Mortgage pool funds can be great holdings for investors seeking real estate exposure, a low risk investment that moves independently of stock and bonds and predictable monthly income. Mortgage pool funds make loans to professional real estate investors such as property developers and house fix-and-flip specialists. Their loans are secured by real estate and are referred to as “hard money” loans or bridge loans. Unlike most bank loans, which rely primarily on the creditworthiness of the borrower, hard money loans mainly consider the value of the underlying property.
Real estate investors prefer hard money lenders over traditional lenders because of their ability to fund loans more quickly. In most instances, a hard money loan can be funded within a week versus more than a month for the typical mortgage. The ability to obtain funding rapidly provides a significant advantage for an investor when many bidders are competing for the same property,
Because of the projects they fund (construction and renovation), term lengths for hard money loans are shorter than most mortgages. Term lengths typically range from a few months to three years, whereas conventional mortgages have 10 to 30 year terms. Their shorter terms make hard money loans less sensitive to interest rate swings, resulting in more predictable cash flows.
Interest rates on hard money loans vary by lender and region. For example, rates are generally lower in California due to intense competition among lenders in that market. California has a vibrant housing market characterized by profitable fix-and-flip opportunities and thus attracts large numbers of hard money lenders. In general, interest rates on hard money loans are higher than on conventional mortgages, typically ranging from 10% to 15%, depending on the lender and the perceived riskiness of the lending opportunity.
The higher rates earned on hard money loans translate into attractive risk-adjusted returns for mortgage pool fund investors. However, mortgage pool funds vary. For example, some focus on specific regions and property types and some are more general. The differences between funds can impact risk and return so it’s important that investors do their homework first. Here are a few of the key ways that mortgage pool funds may differ:
- Geographic focus of the portfolio. Some mortgage pool funds operate nationwide while others concentrate on a particular geographic region. There are some advantages to a regional focus. Real estate is essentially a local business and superior knowledge of the local market may result in more profitable lending opportunities. Regionally focused mortgage pool funds know the local investment community, can more easily identify up and coming neighborhoods and are better equipped to assess the risk of each deal. The flip side is that portfolio diversification reduces risk so the local area must offer sufficient variety and enough lending opportunities to diversify away risk. The California market where the Socotra Fund operates is known for the diversity of its local markets and abundant lending opportunities.
- Property type and lien position. Hard money loans are made on all types of properties, including single-family and multi-family residential homes, commercial buildings, land, and industrial space. Some lenders specialize in residential and may not offer commercial loans because of lack of experience in that niche. Hard money lenders generally prefer to hold first liens, which represent the most senior claim on the property, but some will also accept second liens. The Socotra Fund lends across a variety of property types and thus benefits from more lending opportunities and a more diverse portfolio. Approximately two-thirds of the fund’s portfolio is single family residential, roughly 29% is commercial and the rest is land and multi-family residential. Unlike other mortgage pool funds, the Socotra Fund won’t accept second lien positions since these are considered too risky.
- Underwriting criteria. A major differentiator between mortgage pool funds is their lending criteria and the loan-to-value ratio they use to underwrite loans. Loan-to-value measures the loan amount as a percentage of the value of the property. A lower loan-to-value ratio creates a safety net that protects investors if the borrower defaults and the property must be sold to recover the investment. Many mortgage pool funds will make loans at 75% of property value. The Socotra Fund is more conservative and insists on a loan-to-value ratio closer to 55%. The advantages of conservative underwriting were apparent when the Socotra Fund was able to recover 100% of the principal and interest on the one foreclosure sale from its portfolio last year.
- Liquidity. Real estate investments are frequently criticized for poor liquidity. Property markets are cyclical and many months may pass before a property sells in down markets. Mortgage pool funds address the cyclicality issue by diversifying portfolios by region, property type and loan term. Even with liquidity-enhancing measures, start-ups and newer mortgage pool funds often have a lock-up period during which subscribers are prohibited from withdrawing capital. The Socotra Fund is more lenient, allowing its subscribers in most instances to withdraw their capital in the quarter following the withdrawal request. The fund’s subscribers benefit from better access to their funds and increased opportunities to reinvest.
- Management experience and skin in the game. A more robust housing market has multiplied the ranks of hard money lenders including mortgage pool funds. While start-up funds may present opportunities, many investors may prefer a mortgage pool fund with a track record of success and a management team well-aligned with fund subscribers. The Socotra Fund has been generating returns for subscribers since 2011. An investment of $100,000 in the fund at its inception would have been worth more than $162,000 by March 2016, as shown in the chart. Managers have committed more than $800,000 of their own capital to the fund, ensuring their interests are the same as fund subscribers.
As an asset class, mortgage pool funds outperformed both stocks and bonds in 2015 and can be great investments for those desiring monthly income and high risk-adjusted returns. Mortgage pool funds come in all shapes and sizes, however, so investors should do their research first in order to select a fund that is best aligned with their liquidity needs and appetite for risk.