9% .. 11% .. 14% .. guaranteed .. or not ? The risks of mortgage investment !

[Thomas Beyer]

Lately,
probably because of the RRSP season that is upon us, we've seen firms
advertise high interest rates again .. using such terms as "guaranteed",
"mortgage backed", "secured by real estate" or "preferred rate of
return" or similar misleading words.










We
do understand the desire for monthly income, especially by older folks
or retirees ! The financial industry is full of clever
marketing people with little or no real world investing experience ..
catering especially to the uneducated and the retired income seekers.










An
annual return in excessive of perhaps 5 or 6% has RISKS ATTACHED. Most
normal businesses in the western world canNOT sustain, over a long period of
time, 6%+ fixed distributions without exposing you to undue risk !










Many
real estate firms or other investment syndicators have gone bankrupt or into foreclosure during the recession of 2008/2009. Just because the
recession is over doesn't mean a 12% annual return, paid monthly, is
very doable. It is only achievable under some very select scenarios - but with
very high risk.










One
such risky investment class is construction, especially in commercial
construction, resort locations, rural areas or in tropical locations.
Another one is land development. A third is second mortgages on unusual or poorly performing assets. If you are the lender and the project
does not sell as planned your capital is at risk especially if your
"mortgage backed" or "real estate secured" loan is in 2nd position
behind an expensive construction mortgage in 1st position- or on a hard to sell or semi-finished project. This lender
is in priority to you and may take the asset away, through a foreclosure
process, and you lose all your principal.













Therefore, understand the nature of the business, the experience &
proven track record of the operator and the position your investment is
in - don't look only at the glossy marketing material. Promises and
fancy charts and brochures are easily created, but delivering results in
the real world is very hard!

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Also,
have a look at their existing balance sheet. If you see other mortgages
with interest rates that are higher than perhaps 5 or 6%, BEWARE.
Commercial mortgage terms today are around 5-6% .. lower for apartment
buildings or residential houses/condos, around 4%. Therefore, if you invest with someone that has 8%
or 10%+ mortgages on their balance sheet, ask WHY IS THAT .. and the
answer should be (but usually is not): "because our business is very
risky and no commercial lender would give us reasonable terms !!
Therefore we are looking for suckers such as you to be fooled by a 12%
interest rate, paid monthly". Best to walk away from such an investment !










Keep in mind that in a 3 year construction project, the "interest" paid to you on a monthly basis is just a return of capital, from your own money
.. or from new investments. A modified Ponzi scheme really ! The income
in these projects comes from selling land parcels or condos .. years
down the road.









Therefore,
always, always consider return OF capital before you consider return ON
your capital when evaluating any investment option !










Consider
that you have a capped upside, but can still lose all of your invested
principal if the project is not selling as fast as planned or for the
prices targeted.









Consider the risk adjusted return,
please .. not just the promised return. A bit like gambling in Las
Vegas, you can double your money in a few minutes placing it on "red" on
the roulette table, but on average, you'll lose. The risk adjusted
return is negative, despite the ad "double your money with us" !





If
you invest in a JV [with a REIN member] or a real estate equity syndication firm you are the owner of the
underlying real estate, benefiting from all the equity and gains being
created through mortgage paydown and value upside.

 

[housingrental]

Good post Thomas

Except for the promotion of JV's and syndicates etc.. Perhaps you could edit?

 

[Thomas Beyer]

hey many REIN members do JVs where the investor gets X% (usually 50%) of equity .. and there it has to be mentioned in contrast to a mortgage where investor gets X% !

 

[housingrental]

Fair enough

 

[johnsu]

Hi Thomas,



I really appreciate your post on this. The words "Guaranteed" usually come from rookie investors or rookie sales people who "imply" the Guarantee. Seasoned investors know that only GIC's are guranteed and no other person can use that term "Legally"



The tricky part of what you're stating is "Understand how the Asset is financed" When people understand that they better understand the risks.



Personally rather than a MIC, I'd rather just do private 2nd's and eat all the fees myself and have WAAAAY more control over the asset and investment!

 

[Thomas Beyer]

[quote user=johnsu]Personally rather than a MIC, I'd rather just do private 2nd's and eat all the fees myself and have WAAAAY more control over the asset and investment!




That may work for you .. or in some selected low loan-to-value scenarios, but I still think this potential interest on the money lent doesn't compensate for the real potential of loss of capital !



If you lend money in 2nd position, by the time you get a letter from a law firm that the project is in foreclosure YOU have to be willing AND ABLE to



a) judge if the first plus 2nd plus interest owing plus sales expenses plus upgrades is below the true property value, i.e. be able to judge if there is any equity left, and if so,

b) take over the 1st mortgage and

c) pay its usually sizable arrears and

d) pay legal fees and

e) operate the property for some time until sold and

f) pay its operating expenses incl. first mortgage interest and possibly

g) pay for the required upgrades so the property is actually sellable



Thus: lending money in second position with an attempt to get 12 to perhaps 15% interest IS VERY HIGH RISK and should only be done after thorough understanding of the true asset value (and not the appraised one) and your ability and desire to do steps a) to g) for perhaps 2 years !!



To wit: I invested in a firm called Liberty Mortgages (not to be confused with Libertygate formerly operated by Dedric Robinson, now bankrupt). I invested $50,000 in 2008 and the first and 2nd were to not exceed 65% of appraised value, secured by three properties in Kelowna. The 2nd mortgage is now OVER ONE YEAR in arrears, the accumulated interest plus 2nd mortgage now exceeds the property value as a sale, now 35% below 2008 appraised price, still hasn't happened !



Hence: always consider return OF your capital first .. then a return ON your capital !! It is the former that is the real issue in 2nd mortgages .. not the latter !!

 

[RandyDalton]

Hi Thomas,



Love that phrase, return of your money. If only we could put some number to it. Say 90% ROfI means there is a 90% chance you will get all your money back. Associated with this is a 7% ROI. Certainly would allow us to make much more educated decisions on our investments.



What would you say the stock market ROfI is? I just looked at my RRSP for end of year 2010 and I am still down. Guess that would put stocks at 0% ROfI hugh?



Regards...Randy D.

 

[RedlineBrett]

When you invest in high interest seconds you are really investing in the person ultimately borrowing the funds. You might be in a MIC but the risks are the same just spread over a wider range of borrowers.



Ask yourself this - Who needs to borrow at 10%+? Would you cut them a six figure cheque directly and skip the institution? Might as well because that's what you're exposing yourself to.



Contrast this against a professional firm betting on sound fundamentals and the risk/return profile is much more attractive. They likely won't dangle 10%+ in front of you but the downside risk is certainly lower and there's actually upside potential unlike fixed return offerings.

 

[bizaro86]

[quote user=RandyDalton]What would you say the stock market ROfI is? I just looked at my RRSP for end of year 2010 and I am still down. Guess that would put stocks at 0% ROfI hugh?




The stock market is a lot like real estate, in that it takes time, education and competent management to make money. So the RofI would depend on the person doing the investing, not just the investment itself, just like real estate. If you believe it to be 0%, its obviously not the investment class for you, but that doesn't mean its an exclusively bad idea.



Regards,



Michael

 

[Rickson9]

[quote user=bizaro86]The stock market is a lot like real estate, in that it takes time, education and competent management to make money. So the RofI would depend on the person doing the investing, not just the investment itself, just like real estate. If you believe it to be 0%, its obviously not the investment class for you, but that doesn't mean its an exclusively bad idea.





This is an excellent point. If an investor's long-term return in a particular asset class is 0%, it is fair to assume that the investor has little or no competency investing in that asset class.



Best regards.

 

[bizaro86]

[quote user=Rickson9]This is an excellent point. If an investor's long-term return in a particular asset class is 0%, it is fair to assume that the investor has little or no competency investing in that asset class.



Best regards.


Exactly. It is entirely possible that a person may be ill-suited to an asset class. For example, I don't trade commodities. That isn't to say commodities are a bad investment, but they're ill-suited to my temperment and skill set, even if I could predict when oil will switch between contango and backwardation. I do invest in shares of individual companies (as opposed to the stock market) and individual real estate properties, because they suit my prediliction for analyzing financial statements. I find it hard to invest in anything that doesn't have a financial statement (gold, orange juice, the stock market as a whole, etc) so I don't.



Regards,



Michael