What to look for when considering investment in a mortgage loan fund

A mortgage loan fund is an investment vehicle that pools investor money to lend to borrowers in exchange for registered first mortgages over improved or unimproved property as the primary security. In return for their investment, investors receive a regular income called a ‘distribution’ which is generally derived from the interest paid by borrowers.

The mortgage loan fund sector is showing growth of nearly 200% on the previous year as many Australians seek income and yield from an investment that isn’t directly correlated to the share market.

Prominent property market commentator, SQM Research, has attributed the popularity of mortgage funds to the restrictions on bank lending enforced by the Australian Prudential Regulation Authority and the continued demand for loans. As such, non-bank lenders are picking up the slack and with a solid portfolio of loans and quality management, investors are benefiting from consistent returns and a steady source of income.

To help you get to know more about this style of investment, its features, and its role in building a diversified portfolio, we’ve compiled a list of key things for you to look for when considering an investment in a mortgage loan fund with your Financial Adviser.

Pooled or contributory mortgage loan fund

There are two types of mortgage loan funds; pooled and contributory.

In a pooled fund, your money is pooled with that of other investors to finance a portfolio or ‘pool’ of loans.  You do not hold an ownership right in respect of any particular loan, just a right to the number of units that you subscribe for. Together with all investors, you share in the income generated by the entire pool of loans proportionately to the number of units you each hold. The risks associated with the individual loans are diversified across the portfolio and are all outlined in the fund’s product disclosure statement (PDS). You may redeem your investment subject to the terms and conditions outlined in the PDS.

In a contributory fund, you decide which loan to invest in after reviewing the specific features, benefits, and risks associated with that loan. Your money is then joined with other investors to lend to the borrower. Distribution returns and the term of your investment then reflect the nature of the loan selected. Each available loan will generate it’s own return different and as such it’s important to note that this style of mortgage fund carries a higher risk because investments are concentrated in one mortgage loan.

Types of loans

Generally, a mortgage loan fund is exposed to the risks related to lending money and the types of underlying assets and projects to which the loan relates.  Importantly, some mortgage loan funds lend money in respect of development activities, with security interests over properties at various stages of property construction and development, or land subdivision projects.  These may include residential, industrial, retail and commercial property which vary in their stage in the property market cycle.

It is important that such projects are managed by experienced developers and that you understand the additional risks of exposure to such activities. The PDS for the mortgage loan fund will set out the types of loans to be funded. It will set out details of the fund manager’s approach to valuations on the security properties (see further below). It will also state the manager’s policy on seeking first or second mortgages. Whilst a first and second mortgage may use the same real property asset as security, the first mortgage has priority over the second mortgage should the borrower default on their repayments.

Loan-to-Valuation Ratio

Loan-to-Valuation Ratio (LVR) is a term used to describe a lending risk assessment examined before providing approval for a mortgage. The LVR is calculated as a percentage of the loan amount compared to the appraised value of the property. A mortgage with a high LVR is associated with a higher risk.

An LVR can be calculated two ways. For development and construction loans, the LVR represents the maximum loan amount as a percentage of the “as if complete” valuation. The LVR for completed properties (or at the point prior to any development or construction work) represents the maximum loan amount as a percentage of the “as is” valuation of the security property.

A mortgage loan fund will generally be operated in accordance with specific criteria providing strict limits for LVRs to assist with risk management in the portfolio. Understanding these criteria and the current weighted LVR of the entire mortgage loan portfolio should help to make an informed decision about investing.

Before deciding to invest, it’s important to read the PDS and any updates on the portfolio (such as the RG-45 updates) to find out the LVR limits. You should also research the average LVR of the mortgage loan portfolio to ensure you’re comfortable with the associated risks.

Geographic diversification

As a property investor, no doubt you’re aware that the status of the property market in Australia differs between states, sometimes even regional territories. The markets in Sydney and Melbourne differ significantly to that of Brisbane or Perth and depending on their position on the property clock, some states may find themselves in a slump whilst others a boom. Furthermore, some states may even have micro-markets operating at different ends of the clock. A mortgage loan fund with an appropriate level of geographic diversification spreads this risk across various property markets reducing the risk of one market not performing and therefore insulating investors against any diluted returns.

Investment manager and executive experience

A strong investment manager underpins the success of any investment, in any class. The decisions an investment manager makes impact how your money is used to generate returns. Traits you may look for in an investment manager may include:

  • Experience: an investment manager’s experience in their market means they should have developed an in-depth understanding of how it works, so they’re well placed to make calculated investment decisions in the best interests of their investors.
  • Discipline: an investment manager’s ability to adhere to their investment mandate, criteria, and representations to investors means that investors benefit from transparency and strong emotional control when making investment decisions.
  • Risk management: there are inherent risks with any investment. The investment manager’s ability to identify risks and effectively manage their impact on returns provides added security for investors.
  • Staff retention: low staff turnover means that there is more time spent on managing investment than recruitment and team training.

Distribution yield

“Distribution yield” is the income paid to you and is derived from the interest payable on the mortgage loans made by the fund. The distribution yield is generally expressed as an annualised percentage and paid either monthly, quarterly, half-yearly, or annually. It’s important to consider this payment frequency with respect to your need for investment income. Many trusts offer two options for payment of distributions. You may either nominate to have distributions paid to your financial institution account or reinvested into the mortgage fund so you are able to harness the benefits similar to those of compound interest.

Redemption terms and conditions

A mortgage loan fund is generally an illiquid investment, meaning that, unlike a cash-style investment, you’re unable to redeem your investment and get instant access to your money. This is due to funds being lent out to borrowers and the fund manager’s processes for managing liquidity and protecting the integrity of returns paid to investors. It’s important to understand the redemption terms and conditions outlined within the mortgage fund’s PDS and consider, with professional financial advice, your budget and need for access to your money before making an investment decision.

The value of advice

Before making an investment decision, it’s always helpful to seek professional advice from a licensed Financial Adviser. All investments involve risk and an Adviser can take a holistic view of your current circumstances and help bridge the gap between where you are now, and where you want to be. This involves the development of a strategic financial plan supported by a diversified portfolio of investments and other financial products which are recommended in your best interests.

If you’re considering an investment in a mortgage fund and you’d like to find out more, speak to Trilogy, an experienced fund manager with a high performing pooled mortgage fund offering or your Financial Adviser.

This article has been prepared by Trilogy Funds Management Limited (Trilogy) ABN 59 080 383 679 AFSL 261425 and provides general advice only that does not consider your objectives, financial situation or needs. You should consider whether the advice is suitable for you and your personal circumstances and we recommend that you seek personal financial product advice on your objectives, financial situation or needs and obtain and read the relevant product disclosure statement before making any investment decision.