For investors seeking a low risk vehicle for real estate investing, a mortgage pool fund may offer greater safety than traditional real estate opportunities such as development, acquisitions or REITs. Mortgage pool funds do not provide capital appreciation, but they do generate a reliable stream of interest payments which, in today’s climate of low interest rates, can exceed Treasury bill returns by several percentage points. With a mortgage pool fund, investors may earn superior risk-adjusted returns on their investment.
Mortgage pool funds have a different risk profile than stocks and bonds. Portfolio assets consist of tangible bricks and mortar and are protected by title insurance and other legal rights that ensure the mortgage lien is enforced and downside risk is limited.
In selecting a mortgage pool investment, investors should look for a professionally managed fund, led by experts with demonstrated skills in real estate, financing, construction, fund accounting and reporting, and real estate law. The principle risks that fund managers want to control are: 1) a decline in property value; 2) an interruption of the fund’s cash flow, which may occur if a borrower misses payments; 3) legal action; and, 4) losses associated with a foreclosure sale. How well these risks are managed determines the fund’s overall safety. Here are six specific strategies that fund managers use to limit risk:
Maintain a conservative loan-to-value ratio. The most important tool for controlling risk is maintaining a low loan-to-value (LTV) ratio. This ratio is calculated by dividing the loan amount by the fair market value of the property. For example, a $70,000 loan made against a property valued at $100,000 yields a 70% LTV ratio. Lower LTV ratios are considered safer than higher ratios since in the event of a foreclosure sale the lender has a greater likelihood of recouping his investment if the property is worth more than what’s owed on the loan.
Most mortgage pool funds consider a LTV ratio below 70% reasonable. Socotra Fund insists on a more conservative LTV ratio below 60%. In addition, the portfolio’s actual LTV ratio is typically less than that. An analysis of the Socotra Fund’s portfolio’s top holdings in July showed a LTV ratio of 49%.
Evaluate property value and borrower creditworthiness. In conventional lending, banks rely heavily on the borrower’s credit history to determine whether a loan should be made. Hard money lenders such as mortgage pool funds are different. For these lenders, the value of the property is more important than the borrower’s credit history.
Socotra Fund uses a three step approach to valuing properties. The process begins with analyzing recent sales of comparable properties in the same neighborhood. A real estate professional familiar with the area visits the property and determines a baseline valuation. The next step involves bringing in a licensed appraiser. The appraiser will determine an “as is” value for the property, a post-renovation value and a liquidation value, which is the value that could be obtained from a forced sale. Included in the post-renovation valuation are estimates of construction costs. Most mortgage pool funds require firm bids from contractors before work can begin.
Banks lend primarily to owner-occupants, but mortgage pool funds focus their efforts on real estate professionals who acquire, upgrade and sell properties on a regular basis. These borrowers want to close financing deals quickly and are willing to pay above-market interest rates for a fast turnaround.
Insist on first lien position. The loans held by mortgage pool funds are referred to as trust deeds. Each trust deed is assigned a lien position when it is recorded by the county clerk; the position indicates whether there are prior liens on the property. The highest priority lien, known as the first lien, is considered the safest since it is paid first if the property is foreclosed and sold. Any leftover funds will be used to pay the remaining liens. Socotra Fund insists on maximum safety and invests only in first lien trust deeds.
Diversify the lending portfolio. One of the basic tenets of investing is that portfolio diversification reduces risk. The same reasoning applies to real estate portfolios. A portfolio that contains multiple property types and is varied by geographic location is generally safer than one that holds only a few properties. Socotra Fund’s portfolio is diversified across 134 properties and a variety of property types (commercial, non-owner occupied single family residential, multi-family property and construction/rehabilitation). Loans are spread across 32 counties in California and loan maturities range from six months to ten years.
By building a diversified portfolio, Socotra Fund minimizes the impact if any one loan ceases to perform. The largest loan in the portfolio represents only about 3% of total loan volume. Diversification results in a steadier stream of income, delivered within a predictable time frame.
Focus on shorter loan maturities. Loans with very long maturities (more than ten years) may present liquidity concerns and interest rate risk. Liquidity is poor since the investor’s capital may be tied up for many years. If interest rates rise or inflation increases, the investor is trapped in a low return investment, with no opportunity to reinvest and take advantage of new higher rates. Socotra Fund invests mainly in short-term loans that are relatively insensitive to interest rate changes. Most of the loans in the portfolio have terms ranging from one to three years.
Ongoing investment monitoring. Before the loan is made, most mortgage pool funds check that the property title has no prior liens or other issues that could impair its value. After the loan is made and renovation work begins, construction progress is monitored to ensure that work is completed on time and on budget. Professionally managed funds usually have procedures in place to service the loans, including IRS reporting requirements, systems for monitoring default risk and procedures for handling foreclosures. Socotra Fund maximizes efficiency by managing all loan servicing operations in-house and reduces risk by requiring all borrowers to purchase title insurance. Hazard insurance may also be required for properties undergoing renovation and some loans may be required to carry mortgage insurance.