dimensional graphs show the relative “asset-type and geographic diversification” of each fund’s mortgage portfolio as at this time:

Mortgage Graphs

The NWM Mortgage Pools also invest in mutual funds (mortgage and money market funds primarily to manage liquidity), and may also invest in other mortgage related products.

The NWM Mortgage Pools are actively managed by Nicola Wealth Management.

Nicola Wealth Management utilizes the services of CMLS Financial Ltd., based in Vancouver, to source mortgage loan product for the NWM Mortgage Pools. All loans are supported by cash flow and meet certain investment criteria specified in the NWM Pools’ Declaration of Trust.

Loans are fully investigated by CMLS and presented to Nicola Wealth Management for review and approval. Before any loans are made, they must be approved by Mike Taylor (Nicola CFO/CCO) and Wayman Crosby (Nicola Crosby CEO [SPIRE RE LP/SPIRE US LP]).

While the NWM Mortgage Pools are actively managed by Nicola Wealth Management, they are further supported by the infrastructure applicable to all NWM Pools including an independent custodian and trustee, fund accountant and record keeper. All NWM Pools are independently audited by Collins Barrow.

What about Mortgage Investment Corporations (MICs)? Didn’t we used to invest in MICs?

Many years ago, Nicola Wealth Management invested client money in MICs. At the time, MICs were a very efficient and economical way of obtaining mortgage loan exposure. Now that Nicola Wealth Management has created and manages its own investment products, MICs no longer feature as an attractive investment option.

MICs offer limited redemption and are required to invest at least 50% of their portfolios in residential mortgage loans. Many MICs pay a fixed quarterly or monthly distribution and pay a so-called “top-up” in the Spring of each year – but only if you still own the MIC at that time!

MIC prices are fixed, which means accrued-but-undistributed earnings not being reflected in the Net Asset Value (NAV). Also, term-to-maturity interest rates and changing credit spreads do not affect MIC NAVs. Since we know all of these things are at work, a fixed NAV is simply incorrect; meaning that investors are usually not transacting at the right price when they buy or sell MIC shares.

Conversely, the NWM Mortgage Pools are pooled funds and they are redeemable on demand (currently traded weekly). Thanks to a sophisticated pricing model used by CMLS Financial Ltd. the NWM Mortgage Pool NAVs vary weekly with changing market conditions (including accrued-but-unpaid income, as well as changing interest rates and credit spreads).

All income earned by the NWM Mortgage Pools is distributed monthly without hold-back. Also, as pooled funds, the NWM Mortgage Pools have no restrictions on what type of mortgage assets they can invest in.

In NWM Balanced Mortgage, the pool participates in the upfront fees charged to borrowers, so there is no conflict of interest or potential arbitrage between the upfront fee and the interest rate negotiated on the mortgage loans. MIC managers typically keep all up-front fees!

The all-in management expense ratio (MER) of the NWM Mortgage Pools is very low at 70 to 75 basis points and there are no performance fees. (This is much lower than MICs, where the all-in MER is typically double or more.)

Also, unlike a MIC (which is a “blind pool”), Nicola Wealth Management controls the mortgage underwriting process and we choose which loans go into the funds. Consequently, the funds are very transparent and we obviously know exactly what is in them at all times.

But aren’t mortgage loans illiquid?

Mortgage loans are a bit like bricks. When many of them are bundled together, they can be thought of as bricks in a wall (119 of them between the two funds at the time of this article).

BricksThe real estate reference here is definitely intended! Mortgage loans are secured by hard asset real estate and they are generally very illiquid. There is virtually no secondary market for mortgage loans.

So first of all, you’d better be sure you like the loans you make! Secondly, building a portfolio of “bricks” (and mortar) means you have to manage liquidity very carefully in order to match new loan opportunities with loan repayments, fund unit redemptions and subscriptions, and income distributions as well. This is quite a challenge because a mortgage pool’s yield is greatest when it has as little cash-on-hand as possible.

In order to balance the liquidity risk against the desire for full investment, Nicola Wealth Management has negotiated credit lines with a major Canadian bank. Standby credit is a very cost effective way to provide the NWM Mortgage Pools with the liquidity needed to operate at maximum efficiency.

And a word about credit quality and performance.

A loan portfolio can always expect defaults from time to time and the NWM Mortgage Pools are no exception.

That being said, the overall credit quality of a loan portfolio is determined by the LIED (“loss in the event of default”). Defaults are inevitable, but losses can be avoided if loans are properly underwritten and the pools are proactively managed. The NWM Mortgage Pools have never experienced a loan loss and all interest and fees have been collected since inception.

With respect to returns, as of Oct. 31, 2013, NWM Primary Mortgage and NWM Balanced Mortgage have respectively generated annualized returns of 5.0% and 6.4 % since inception. (Returns are net of fees. Inception date of NWM Primary Mortgage is 2/28/2009. Inception date for NWM Balanced Mortgage is 11/30/2009.)

So, perhaps “mortgaging” your future isn’t a bad thing after all?

No it isn’t; in fact, it can be a very good thing. In our view, commercial mortgages are an important addition to the fixed income component of a diversified investment portfolio.

With first class access to the market, strong research, and diligent risk management in place, having mortgage loans as part of one’s investment future can be a very positive strategy.

To learn more about how the NWM Mortgage Pools can impact your portfolio, contact your NWM Advisor.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. NWM fund returns are quoted net of fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.