What is your experience in the mortgage industry (i.e. how did you become an expert)?
In 2008, I had the opportunity to arrange an investment for a client in a private mortgage. I was hooked from this first deal and began my real estate career then, moving out of investment advisory. Aside from a lot of education and licenses, I developed an expertise by seeing and transacting thousands of loans, studying real estate cycles, and of course owe a lot to others who came before me who were mentors and examples (or warnings). In 2012, I founded Alpha August Real Estate Advisory (AAREA), a private equity real estate firm; I wouldn’t be where I am without an incredible team of advisors and industry professionals who have been invaluable along the way.
Over the past 8 years I have had the pleasure of consulting with other companies spanning real estate advisory, private equity and development, which have all been valuable experiences. In my opinion, real estate and investing is not something completely learned in a book or a course, expertise can only come from transactional experience and being a market participant.
What attracted you the industry?
I have always been interested in the investment space and was previously an investment advisor. Real estate and mortgages, in particular, felt right for my skill set and approach to investing. In 2008, we were dealing with the effects of a changed tax environment for income trusts and a low interest rate environment, which developed into what we thought were rock bottom interest rates (although this is yet to be determined as some countries have ventured into negative interest rate territory). For investors seeking income, private debt emerged as a solution. I was also attracted to it because it is an inefficient market, there is an opportunity to generate alpha (excess return) by being a superior operator or manager than other market participants.
Most investors are familiar holding stocks, bonds and mutual funds in their investment portfolios. Do you believe there is a case for adding mortgages/real estate to this mix?
Well, since I am inherently biased in this answer I will try my best to be objective. Each individual’s or family’s wealth plan is going to be unique to their return requirements, objectives and constraints. There is no question that if an investor only had exposure to stocks and bonds that adding real estate or another alternative asset to the mix would increase diversification; this is well understood. For some investors, when they consider their entire asset mix, they may already be over exposed to real estate based on their other holdings. However, mortgage investments can be used as a proxy for fixed income. At AAREA, in our initial discovery meeting with new clients, we discuss the client’s overall wealth plan and asset mix to determine how we can best contribute to that. We also develop a personalized Investment Policy Statement that addresses the clients objectives, preferences, and constraints.
In the current environment, many investors have become capital gains focused because with the effects of quantitative easing, and low interest rates, it has been challenging to be an income investor in the traditional sense. Cap rates have been compressed so much that some investors are looking at real estate holdings as capital preservation instead of basing their decisions on the income the asset does or does not generate. We are in very interesting times. Mortgages provide an income stream that is difficult to replicate in the current public equity and debt market environment.
Remember also that institutional investors have become some of the largest investors in real estate and private debt over the past 10 years. Pension funds, insurance companies and foundations/endowments have substantially changed their strategic asset allocation with the majority of funds increasing their allocation to real estate and other alternatives. The traditional mix of 60/40 is over for many investors.
Every investment carries risk, what are the risks with mortgages?
The main risks are borrower default and changes in the valuation of the asset or the environment where the asset is located which could impact the loan to value.
Other considerations include mortgage fraud, appraisal fraud, and interest rate moves.
If someone was invested in a fund, I would be concerned about geographic concentration, concentration to a borrower or a group of borrowers, the default ratio, how the manager dealt with defaults, what the manager’s experience was, fees, if the fund is leveraged, and what that leverage is. If the mortgage is a syndication, who the other participating investors are would be of interest.
If the mortgage was on a commercial building, a consideration of building condition and rent roll among other standard due diligence measures would be recommended. If the mortgage is for development or construction, I would encourage investors to evaluate whether they are being rewarded for the additional risks they are taking in comparison to the rate of return they could achieve by investing in a residential mortgage or pool of mortgages. Also, I would encourage the investor to do a review of the developer’s track record and the fees associated with the investment.
AAREA provides commercial real estate consulting and due diligence services to assist with these issues among others.
How do these risks differ from the more conventional forms of investment risks?
Many of the risks and due diligence procedures are similar when considering other types of funds or investments. Mortgages are typically illiquid, so this can be a unique concern if comparing to public equities. Volatility is smoothed in the real estate market, which can in some cases encourage less diligent risk management, particularly when markets are rising as we have seen over the past few years.
For some families, particularly those with multi generational wealth planning requirements, the illiquidity of the asset class can actually be a benefit.
How much should an investor allocate to this asset class?
This is impossible to answer without context. It would depend on the individual or family’s unique set of goals, circumstances, planning requirements and investment constraints.
Why do you think so few investors consider mortgage investments for their portfolio?
Mortgage investing and private debt investing has become more of a known asset class. I don’t think it is very rare anymore. The MIC industry has done a very good job marketing itself and raising capital over the past several years; some via syndication platforms others in MICs or trusts.
At AAREA, we work solely with accredited and high net worth investors and family offices to develop and manage their mortgage portfolios and other real estate investments with a high touch approach within a context of wealth management and often multi-generational planning, which other funds do not replicate.
In Canada there are a number of publicly listed mortgage funds, and many in the US that offer public company governance standards and liquidity but also come with the daily volatility of being a publicly traded security. Many investors have (or have considered) exposure to traditional REITs because of the income yield they offer.
If a mortgage investment isn’t something that all investors consider, it may be due to lack of awareness or confusion around the asset class. For some people it is new but it is actually a very old investment – the history of lending and debt is literally ancient. The modern concept of a mortgage as we know it today has been around since the 1930’s. Many people are unaware that in Canada a mortgage is an eligible investment in registered accounts (RRSP’s etc).
How much of this is because managers and brokers are not recommending exposure to clients due to system issues, structure issues, liquidity, etc.?
Many rules and regulations were put in place by securities regulators to protect investors. If there is a lack of distribution, I would speculate it is because not enough of the funds are doing what is necessary to be approved for sale by a broker dealer, or it is less expensive for them to raise funds in other ways.
From my perspective, as an owner of a real estate firm that has a foundation in private mortgage debt, I think there is sufficient supply of capital for the existing investment opportunity. In some markets, there is more than sufficient capital which has led to lower rates of return as supply is greater than demand. The requirement for private mortgage debt continues to grow but this will be cyclical. There are a lot of funds, and operators in the space now that are available to retail investors. The hard part for the investor now is not access but is identifying a great manager with strong governance and deal flow.
What should an investor do if the person managing their portfolio hasn’t told them or offered the opportunity for them to invest in this asset class?
Like anything else in life, educate oneself first. It always surprises me how hard individuals work to earn money and how easily they will give it to investment managers. There is a lot of transparency in the market now, compared to what there used to be; a savvy investor can gain a lot of information and knowledge without cost. Talk to your wealth planner or other advisors to determine if an allocation to mortgages is suitable.
What do you see in the future for mortgage investing? Do you see it ever becoming so popular that becomes a part of every investor’s portfolio?
That is an interesting question. A lot depends on what Canadian regulators allow in terms of crowd funding to individual (non-accredited) investors and advertising on the internet. We are seeing US and UK real estate crowd funding companies grow at an exponential pace, but when you are starting at zero, huge growth rates tend to look more impressive than they are. They still only account for a small percentage of overall financing but I wouldn’t be surprised if that changes in the future. I anticipate that the origination of mortgages will change with technology and innovation in the future. There is still a lot of friction in the process that can be removed. So access will be different. There is the potential for a lot of change. This is a very old, traditional industry that could be disrupted with change, innovation and different thinking. I think different methods of ownership will evolve over time as more and more people are priced out of markets which will create interesting opportunities for investors.
Will this be a staple of every investor’s portfolio? The market capitalization of the TMX is roughly $2 Trillion, the size of the residential prime (non alternative) mortgage market in Canada is approximately $1.4 Trillion. The size of the alternative mortgage market in Canada is anybody’s guess, we have estimates ranging 1-3% of the total residential market, or perhaps $15 Billion to $50 Billion. Currently, I think this opportunity in the alternative mortgage market is not large enough for it to be in everyone’s portfolio. However the demand for income producing investments will only continue as the baby boomers move into retirement and need to generate income from their asset base.
Is part of your portfolio invested in mortgage backed or direct mortgage securities?
Of course! At AAREA our first priority is capital preservation, our business model is fully aligned with our clients; we often co-invest in mortgages and always do in real estate opportunities.