Bank stocks have generated robust returns so far this year as they have benefited from strengthened economic growth and increased consumer lending. Through the first eleven months of 2016, the banking sector has delivered 21% investor returns, which is more than twice the S&P 500 return of 10%. Gradually rising interest rates as the Fed commits to multiple rate hikes next year may improve profit margins. In addition, expectations of a less restrictive regulatory environment under President-elect Donald Trump may further enhance banking industry growth prospects for 2017. However, the rosy outlook for the banking sector is also clouded by a few challenges. For example, competition from non-bank lenders is increasing and cyber-security is becoming a major issue for banks.
On the other hand, rising interest rates and a stronger economy should also benefit mortgage pool funds, whose primary business is making loans to professional real estate investors. Mortgage pool funds provide much of the capital used by real estate professionals to fund property fix-and-flips.
While resembling banks in many ways, mortgage pool funds also have a few critical differences that make them attractive investments. Four of the key differences between mortgage pool funds and banks are discussed below:
1. Ability to more rapidly redeploy capital.
Mortgage loans made by banks typically have terms ranging from 15 to 30 years. Due to lengthy maturities, fixed-rate bank loans may lose value as interest rates rise. The situation is very different for mortgage pool funds, whose loans are generally short-term in nature. Terms for mortgage pool fund loans generally range from one to three years. These shorter loan maturities not only lessen exposure to interest rate swings, but also give mortgage pool funds the ability to re-deploy capital more quickly and thus capture the benefits of rising interest rates. As rates increase, mortgage pool funds are able to reinvest the proceeds from maturing loans into new higher-yielding assets and lock in profits.
2. Monthly payouts and richer yields.
The typical bank stock pays quarterly dividends, whereas most mortgage pool funds pay distributions on a monthly basis. Many income investors (especially retirees) prefer monthly payout since this allows them to more easily match monthly expenses with income.
Mortgage pool funds generate income from interest paid on loans. This income is passed along directly to fund investors through distributions. Due to the specialized lending niche they serve, mortgage pool funds are able to charge higher interest rates than banks, which enable them to reward their investors with richer dividends. Returns vary by region, but most California-based mortgage pool funds delivered 8-9% distribution yields in 2016.
Bank stocks are different. Their returns have both a capital component and a dividend component. The capital component can make bank stocks volatile. While bank stocks rose during 2016, there have also been many years when prices declined, resulting in a capital loss on the investment. Data from Morningstar shows that the global banking sector lost nearly 7% of its value in 2015 and three-year returns on bank stocks have been lackluster, averaging only about 4% per year. Dividends make up a minor component of bank stock returns and their dividend yields are generally modest. Yields on bank stock currently average only about 1.8%. Of the 15 largest US bank stocks, only four had yields exceeding 3% at the beginning of 2016 and their yields have since dropped below 3%.
3. Niche focus and superior due diligence.
Most mortgage pool funds operate in regional markets that they know well, which gives them a superior ability to manage portfolio risk. These funds also serve a small specialized niche consisting of professional real estate investors, and are able to personally inspect every property and individually monitor each loan. Superior due diligence further reduces loan risk. In addition, many mortgage pool funds require borrowers to provide a personal guarantee and a large down payment on loans. This is different from banks, which may require only a minimal down payment from borrowers. Banks rely on the credit history of the borrower to assess risk, whereas mortgage pool funds focus on the underlying value of the property. Mortgage pool funds make loans only in instances where the property’s value substantially exceeds the loan amount. Most mortgage pool funds limit the loan amount to less than 70% of the property’s value. This is in marked contrast to banks. Many banks were making loans at 80% or more of property value during the last real estate boom. A 70% loan-to-value ratio creates a safety cushion for mortgage pool funds that insulates the fund against losses if a loan defaults and a property must be foreclosed and resold.
4. Fewer regulatory hurdles.
Mortgage pool funds have greater freedom to capitalize on a booming real estate market and grow their assets and earnings. Banks have been stymied by new regulations that went into effect in 2015 such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and Basel III. These regulations require them to hold more capital on their books by forcing banks to retain 150% of the risk weight of some loans compared to the 100% weight previously required. These heightened capital requirements limit the ability of banks to grow their portfolios and provide non-bank lenders with a competitive advantage.
Both banks and mortgage pool funds are poised to benefit from a strengthening economy and gradually rising interest rates in 2017. However, mortgage pool funds have a few competitive advantages, such as higher yields, monthly payout, fewer regulatory constraints and the ability to redeploy capital more rapidly, that heighten their appeal for many investors. Talk with your financial advisor, who can help you decide if a mortgage pool fund belongs in your retirement portfolio.