Education Centre

Mortgage Investment Guide for Beginners And the Role of the Advisor

by Gregory M. Colford, B.A., J.D., C.I.M.®

Real estate investing is an avenue many modern investors are choosing to explore. Paired with traditional investments like stocks and bonds, real estate investing provides stable returns and lower fees while mitigating investment risk. It also offers critical diversification.

However, many remain in the dark, believing a mixed bag of public exchange traded funds gives them a balanced portfolio. The credit crisis of 2008 showed us all this was very bad portfolio management. To avoid the correlation nightmare that swept the public markets in 2008, every investor, big or small, needs some portion of their investment portfolio in private real estate.

In this article, Fundscraper provides an investing playbook to show you how to invest as little as $5,000 in private real estate without the hurdles, obstacles and barriers that traditional mortgage investment techniques often throw up for the “newbie”. Careful real estate investment will give back substantially more than a savings account or a GIC and will often outperform popular mutual funds and exchange traded funds. Most importantly, it enhances diversification to a portfolio of publicly traded securities.

So, Let’s Begin! What is real estate?

Fundscraper’s General Counsel John Pizale wrote an excellent article on why real estate is an important part of anyone’s investment portfolio. You can read John’s article here. John gives you all the reasons why you should invest in real estate; this article tells you how!

First, the basics. Real estate is easy – it’s what you’re standing on and the stuff stuck to it! It may be a home (single family housing, condominium housing, rental apartments, retirement residences, etc.), a place of work (office building, warehouse and distribution centre, manufacturing facility, etc.), a place to shop (shopping centre, main street retail, etc.), or a place to recreate (hotel, resort, etc.), some combination thereof or just bare land (the stuff we’re not making any more of)!

The value of real estate will be a combination of scarcity and the ability to generate income from the real estate. Therefore, the value of your family home is more likely a reflection of scarcity in the market and not the future income it can generate. On the other hand, a commercial building is generally valued on the net income it generates. You can have two buildings exactly the same standing side by side, but it is the building that generates more income that will be considered more valuable.

Real estate: It’s different from what the robo advisors are pushing.

For the majority of us real estate as an investment is remote, foreign, out of reach, or weird. When most of us think of buying real estate, it’s buying a home. And for many, that’s not even possible. So we stop thinking about real estate and listen instead to folks pushing simple solutions to our investment conundrums. This generally results in a mixed bag of publicly traded ETFs with no diversification into private real estate.

It’s time to start thinking differently about real estate investment.

For “kids in the know” real estate investment is not buying a building or a piece of land. It’s buying (or investing) in what the building owner needs in order to buy a property: the mortgage!

Everyone knows that a mortgage is a loan that is backed up by the property the owner has purchased. If the borrower fails to pay you back, you can take the property and sell it to pay yourself back. A mortgage can be funded by anyone: a big chartered bank or you and your friends acting together! So a mortgage can be fractionalized, divided up and everyone can take different pieces.

Yes, you can invest as little as $5,000 in a mortgage. A mortgage investment admits everyone – it’s very democratic!

Mortgages are Funky

Mortgages have been around a very long long time. For example, hedge funds have been around for about forty years. Mortgages have been around for over 700 years. By comparison, hedge funds are a fad! The word “mortgage” has nifty roots. “Mortgage” is an old french word that literally means “death pledge” from the old french mort gaige (death + pledge). The “pledge” of land to support the borrowing would literally die if the loan was repaid (the land would fully vest in the borrower) or if the loan was not repaid, the lender would realize on the “pledge” and take the land. In both cases the “pledge” goes away, dies!

So, what am I doing when I lend money by way of a mortgage?

When you become a “mortgagee” (the fancy word for people who lend money where the repayment obligation is secured by the property the borrowed money is being used to purchase) you lend your money out with the expectation that the money will be returned to you. To “secure” the repayment, the borrower gives the lender an interest in their property that will allow the lender to take ownership of the property if the borrower fails to repay the loan.

While the money is outstanding, the borrower will pay you a fee for the use of your money. That fee we call interest. How much interest is paid by the borrower is decided between you and borrower. The rate of interest is set on a yearly basis and the most common way it is paid is monthly. For example, if you lend your friend $100 to buy a house and your friend agrees to pay you 10% every year, then you can expect from your friend $10 every year or $0.83 every month. $0.83 does not sound like a lot, yet had you advanced your friend $100,000, the monthly return would be $833.33! Impressive. Compare that to a “high interest” savings account rate of 0.9% offered today at two of our Canadian chartered banks on the same $100: after a year you have a whopping 90 cents! On $100,000, the monthly return is $751.

Further a mortgage means it’s secured. That means notice of your mortgage has been “registered” or filed with the office of the Government that keeps track of all the real estate in Ontario!

Now the entire world knows your friend owes you; your friend cannot sell the property to anyone unless your friend pays you first! From this point going forward, anyone who wants to buy or sell your friend’s property will have to deal with you first! If someone registers after you, you have to be paid out first before they can be paid at all! The land registry sets out the order of how people get paid.

If your friend fails to pay you back, or runs away to Tahiti to live a life of leisure, then you can compel the sale of the land to get your money back with the interest owed to you and costs you incurred enforcing the mortgage!

Will I always get my money back?? – Maybe/Maybe Not

When you lend money to folk it is done on the expectation that the borrower will pay you back. If there is little likelihood that you will be paid back, then you likely would not lend. You might “gift”, but that’s not lending; that’s just being generous.

If you’re lending, you want to be aware of the borrower’s circumstance which will give you some idea as to the likelihood of being repaid. If the borrower has a good job, is known to pay debts when due and repayment appears to be well within the borrower’s means, you have a good chance of being repaid. So, you lend the Borrower $100 and hope for the best. If the borrower repays you, terrific; if not, you have nothing except a sad life lesson.

The borrower is buying real estate with your money. “Hey,” you say, “in case something happens to you, I should put a notice on the land that you owe me a $100!” “OK,” your friend agrees. You advance $100 to your friend who buys the land. You register your loan with the govern that authority. Your friend eventually pays you back. You remove notice of your loan. You and your friend are both happy.

Now, instead, your friend goes to Tahiti leaving you a Facebook posting “Sayonara Sucker!” Darn, you think to yourself; you wanted to go to Tahiti too!

You’re not worried about the $100 because you were smart and have a mortgage to secure repayment. There’s no hope of your friend paying you back. You’re forced to sell the property. As a “mortgagee” you can do that without your friend’s cooperation. You don’t need the Borrower’s consent as that was part of the original deal when you registered a mortgage: If you fail to pay me, I get to sell the property and use the sale proceeds to pay myself off!

You sell the property and the property sells for $200! Wow! Can you keep the extra $100? No. A mortgagee can only take what the mortgagee is owed under the mortgage (plus any expenses enforcing the mortgage!). If there is any surplus, the surplus has to be returned to the borrower.

But what happens if you sell the property for $50?! Then that is another life lesson – you have sold at a loss. Does the Borrower still owe you the difference? Yes, in Ontario the Borrower will remain liable for the amount outstanding and owed to you. In some jurisdictions, especially in the United States, once the lender has taken over the property, the lender will have no claim against the borrower. It is called a “quitclaim” meaning the lender relinquishes its claim against the Borrower. The other expression used when a lender can only go against the property is “non-recourse”. You are happy you are in Ontario because now you can bring a claim against your friend for the difference! Your loan is “full recourse”!

Mortgages are a long term investment.

Mortgage investment is for a long term. If you think you will need your money in the next 12 months, stay away from mortgage investment. If you have money that you simply want to sock away and forget about, then mortgages are something you should definitely look at.

Mortgages have a term and investors who invest directly in a mortgage are expected to hang out of the entirety of the term of the mortgage. The term of a mortgage can be as short as six months or as long as the parties may agree. 12 months to 3 years tends to be the most common terms for mortgages in the private markets. 5 years is the most common term for a residential home mortgage offered by the banks.

So, How do I suss out a mortgage?

Loan-to-Value

People who successfully invest in mortgages will only look at mortgages that are valued less than the property against which they are secured. It’s called the “loan to value”. If the loan is worth $100 and the property is worth $100, the “loan-to-value” is 1. For a successful mortgage investor, this is terrible. The lower the ratio, typically expressed as a percentage, the more secure the investor is. If the mortgage was $50 and the land was worth $100, the loan to value would be ½ or 50%. That means for every one dollar of debt, there is two dollars of property to secure the repayment of the $50! 75% loan-to-value is generally considered a standard LTV for the greater Toronto area. When assessing the value of a mortgage, loan-to-value is a critical element in the assessment.

Liquidity

The second most critical element is liquidity. “Liquidity” simply means how fast can I sell the property against which I have secured my mortgage in order to pay myself back if I have to enforce the mortgage (because my friend has gone to Tahiti!).

If your mortgage represents 50% LTV, yet you cannot sell the underlying the property, then the loan the mortgage secures is a loss. If the property is in a hot real estate market and you can sell the property quickly, then you will not suffer any loss.

If the mortgage is in trouble, the lender (you!!) want to get out quick. With high liquidity and conservative LTV the lender will be able to sell the house quickly and be repaid all of the interest, principal and expenses owed.

Learn how to spot the three red flags!

The high interest rate! Sooooo tempting! The first red flag!

A mortgage (any mortgage) is generally priced on its (i) LTV and (ii) the ease of sale (or liquidity) of the property in the event you have to sell it. Pricing a mortgage means how much it is going to cost the borrower to borrow the money. When the loan is first negotiated, the borrower’s cost is reflected in the interest rate paid on the mortgage. The higher the interest rate, the higher is the perceived risk of the mortgage investment.

The first two things you will now think about when you see a high rate of interest is maybe (i) there is a very high LTV associated with the loan and or (ii) the property is located in a difficult market. The high rate interest is the first red caution flag for any mortgage investor.

The discount! Is it really a good deal? The second red flag!

After a mortgage is put in place, mortgage brokers will buy and sell mortgages on behalf of themselves and their clients. As the rate of the mortgage is already settled, the amount that changes in a purchase and sale of a mortgage is the “face amount” or the principal amount.

In our example above, if the repayment of the $100 mortgage is in doubt and the mortgagee (the lender!) wants to get out, the lender will offer to sell the mortgage to another investor for an amount less than $100. How much less depends on how much the mortgagee wants to get out! What the mortgagee is hoping to do is transfer the risk of non-payment to someone else. The person who agrees to buy the mortgage does so hoping to be rewarded for assuming the transferred risk by buying the $100 mortgage at a discount!

Therefore, if the original mortgagee sells the $100 mortgage for $95 dollars, the new mortgagee now acquires a $100 debt obligation for only $95! The repayment obligation of the borrower never changes. The new mortgagee now stands to make not only the interest on the $100, but a further gain of $5 when the mortgage pays out! Easy money, eh!

Well, no. The extra $5 represents the cost of the additional risk the new mortgagee has assumed. If the mortgage is repaid, great. If the mortgage defaults then the only person happy is the first mortgage holder who sold the mortgage for a small loss of $5. So, a second red flag is when a mortgage is offered to you at a steep discount to its face amount. Just ask yourself, why would someone offer me a $100 for $95? There’s a catch of course. Understand what it is!

The perils of the hunt for income – “Like, I gotta live on this!”

One of the big reasons folks invest in or buy mortgages is for the income they generate and the security they provide. This is especially true for people who are no longer earning an income and living off their savings such as retired seniors or lucky trust babies!

The income generated from a “high interest savings account” described above will not be enough for many on a fixed income to survive upon. Though their money will be very safe in a Canadian chartered bank savings account, they will likely starve to death on the street if they are hoping to live off the interest. Therefore, the hunt for income!

There are literally thousands of income products in our financial markets today. The oldest among the lot is mortgages and they remain today one of the top income products for institutions of all kinds and individuals seeking income. Therefore a huge concern for mortgage investors is whether or not the mortgagor (the borrower!) can regularly meet its obligation to pay the interest the mortgage investment promises.

It’s great to know the mortgage is secured against the property the mortgage monies were used to purchase – but no one who relies on the income stream from the mortgage wants to be stuck enforcing the mortgage! Enforcing a commercial mortgage can take years! During the time a mortgage is enforced it is most likely the borrower is not paying any income. People relying on that income are now wondering how comfortable the street corner will be!

The Borrower’s Ability to Pay. The third red flag!

Determining the ability of a borrower to pay its interest obligation is the job of the lender (and often the mortgage broker working together). The borrower may have a great property in a fabulous location where the lender’s mortgage will have a low LTV but whether or not the borrower will repay is another issue.

The lender is looking to the income, in fact relying on it, for its own cash flow needs (this could be a senior putting food on the table, a charitable foundation financing its ends, a pension fund needing to pay pension entitlements, a trust established by parents to pay the expenses of a special needs child, etc.) If the borrower, though, cannot pay the coupon (the interest!), then the mortgage, notwithstanding how secure it is, is kinda useless if the primary goal of the mortgage investment was the income stream. Determining the borrower’s ability to pay is a critical factor and the third big red flag in determining whether or not to invest in a mortgage.

Help! How to protect yourself against red flags involved in mortgage investment.

Mortgage investment is not simple. Building wealth never is. Mortgages, though, are a smart investment. As noted above, a high interest savings account will give you 0.9% on your cash. Your buddy’s 5 year fixed rate mortgage on the home will likely give you three times that at 3%! There are mortgage investment opportunities in Ontario that can range from 3% to 15% and more. Simply remember the rule: the higher the rate of return, the more risk there is in the mortgage! So, how to sift through the good and the bad? And to make matters more complicated, you only have $5,000 to invest!

Not to fear – help is here!

Find an advisor. For a neophyte investing in mortgages is complicated. Unless you have years of experience, you cannot do this alone. We cannot stress strongly enough that you must find a registered advisor.

All persons who advise on the purchase and sale of mortgages or securities based on mortgages must be registered with FSCO (soon to be called “FSRA”, the Financial Services Regulatory Authority of Ontario) or the Ontario Securities Commission (the “OSC”). A “registered” advisor is accountable to both you and the regulator and it is the job of the advisor to act in your best interest! If it is proven the advisor has not acted in your best interest, you can sue the advisor and the regulator can put them out of business for good. That’s good for you and good for our markets.

Registered advisors like Fundscraper make this complicated investment easy. The buying and selling of mortgages and investing in mortgages is all regulated by a set of laws a telephone book thick. (For the younger crowd “telephone books” were bound paper compilations of all the thousands and thousands of telephone numbers in a given locality. They were several inches thick. When not used for looking up telephone numbers, they were often employed as booster seats for young children). Registered advisors like Fundscraper know the way through the maze of this book of laws, regulations, notices and policy statements.

So, let’s invest your $5,000 in mortgages! There are three popular ways of investing in mortgages and Fundscraper would work together with you to help you determine what might be best for you in your circumstances.

1. Public Mortgage Funds

One can invest in a publicly traded fund (meaning it trades on a public exchange and you can buy and sell whenever you please) that is made up of mortgages. Examples of popular funds are Timbercreek Financial and Atrium Mortgage Investment Corporation. Each are easy to access through your investment broker or through a direct investment account that is likely available through your bank. Yet the drawback of these investment vehicles is that they are publicly traded. If you haven’t got at least 20% of your current portfolio in the private real estate market, you should look at further diversifying your investment portfolio in one of the two further options below.

2. Private Mortgage Funds

Another way to invest in mortgages is through a private fund. A private fund does not publicly trade and once you invest your money you might not be able to get it back right away. Again, mortgages are long term investments. People will invest in a private fund as the returns can often be significantly better than a public fund.

The better return is generally the result of a unique skillset the asset manager brings to the mortgage fund. Private mortgage funds are widely available in Ontario and the simplest way to find one is to ask a licensed mortgage broker or securities dealer like Fundscraper. Your licensed mortgage broker or securities dealer should be able to advise you as to which funds are most suitable for you.

If the advisor does not or is unable to tell you the differences between the various private mortgage funds and which ones might be suitable for you, THEN GET A NEW ADVISOR.

3. Mortgage Syndication

A third way of investing in a mortgage is through what is called a “mortgage syndication”. A mortgage syndicate is where you and one or more persons fund a mortgage directly. A mortgage syndication is where a mortgage is funded by two or more parties. Investing in a mortgage syndicate is strictly for people who are experienced mortgage investors.

The investment return can be inordinately good or ruinous. Being part of a syndicate is not for the faint of heart! When you invest in a mortgage syndicate, you acquire a direct fractional interest in the mortgage – you go on title! In this investment scenario you are literally putting all your investment eggs in one basket! The mortgage pays off or it doesn’t.

Mortgage syndicates are generally private and good mortgage syndicators will only admit investors they know are sophisticated and are able to withstand the loss if the investment fails.

To become part of a syndicate, one generally has to go through a qualified mortgage broker or securities dealer like Fundscraper.

“Ok, I’m ready! What do I have to do?”

First

Find a registered investment advisor.

It is easy to find out if your advisor is registered. For example, if you go the FSCO website you can check to see if your advisor is registered as a mortgage broker here:

http://mbsweblist.fsco.gov.on.ca/agents.aspx.

If you were to type in “Fundscraper”, you will see this as you click through the links:

Mortgage products are also sold by securities dealers. If you are investing in a fund or a pool of mortgages or into a mortgage investment corporation or a mortgage syndicate you will want or need the services of a registered dealer.

If the person inviting you to invest is not registered as a dealer with the OSC, then move on. Find a dealer whose business it is to protect you. To check whether or not a person is registered as a dealer, the securities regulatory authorities across Canada set up a large database where all dealers are catalogued. To check on someone, visit here:

https://www.securities-administrators.ca/investortools.aspx?id=1128#check

Again, if you were to type in “Fundscraper”, you will eventually see the following:

Second

Meet with your advisor. After pleasantries are exchanged, the very first thing your advisor will want to do is get to know you and what kind of investor you are.

This process is called “know-your-client” or KYC for short. You will be asked to fill out several forms disclosing to your advisor all the financial details of your life. The advisor does not care if you own cats – keep the pictures in your wallet!

After you have completed the forms, you and the advisor will discuss what investments might be appropriate that the advisor has to offer you. If the advisor has nothing suitable for you, the advisor will tell you that. At Fundscraper this exercise is done all online. You can complete it on any tablet or laptop with your cats helping you along the way.

Once you complete your online KYC, our platform does a complete suitability analysis of you and determines what kind of products we offer that might be most suitable for you. There are rules about who can invest in the private markets and our platform will determine in what capacity you can participate. Once everything is completed, a dealer (like, a real person) will reach out and speak to you to confirm the information you have provided and the investment direction you should go!

Third

Invest! Put on your Warren Buffet water wings and take the plunge! Your registered advisor, with your KYC in hand, will now endeavor to match you with an investment that is suitable for you. The advisor has a “know-you-product” obligation. That means the advisor has to be able to defend why the advisor is recommending the product choice suggested. The advisor must know the product well to conclude whether or not it is suitable for you the investor! In Fundscraper’s online environment, our algorithms will highlight to the advisor what products we offer that will be most suitable for you based on what you have told us.

The paperwork!

Finally, once you have chosen what to invest in, you will have to complete some paperwork, especially if you are purchasing in the private market. The key document is called a “subscription agreement” and it lays out the terms and conditions of purchasing the security you want.

It will also have a description of that security. It is very important that you review closely the subscription agreement. Often they are in “legalese” and you may need the help of your advisor to clarify matters you are uncertain about. What is most important is that you understand what it is you are buying!

Once your investment is made, relax and “clip your coupons”!2

Conclusion

Investing in mortgages wasn’t always simple; at Fundscaper it is. You can do it and you can do it with as little as $5,000. Let Fundscraper show you how. Talk to one of our advisors today.

1.

High Interest Savings Accounts 1 Interest Rates Minimum Balance
RBC High Interest eSavings 0.9% $0
CIBC eAdvantage Savings 0.9% $5,000

March 5, 2019

2 The expression comes from what Government bond holders years ago used to do each month. On the margin of a Canadian Savings Bond were the listed “coupons” for each month’s interest payment obligation the Government owed to the bondholder. With a pair of scissors, the bondholder would literally clip out the relevant monthly coupon from the bond and bring it to a bank to redeem!

ABOUT THE AUTHOR

Gregory Colford
Gregory Colford

PRINCIPAL BROKER, EXECUTIVE VICE-PRESIDENT & CHIEF COMPLIANCE OFFICER

Gregory Colford, JD, CIM, was a senior partner at Heenan Blaikie LLP, once one of Canada’s ten largest law firms. Over his 12 years at Heenan Blaikie LLP, he headed the Toronto Securities Department, the Corporate Services Department, the Precedent Committee, the Legal Opinion Precedent Committee, and was the Toronto representative on the firm’s Stock Trading Committee. Through the course of his practice, he brought many companies to the public capital markets and advised extensively on corporate governance, board integrity, and market compliance.  He was also the co-founder of Carlisle Capital Structures Corporation and helped the company grow to over $1 billion CAD in AUM of mortgage securities on behalf of a top tier Ontario pension fund.