How to explore the world of mortgage funds

This article was written by Duncan Hughes, Australian Financial Review reporter, originally published by the Australian Financial Review on November 28, 2020. It is reproduced here in full without amendment. 

Yield-starved investors are being offered appetising returns from funds investing in residential and commercial debt. But they need to check the track record of the manager and beware of the risks.

Investors seeking to diversify their portfolios and boost income can earn around 6 per cent to 8 per cent on residential mortgage trust portfolios and up to 15 per cent on commercial property, but need to beware of the risks.

Advertisements offering the products and returns are proliferating, particularly targeting self-funded retirees, as fixed-term bank account returns and dividend payments continue to slide.

ASIC, the nation’s securities watchdog, recently reviewed some of the funds and found several were making misleading and deceptive claims about the security of assets, returns and liquidity.

The mortgage income fund sector has been trying to rebuild investor confidence following the 2008-09 global financial crisis when a liquidity squeeze and loss of confidence resulted in heavy losses as asset values collapsed or funds were frozen.

But Louis Christopher, managing director of SQM Research, which monitors property markets, says most mortgage fund managers have handled the COVID-19 crisis well.

SQM analysis shows residential housing loan funds are generating around 3 to 6 per cent and commercial funds anywhere from 8 to 15 per cent.

“Lessons have been learnt,” says Christopher. “Systems of management, loan monitoring and debt collection have all improved.”

The next big test for the market will be early 2021 when the proposed scaling back of the government’s JobKeeper wage subsidy is expected to lift vacancies and lower demand and returns for commercial and residential properties.

At present, risk is being offset by massive stimulus from federal and state governments for housing and major construction projects, record low interest rates, and strong demand from first-home buyers and downsizers.

Highly Speculative

Mortgages, unless they are securitised, are illiquid assets with varying terms of maturity and credit risk.

“If fund managers are offering daily or weekly redemptions, investors must take into consideration that mortgage funds are not a liquid asset class,” according to an ASIC spokesperson.

“The higher the return, the higher the risk,” he adds. “There is a possibility investors may lose their capital.”

Investors considering property mortgages can choose between contributory mortgages and pooled mortgage funds ranging from residential to highly speculative property developments.

Contributory funds enable investors to acquire an interest in the mortgages of a developer building anything from townhouses and apartments to small buildings.

Developers pay higher rates to the funds because risk-averse traditional lenders are often reluctant, require large deposits, or undertake exhaustive financial checks.

Some fund managers provide a list of projects which the investor can match to their appetite for return and risk.

Alternatively, investors can choose a pooled mortgage fund where the underlying properties, which can include a mix of residential, commercial and industrial, are managed by a fund manager.

Top performing funds include Trilogy Monthly Income Trust returning 6.56 per cent, LaTrobe Australian Credit Fund (pooled mortgages option) 4.8 per cent and EQT Wholesale Mortgage Income Fund, around 3.8 per cent, according to SQM Research.

Annual management fees for the funds are 0.96 per cent, 1.56 per cent and 0.81 per cent respectively. Other funds in the top five performers charge more than 2 per cent.

Philip Ryan, Trilogy’s managing director, says his pooled fund has a portfolio of about 80 projects located in south-east Queensland, NSW and Victoria with mortgages ranging from $3 million to $25 million.

Ryan says net investor returns have varied little in the past 13 years – despite cash rates having fallen from 3 per cent – because builders are willing to pay higher rates to complete their projects.

Financial adviser Cody Harmon, a partner of Hard Line Wealth, says he prefers funds targeting a larger weighting towards high-quality pooled residential property.

“Commercial and offices will be under future yield pressure as more employees choose to work from home, reducing capacity utilisation and demand for lease renewal as existing spaces will be used more efficiently,” Harmon says.

The funds are suitable for a portion of fixed interest allocation, which typically constitute around 35 to 40 per cent of a balanced portfolio, adds Tracey Sofra, a partner at Sofcorp Wealth.

Omar Khan, executive director of Freehold Investment Management, whose Debt Income Fund is targeting an annual return of 7-8 per cent, adds investors need a manager to assess financial, capital, management and construction risks. “This is where most of the risk sits for investors,” Khan says.

Australian Unity’s Select Income is a contributory fund that allows investors to choose a mix of projects that best suit their investment goals and risk profile. Investments are typically geared to a maximum of 70 per cent. Returns have been in the range of 7.5 per cent to 8 per cent.

Roy Prassad, general manager at Australian Unity’s Select Income, says investors need to “look under the hood” to find out what is driving the returns.

Key issues include: Manager criteria for lending money and assessment of borrower’s capacity to repay the loan; loan to value ratio; how can funds be drawn down and dates of completion; how and when is the property valued; when are distributions made and capital returned?