Mortgaging Your Future: The Ins And Outs Of Mortgage Investment Funds

Over the last two years, the economic landscape has undergone a seismic shift. Interest rates and inflation have both spiralled to levels not seen in decades—the last time Bank of Canada (BoC) interest rates reached current levels was prior to the 9/11 bombings. And, although inflation has dipped from its peak, we have still been dealing with levels of inflation not seen since I was in high school, a period long since vanished into the mists of time. 

These enormous changes, coupled with recent stock market declines and concerns over further market retreats, have left many investors befuddled and bewildered, particularly those looking for fixed-income returns that actually do better than inflation after paying off the tax man. Although Guaranteed Investment Certificates (GIC) rates have also risen to the occasion when both inflation and tax are factored into the equation, their buying power is, at best, treading water and, at worst, submerged by the waves. Consequently, many investors are clamouring for higher-yielding investments that don’t make them feel like they are plunking their money down at a craps table, hoping not to roll snake eyes.

I’ve recently written on a type of structured bank note with significantly higher yields than GICs with some downside protection but want to talk about another option: Mortgage Income Funds (MICs). I’ll outline what they are, how they work, and key factors to consider so that you can decide whether they are worthy of a special place in your life—inside your retirement portfolio. Thanks to Russ Mortgage, mortgage broker extraordinaire, and both Thomas Tsiaras and Wail Wong, portfolio managers at Aligned Capital, who regularly incorporate MICs in their client portfolios, for their valuable input.

The Basics

A. Background and Basic Features

MICs are investment funds that were created by the Federal government in 1973. They hold a pool of mortgages and are required by law to pay out their yearly after-tax earnings to their investors. In return, the government doesn’t make MICs pay tax directly. This means more money for investors, unlike most other types of investments, where companies must pay taxes on their earnings and can only distribute whatever is left (although the dividend tax credit on eligible dividends can admittedly ease the pain in non-registered accounts.)

On the other hand, even though MICs may describe their distributions as “dividends,” they are taxed as interest or income by our friends at the Canada Revenue Agency (CRA). As a result, MICs are not tax efficient and are often better owned inside registered accounts like Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs).

MICs play a surprisingly large role in the lending business. One recent article suggests that there are between $13 and $14 billion invested in MICs in Canada and that they account for about one per cent of the mortgage market. Another slightly older article suggests that there were over 200 MICs in Canada as of 2018. In other words, there are more MICs in Canada, and they are collectively worth far more, than most of us realize.

As you might expect, all MICs are not created equal. Each has its own investment mandate and strategy. Some may lend across Canada, while others focus on distinct geographical areas like the Lower Mainland of BC or Greater Toronto. Some only lend against residential properties, while others lend to commercial developers. Perhaps most importantly, some seek higher returns by issuing second or third mortgages, while others focus primarily on first mortgages. Different MICs also have different loan-to-equity rules; more conservative MICS may lend $0.65 or less per dollar of collateral, while other MICs may be willing to lend as much as $0.85 per dollar and, as a result, pay higher distributions. Yet another recent article ranged expected returns across the MIC universe this year between six and twelve per cent.

Finally, there is one more significant distinction between MICs: some trade on the stock market and are subject to fluctuations in value like a stock, Exchange-Traded Fund (ETF) or mutual fund, while private MICs generally maintain a fixed value of $10 per unit, so that investors’ total returns will be limited to interest earned with no chance of capital gains. Also important to know, private MICs are not nearly as liquid as public offerings and don’t have the same reporting requirements. On the other hand, private MIC investors are willing to accept no chance of capital gains, plus the reporting and liquidity issues in exchange for removing the whims of the stock market on the day he or she decides to cash in. As in so many areas of life, there are pros and cons to any decision.

In summary, all MICs are not created equal, and each of us needs to carefully investigate the different alternatives before deciding whether or not to invest and, if so, which MIC or which basket of MICs offers you the best mix of safety, returns and quality sleep.

B. The Business of Private Lending

As you’d expect, people usually turn to alternative lenders when they can’t qualify for a traditional bank mortgage, or the banks won’t give them as much as they want. Although poor credit history is always a reason why some people bail on the banks, it isn’t the only one. Here are a few other types of typical MIC borrowers:

• Recent Immigrants: Recent immigrants may not have been in Canada long enough to establish a sufficient credit history to fit within the bank’s lending box and may need to work with an alternative lender until they have been here long enough to build up the necessary track record.
• The Self-Employed and Commissioned Salespersons: The self-employed are generally seen as a big risk, particularly if they have unstable earnings. Likewise, commissioned salespeople are often viewed through a similar lens. Moreover, regardless of how much money someone with a private company may be banking up in a holding company, the banks focus on personal income, ignoring additional corporate earnings that could have been paid out but were not, generally for tax reasons. In some cases, these clients may simply need to bump up their own salaries, work with a MIC in the short term and then circle back to the banks in a year or so. In fact, the big banks are the ones that refer clients to alternative lenders in the expectation that the clients will return to the banking fold in the not-so-distant future.
• Quicker Approval: In some cases, property developers may choose to work with private lenders, particularly for shorter-term loans, because it is easier and faster.

C. The Mortgage Stress Test and Its Impact

The stress test was introduced in 2018 and has resulted in many potential borrowers previously on the side of the banking angels no longer qualifying for a traditional mortgage despite solid credit scores. As alternative lenders, such as MICs, aren’t bound by the stress test, they can adopt their own flexible lending policies and fill the gap when the banks say no. Ultimately, this increases both the size and quality of the pool of borrowers MICs can choose from. On the other hand, many MICs have been growing like gangbusters since 2020, which might erode some of this benefit.

For those of you who are normal people (i.e. aren’t up to speed on all things stress test), the basic rules are as follows. Borrowers working with the banks must be able to qualify for a mortgage at whatever rate is higher: 5.25 % (this rate is reviewed yearly) or two per cent more than what their bank is offering them without using:

• More than 39% of their pre-tax income to cover the mortgage and other housing costs, like utilities and property taxes, and
• More than 44% of their pre-tax income to pay toward all personal debts, including the mortgage.

To put how much interest rates have climbed into perspective, the 5.25% is so out of date (borrowers must be able to sustain mortgages between eight and nine per cent as of early December 2023) that most people successfully applying for a mortgage will be paying actual interest that is higher than preset stress test rate. The rate surge that the 5.25% minimum rate was designed to insulate has now arrived in full force and now seems to have stalled. Accordingly, the stress test has saved many borrowers from a world of hurt or will at least reduce their pain when it is time for them to renew over the next few years by capping how much they were able to borrow when the getting was good. On the other hand, if you believe that we are primed for interest rates to finally start falling or at least not to grow by another two per cent over the next five years, then you may feel that the stress test is now getting in the way people and banks’ ability to think for themselves. That’s where MICs play a role.

Factors To Consider When Comparing MICs

Although I’ve already discussed some of the key differences between various MICs in passing, here is a more detailed summary:

• Type of Mortgages: 

Different MICs lend against different types of real estate. Some may lend to developers or other investors, while others restrict their loans to homeowners. I personally prefer residential mortgage MICs in the belief that homeowners will move heaven and earth to protect the place where they and their family sleep at night versus a corporate developer who is protected from personal liability if things go wrong.

• Geographic Considerations: 

Some MICs focus on Canadian real estate, while others will also lend outside of the country. Moreover, within Canada, some MICs target specific areas, such as BC’s Lower Mainland or Toronto, while others sprinkle their loans further afield. There are different benefits and risks to each approach. For example, a MIC focusing on a specific geographic area may be able to understand that market better than a MIC with greater geographic diversity and may be able to build up better connections and quality of borrowers than a MIC without a homecourt advantage. On the other hand, as all of us investors know, diversification has its own advantages.

• Downside Protection/Loan to Value Ratio: 

How much does the MIC lend per dollar of equity in the property? And how much extra does a higher-paying MIC generate for taking on this additional risk? I generally restrict myself to MICs who lend no more than approximately 75% of a property’s equity, but to each their own.

• Priority of Mortgages: 

Some MICs (often called “Prime Mortgage Funds”) only issue first mortgages, while others may blend in some second and third mortgages. It’s important to determine the mix (see what I did there) of different mortgages in each MIC and how much fits into each category. Also, how much (or how little) yield do you give up by investing in a fund that only provides first mortgages?

• Average Loan Size and Number of Mortgages: 

I believe that the greater the total number of mortgages and the smaller the size of the average mortgage, the better the protection.

• Average Value of Borrowersí Property: 

I prefer MICs that focus on starter homes, as I see them as more resistant to market drops than swanky luxury pads. As the value of a starter home in Halifax is a fraction of Toronto’s or Vancouver's values, it’s also a question of knowing what a starter home costs in that MIC’s target area so you can determine if the MIC is focusing on entry-level residences or palatial estates.

• Leveraging: 

Some MICs boost returns by borrowing from banks or other lenders at one rate and then lending the money out to borrowers at higher rates. The bank or other financial institution working with the MIC will have done its own due diligence before agreeing to this arrangement and will continue to monitor things closely, but you will need to decide for yourself whether you’re okay with this. I also suggest determining how much a fund is currently leveraged and the maximum amount it can borrow.

• Liquidity Restrictions: 

Private MICs usually have a minimum holding period and only offer redemptions monthly or quarterly, which means waiting another month or two at least from when you want your money back. If a minimum holding period applies, determine the penalty for cashing in your chips early in case your plans change. Private MICs, like other exempt market investments, can also “gate” or restrict redemptions in exceptional circumstances, such as if too many people want to redeem at once. This is potentially one of the biggest disadvantages of private MICs.

On the other hand, it’s also important to keep things in perspective. Although public MICs can’t gate redemptions, if there is a run on a public MIC, expect to sell at a significant discount. A private MIC that gates redemptions may ultimately allow cooler heads to prevail so that investors ultimately do better in the long run. In any event, doing your homework prior to investing can go a long way toward avoiding things going wrong later.

• Term to Maturity: 

The shorter the duration of a MIC’s portfolio of loans, the less time for things to go wrong and less time for the value of real estate to decline enough for my equity to be at risk if it does. Many MICs focus on one- to two-year loans loans, although the average duration of loans may be even less than a year.

• Public vs. Private: 

The typical pros and cons of public versus exempt market investments apply to the MIC world like they do public or private Real Estate Investment Trusts (REITs). As I’ve mentioned the key issues earlier in this article, I won’t rehash them now. For those of you who have never purchased an exempt market investment, however, you will ultimately need to sign the standard acknowledgement that states that you know you could lose all your money, regardless of its track record and downside protection. Strangely enough, there is no such requirement when purchasing a penny stock on the TSX.

• Track Record, Management Team, etc: 

Like any investment, you’ll want to look at how long they have been in business, who is calling the shots, the company size, the continuity of their management team, and whether they have missed any payments and whether they have ever gated redemptions.

• Deal Flow and Growth: 

I like to know where a fund gets most of its clients and how quickly a MIC has grown. I also want assurances from MICs that have grown quickly that they aren’t scrapping the bottom of the borrower barrel simply to deploy funds. It’s actually a good sign to me if a fund refuses to accept new money from time to time if they don’t feel they can deploy it prudently, as this shows a responsible management team.

• Average Credit Rating: 

Although this won’t tell the full story, it’s useful to know the average borrower’s credit rating and how this has changed over the life of the fund, particularly over the last few years if a MIC has been growing on steroids.

• Default Rate and Loan Loss Provisions: 

How many mortgages are in default or trending in that direction, what is the fund’s typical default rate and what sort of default assumptions are baked into their projections when calculating their yearly distributions? A portfolio manager friend of mine has a personal favourite that has never had a single mortgage default in its 14 years of existence, although that doesn’t mean they shouldn’t continue to plan for the worst. A healthy MIC will have a low default rate well below the rate used for its forecasting. As different provinces and states have different foreclosure rules and timelines, knowing how things work in MIC’s prowling grounds can give you an idea of how long it will take to convert real estate into hard cash so the money can be reinvested.

• Minimum Purchase and Qualification Criteria:

 For private MICs, some require at least a $5,000 initial purchase, while others may require significantly more. There are also restrictions on qualified investors based largely on their income and/or net worth. Moreover, not all MICs have the same minimum investment limits. In some cases, investors may need a sizable income or over $1 million in investable assets, while others may be accessible for those with a lower income and over $400,000 in investable assets. Once more, although anyone can buy a penny stock and invest as much as their heart desires, not everyone is eligible to invest in a private MIC or allowed to invest as much as they would like.

• Information Flow: 

For private MICs, determine how often they will provide you with information updates and what sort of information you might receive. Some provide monthly newsletters.

• Variable or Fixed: 

MICs that only issue variable mortgages have been able to raise distributions in lockstep with an increase in the BoC’s lending rate, which is also a great inflation hedge. One of my MICs with variable-only mortgages literally increased distributions within an hour of the BoC rate decisions on many occasions. Those with fixed rates aren’t as nimble but will likely be able to sustain rates for longer once the Bank of Canada changes direction. Accordingly, a fixed-rate portfolio with a longer average loan duration might sustain higher rates if interest rates decline, assuming their borrowers meet their commitments.

• Fees: 

Although distributions from MICs are net of fees, and I have no problem with good people getting well compensated, I still want to know what I’m paying. Moreover, sometimes, the management fee doesn’t tell the whole story, as MICs also typically charge borrowers a loan origination fee. Some MICs pocket this themselves in addition to their ongoing percentage management fees, while others share the revenue. Accordingly, sometimes it takes a little extra digging to know the total compensation you;'re paying.

• CHMC Insurance: 

Most MICs do not have their mortgages insured with the Canadian Mortgage and Housing Corporation (CMHC).

• Timing of Payments: 

If you are looking for or need monthly cash flow, then funds with monthly distributions are likely the ones for you. If this isn’t as vital, there are other funds that pay less frequently, such as quarterly.

Conclusion

Although MICs have been around almost as long as we’ve been taxing capital gains, many investors have never heard of this investment product, let alone added it to their investment portfolio. Like all categories of investments, there are the good, bad and the ugly. If you’re looking for a higher-yielding investment and are looking for alternatives to traditional options such as bonds and GICs, MICs might be worth a second look. And, if that second glance turns into a desire to invest, please be sure to ask the tough questions so that you ultimately end up with the MIC (or the basket of MICs) of your dreams.

Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.