Mortgage pool funds can be attractive investments for those seeking income and portfolio diversification. With dozens of such funds to choose from, however, the challenge lies in picking a fund compatible with your risk tolerance and investment objectives. If you are an investor considering holding a mortgage pool fund, a good place to start is with a review of the fund’s private placement memorandum.
Private placement memorandums are legal documents that explain the fund’s objectives, risks and the terms of the investment. Each memorandum contains a summary of the offering, followed by more detailed descriptions of the fund’s business operations, growth strategies, risk factors, history and current financial position. The purpose of the document is to give prospective investors the information necessary to evaluate the offering and also protect fund managers from liabilities associated with selling unregistered securities.
There are several sections of the private placement memorandum that should be studied carefully by investors, including the following:
Offering Summary. The summary describes the key terms of the offering such as price, minimum subscription amount, fund objectives, investor suitability requirements, commissions and fees owed to the sponsor and related parties, fund withdrawal policy and profit distribution to investors.
Prospective investors should check whether the placement is being offered on a contingency basis, meaning that certain conditions must be met for closing to occur, such as a specific dollar amount being raised. If contingencies are not met, the invested capital will be refunded to subscribers. Be leery of funds that don’t specify a minimum capital raise. This can be a red flag that the issuer will deploy capital immediately, regardless of the amount raised.
Investor Suitability. Many private placements limit the offering to “accredited investors”, defined as those with a net worth (excluding primary residence) exceeding $1 million, or annual income of more than $200,000 in each of the two prior years.
At one time, marketing of private placements was strictly limited to accredited investors, but that changed with the passage of the 2012 JOBS Act, which allows advertising of private securities to a much broader audience. It may be possible to invest as a non-accredited investor, but those considering such an investment should carefully weigh their liquidity needs first since private securities are sometimes difficult to sell. Prospective investors should also study the fund’s redemption policy. Most issuers will try to accommodate redemption requests, but are under no obligation to repurchase shares simply because of investor liquidity needs.
Risk Factors. A substantial portion of the private placement memorandum is devoted to a discussion of risk factors that could lead to investment losses. The SEC requires funds to explain those risk factors that are specific to the industry, offering structure and type of business.
Use of Proceeds. This section describes how the offering proceeds will be deployed. Also contained in this section is disclosure regarding compensation owed to related parties, whether in the form of salary, consulting fees, or other direct or indirect compensation paid from the proceeds of the offering.
If the offering memorandum is for a mortgage pool fund, the document will contain additional sections describing the fund’s lending standards, distribution and reinvestment policy, and loan portfolio.
Lending Standards. Key disclosures in this section include the fund’s lien priorities, loan-to-value ratio, types of loans and the terms of loans in the portfolio. Most risk-adverse investors prefer funds that hold first lien positions. First liens are the most senior claims on the collateral property and must be satisfied before all other lien holders.
The loan-to-value ratio calculates the loan amount as a percentage of the property’s value. In general, lower loan-to-value ratios are less risky since a larger cushion is created to protect investors from potential losses. For example, a 60% loan-to-value ratio creates a 40% cushion to cover potential losses associated with a borrower default and forced sale. An 80% loan-to-value ratio provides just a 20% cushion, which may not be enough to cover principal and expenses if the property is foreclosed and auctioned.
The types of loans and their terms also impact the risk of the fund. Among the three major property types (residential, commercial and undeveloped), residential is often considered the least risky. Shorter loan terms (i.e. one to five years) are preferred by conservative investors since short durations minimize the fund’s exposure to interest rate risk.
Distributions and Reinvestment. This section spells out how frequently dividends are paid (monthly, quarterly, etc.) and whether automatic reinvestment for the purchase of additional shares is an option. Investors should read this section carefully for disclosure whether fund income covers distributions or if payments may be made from the proceeds from share sales or borrowings. The latter may be a red flag that the fund is eroding investor capital.
Fund Performance. The fund’s geographic focus, mix of loans, and collections experience are discussed in the performance section. Mortgage pool funds may have a national or regional focus. Many smaller funds concentrate their lending activity within a specific region since this enables them to become experts on that market and build strong relationships with the local borrowers. If a fund has a regional focus, prospective investors should verify that the portfolio is well-diversified across many sub-markets.
A portfolio that has many small loans is usually better diversified and less risky than one with a few large loans. Investors should also evaluate the fund’s collections experience by looking at the percentage of past due loans in the portfolio. The percentage should be negligible. Another item to check is whether loan origination and servicing is done in-house or outsourced to a third party. In-house management is usually more cost-efficient.
In the management discussion, prospective investors should verify that the fund’s managers have many years in the industry and relevant experience. The management team should have backgrounds in both real estate and banking and relevant licensing from the state’s Department of Real Estate and the Nationwide Mortgage Licensing System.