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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2013

Finding Opportunities in Private Mortgage Funds

Help clients uncover the pros and cons of investing in private mortgages

Commercial mortgage brokers often work with a variety of clients with different needs and requirements, many of whom are savvy investors in the real estate arena. Although most frequently called upon to arrange financing for specific deals, brokers who understand and respond adequately to clients’ individual situations and investment aspirations can be invaluable to clients seeking guidance that goes beyond the typical loan-arrangement scope.

For example, based on the net worth and sophistication of your client, an alternative asset — such as an investment in a private first-mortgage loan or a direct investment into a mortgage fund — can be a good diversification strategy. This may be especially true of a real estate investor who is, or was, invested heavily in real estate and now is looking for a way to earn investment income backed by real estate more passively. This decision can be a result of a change in lifestyle, retirement, diversification goals, etc.

Commercial mortgage brokers, often seen as clients’ trusted advisers, have earned the rapport and trust of clients in real estate matters. With that trust, they are in a position to educate and introduce clients to this type of alternative investment. They should be aware of how private mortgage loans work, as well as their pros and cons, before introducing clients to the opportunity they represent.

Basics

A private mortgage loan is a first-lien position mortgage on commercial or residential investment properties, including: apartments, mixed-use office space, warehouse space and one-to-four-unit investment properties. These mortgage loans don’t cover owner-  occupied homes or consumer-type loans, which are subject to different mortgage regulations. Private mortgage loans solely are intended for commercial or business purposes.

In addition, private mortgage loans are a collateralized debt obligation that is also a secured debt. With that, they provide the lender or investor not only with the benefit of regular income in the form of loan payments, but they also have all the security, protections and recourse typically associated with a real estate lien. Because of the shorter-term nature of these loans, they’re not meant to provide appreciation on the capital invested, however. Their purpose is to provide a steady flow of income, which may exceed other fixed-income investments like bonds or annuities.

Pros and cons

The biggest draw of private mortgage loans is the safety they’re perceived to offer compared to publically traded investments sold on open markets. Keep in mind, each of these mortgage loans is based on a tangible real estate asset that serves as collateral to secure the debt. In some states, private mortgage lenders can get legal protections like lender’s title insurance and other remedies to enforce the mortgage lien.

Commercial mortgage brokers should warn their clients of one potential downside to this investment, which is the loss of principal in case of a default. This risk is limited, however, because underwriting criteria typically restrict private mortgage loans to 65 percent of a property’s total value as established by a third-party appraisal. Although it is possible to structure a loan in a way that an investor generates more profit from a loan default than interest paid by the borrower, lenders typically don’t desire defaulting loans.

Yield

Private mortgage funds typically pay investors largely based on the terms of the loans in their portfolios, specifically the origination fee and the interest rate. Many private mortgage loans require at minimum a high single-digit rate. Rates are determined by the following factors:

  • Term or duration of the loan
  • Collateral type
  • Amount of leverage requested on the property, that is, the loan-to-value (LTV) ratio
  • Repayment strategy
  • Value of the personal guarantee, based on the borrower’s net worth
  • Experience level of the borrower
  • Quality of the tenant(s) leasing the property, if leasing will be involved

Typically, rates for private mortgages are fixed for the duration of the loan’s term. If a floating rate is offered, then the lender generally sets the initial rate as the floor — that is lowest rate over the term of the loan. Investors who participate in a professionally managed private mortgage fund can expect to earn mid-to-high single-digit returns.

Types of borrowers

Commercial mortgage brokers should understand why borrowers may be interested in private mortgage loans. Quicker closing times and less stringent requirements are among the top reasons to turn to private lenders — particularly for clients whose deals are time sensitive or face hurdles with conventional lenders.

Borrowers often shop for a lower-rate bank loan to refinance the private mortgage loan once they own the property and are no longer at risk of losing it because of financing delays. Although no one plans to borrow money at high interest rates over the long term, it makes sense in many cases to enter such a mortgage for a one-year or two-year period before refinancing into a low-rate bank loan or reselling the property.

Growing demand

Since the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010, it has imposed stricter regulations and increased oversight on banks’ overall lending practices. The act was intended to ensure that banks make quality loans and not risky loans that could default in large numbers and cause systemic financial stress to the overall economy.

An unintended consequence of this act is that banks have pulled back on making mortgage loans even to well-qualified borrowers. In addition, the act increased regulatory requirements, resulting in longer processing times to evaluate and approve loans.

The added difficulty of taking loans from traditional banks in the past few years has caused many borrowers to turn to private mortgage loans as an alternative source of funding. Even before Dodd-Frank, the demand for private mortgage loans was growing because of the need for faster closing times, which traditional banks often can’t offer.

Management team

As with any investment, investors in private mortgage funds should make sure that the fund management team has the right experience, competence and culture. Sound management particularly plays an important role in this investment because the lending guidelines determine the ultimate risk placed upon the capital.

As long as the fund management is scrupulous about avoiding risky loans, the fund is likely to prosper and provide a good return on investment. In fact, the largest risk for investing in a private mortgage fund is poor loan underwriting and risk assessment of loan opportunities, which can result in a high loan-default rate and the risk of losing the principal.

It is essential for investors to learn how to mitigate the risks associated with fund management. Investors who carefully review the management team before electing to invest in a particular fund can avoid many of the risks associated with private mortgage funds. To do this review, investors should consider the following questions:

  • Is due diligence performed on all loans originated?
  • What is the maximum amount of leverage allowed on a givenproperty?
  • How does the management assess the value of the collateral?
  • Does the management team have a track record of qualityinvestments?
  • What percentage of the fund’s loans has defaulted?

Commercial mortgage brokers also should advise their clients to investigate the kind and number of assets under the fund’s management and its history of compliance with the local regulatory body. These questions will give investors critical insight into how effectively the fund’s management team manages risk and will provide a strong indicator of the fund’s future performance. Because private mortgage funds typically are safe, long-term investments, even risk-tolerant investors are encouraged to avoid funds whose management teams don’t score well on these points.

Borrower default

Default is another major risk involved in private mortgage funds. Even the best fund management teams likely will face a mortgage default at some point. That is why it is important to invest with a fund whose management has solid contingency plans in place to resolve this challenge, should it arise. Your clients only should consider funds that have a thorough understanding of the foreclosure process. Fund managers should be able to demonstrate clearly that they have the resources available to reclaim a property and good legal counsel should litigation become necessary to complete the foreclosure.

Fund managers typically do all they can to avoid a default within their funds, first and foremost by verifying the liquidity of each borrower’s position and the ability to make sustained payments on the loan. This includes estimating longer holding times before the borrower sells or refinances the private loan. Good fund managers also ensure the ability of a borrower to make interest payments, regardless of how much equity is in the property that serves as collateral. Furthermore, a fund’s risk of systemic default can be reduced significantly by diversifying loans among a variety of borrowers, geographic areas, loan terms, property types and purpose of each loan. Equity contained within the property is a primary factor that makes investing in private mortgages appealing because it acts as a buffer to limit downside risk.

Getting started

To get started as investors in private mortgage funds, commercial mortgage brokers can advise their clients to take one of the following three routes:

  1. Investing directly into a professionally managed private mortgage fund: This is the safest option for new investors, because all the responsibilities of underwriting, originating and servicing of private loans, remedying defaults and managing the portfolio are assumed by professional fund managers. The investor’s only concern is to choose the fund that best meets their investment goals.
  2. Purchasing a loan assignment or new loan from a professional mortgage fund: With this option, an investor owns the mortgage lien and collects the monthly payments from the borrower via a loan servicing company. This option is for the more active investor who is willing to take on the responsibility of vetting each new mortgage investment opportunity with due diligence and is prepared to personally remedy a loan default, should one occur.
  3. Underwriting private mortgages on their own: Not to be undertaken lightly, investors who choose this option assume total responsibility for finding and vetting each new private mortgage loan opportunity. They also must perform their own due diligence, including: drafting the underwriting and loan documents; getting and analyzing environmental reports, credit reports and an appraisal; handling title work, insurance and loan servicing; processing payoff and generating a satisfaction of mortgage. Finally, they are responsible for remedying a loan default should one occur.

Because of the specialized, complex and time-consuming demands of underwriting, investors generally prefer to invest in private mortgage funds where professionals perform these functions for them, freeing the investor to enjoy a return on their investments without time and labor commitments.

Investment strategy

Investors who are looking for ways to maximize gains and minimize risk over the long term should adopt a diversified portfolio that combines multiple asset classes that have low or negative correlation. Real estate often is considered one of the best-performing, noncorrelating asset classes an investor can combine with stocks, bonds and commodities. Among real estate investments, private mortgage funds make a viable option for three main reasons:

  1. Private mortgage funds offer a higher security of principal than many real estate investments because fund managers control their exposure to risk through due diligence. They also can hedge against default by holding property as collateral at low leverage and can assure likely profit in the case of a default through comprehensive underwriting that transfers all risk to the borrower.
  2. Private mortgage funds offer high rates of return compared with other real estate investments because they attract borrowers who are willing to pay higher interest rates in return for a more expedient availability of funds than traditional banks can offer.
  3. Private mortgage funds round out a diversified portfolio because they possess low correlation with more traditional asset classes, such as stocks, bonds and commodities. Stock market fluctuations typically have little or no effect on the profitability of these funds. The number of borrowers seeking private mortgage loans in economic downturns may increase as competition for real estate bargains intensifies, which can only be good for investors.

In short, commercial mortgage brokers can help clients decide whether they are interested in diversifying their investment portfolios with private mortgage funds by presenting the advantages and the risks associated with these investments.



 


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