Be The Bank – Investing in Direct Mortgages

With the rise of popularity and mainstream acceptance of alternative investments (in the P2P space), one option that I have not seen thrown around much in the retail investing community is investment in Direct Mortgages (typical return of 5-7% p.a net of fees). This is basically where you are effectively underwriting a loan to a borrower. Simply put, being the banker!

In the sections below, I’m going to talk you through the structures of a Direct Mortgage, things that I looked out for in making investment decisions (tips) and argument versus other alternative investments in a similar space (P2P in consumer lending). But before I start, let’s get the disclaimer out of the way. The information below is general in nature and you should seek professional advice from a qualified financial adviser for your personal financial circumstances. The below are just summary of my understanding/personal interpretation of the asset class (highly subjective/opinionated), but I would highly recommend you to read the PDS in detail before doing anything.

What is Direct Mortgage?

It really is as simple as you being the lender to a borrower. Borrower typically provides property(ies) as collateral or other personal guarantee(s) in the event of a default. You are not directly liaising with the borrower, rather you go through a commercial loan manager like Balmain Private or La Trobe Financial. Their responsibility is to onboard the client (borrower), perform due dilligences, manage credit risks and administration of the investment/loan trusts. In the event a borrower defaults, the manager can try to recoup the amount owed through sale of collateral(s) or other guarantee(s) pledged. Obviously, they would not be doing all of the above for free and they make their dough by taking a decent spread (fees) out of the interests that borrowers pay.

These managers are also called non-bank lenders (you might have seen this term thrown around in the mainstream media) and these type of loans are what bank calls non-prime/subprime mortgages typically originated from low-doc borrowers. Most of the time, your local banks would have probably rejected these guys and they will have to turn to non-bank lenders to get financing, especially after APRA imposed interest-only loan growth restrictions a year or two ago which they have lifted recently (can’t remember exactly when). However, post royal-commission, these borrowers are probably not going to have it much easier either. Now you probably have so many things racing through your minds:

“If the banks wouldn’t want to lend to them, why would I?”

“Aren’t they the type of borrowers that would be having difficulty paying their loans??! Maybe even with debt up to their eye balls”

To appreciate the landscape, subprime mortgages in Australia are typically associated with investor interest-only loans and/or low-doc loans. Low doc loan typically means lending made to people who have no regular jobs and cannot prove their income through traditional measures like providing payslips. This is especially true for contractors, self-employed, freelancers and many others (including if the source of income is from overseas). However, it would be unfair to label all of them as bad quality borrowers. There is merit to the notion that subprime loans are riskier since those people might have actual cash flow issues or income irregularities which could lead to their loan repayments being deliquent or worse. But there are two sides to a coin and on the contrary some of those borrowers are actually successful individuals/business owners who have been put into those category due to box ticking exercise by the banks/lenders and well for lack of better words – “because their risk management system (or computer) said so“.

To make it clear, this is what I would probably classify as a medium-high risk investments (Term deposit being the safest and share/stock being the riskiest in a risk continuum). However, if you understand the risks and have done your due dilligences, these type of opportunities could actually provide you with an attractive risk-adjusted returns especially when compared to the alternative in the P2P scene, which I would talk in more details later on.

Investing in Direct Mortgage

There are various different type of mortgage loans that you need to be aware of (arguably, in order of lower to higher risk), most commonly they can be classified as:

  • Owner-Occupier Loan
  • Investor Loan/Refinancing/Bridging Loan
  • Construction Loan

Personally, I tend to avoid construction loan altogether and would not even venture there given the inherent risks and the number of factors that could go wrong with it. For example, partially completed building is harder to sell in the event of a default. Not only that, problem(s) could quickly escalates for example if the build quality was substandard or it breached the building standards, as I do not think any sane developers would event be willing to buy the development without a deep discount. They tend to provide higher returns, but obviously there is no free lunch. It can be lucrative though if you know what you are doing, but let’s be honest here that I am just a self-directed investor who has a lot of knowledge gaps.

Hence, this just leaves me with owner-occupier loan and investor loan to play around with. The owner-occupier loan is typically extended to those who are self-employed or buyer whose main source of income comes from overseas. While investor loans, typically consisted of people who are buying property to be sub-divided or looking for a bridging loan while waiting for development approvals (any other conditions that need to be satisfied) so that they can then refinance it with other lenders at a much lower rates.

Before discussing about things that I personally look out for when trying to assess a loan and making an investment decision, let me re-emphasise that this investment, despite its fixed-return profile, is riskier than your typical term deposit investment and there is higher risk of losing your capital compared to a term deposit. But, in my humble oppinion, it has its place in a diversified portfolio to improve risk-adjuted return of your portfolio (achieving specific level of return while minimising overall volatility in doing so). In other words, with online savings/term deposit rates being so low now after three rate cuts (!!!) rather than deploying my money in a typical cash instruments, this can be a decent alternative to put those unused cash to work harder.

This option would be particularly attractive/practical to those who are not willing to have their capital value fluctuates as much as if it was invested in the share market, but at the same time getting acceptable average returns closer to equity like return. But do bear in mind, this is not a liqud instrument either as there is always the risk that borrower defaults and it would take some time for the loan manager to unwound the debt before you are getting your money back (partially/in full). For example, if I was thinking of buying a new car in two years time and I am not time sensitive, instead of just putting the money in a term deposit/online savings, I’ll rather invest it in Direct Mortgage to get higher returns and in the worst case scenario, if there is a default event, I would not need the money right then. Well, you get the picture I hope…

Things to Look Out For

Personally, the below are bunch of things that I looked out for before deciding into investing in a loan (highly subjective ofc). Generally, in the world of debt/credit investing you tend to always look out for the worse case scenarios (avenues to recoup capital/interests). As opposed to equity/share investing where you tend to look out for the bright side (e.g. whether this little biotech company could be the next CSL, etc).

Furthermore, each loans are not always a carbon copy of each other, rather with their own characteristics/quirks, but in general the below lists should help you to get started. Without further ado:

  1. Locations – Locations, locations and locations! They are king to me. I would ideally prefer if the security property is located closer to a public transport/public amenities before investing in a loan. As in my oppinion, it would probably attract a better demand if it was to be sold in the event of a default. For example, a property that is 10 minutes walk away from the nearest train station should be more palatable than something that is 25 minutes walk away. Public amenities like shopping complex, schools and public POIs (point of interests) need to be considered as well.
  2. Property/Security Conditions – Take a closer look at the securities or guarantees offered and how they can help you recoup your money. For example, if a loan is enhanced by a building, you need to ask if the buildings are still liveable/rentable or better if there is currently a tenant renting it. If not, take a look at the building condition and potential exit strategies you can have with them.

    Do not forget to make sure collaterals are first registered mortgage. You never want to be second in line! If there is any subordination, I would run the other way faster than Usain Bolt! Although, from what I have seen so far, loans that retail is eligible to invest in have always been first registered mortgage. I am only seeing subordination on products that are offered to wholesale/sophisticated investor. But it pays to keep a lookout for I guess.

    This is probably a bit more controversial, but I am never a big fan of multi-dwellings as collateral, especially apartments given the headwinds they are observing in the past few years (overbuilding, building quality and price/valuation).
  3. Durations – The longer the loan, I would typically demand a higher return and if it is longer than 18 months, I would usually filter them out altogether. There are a lot more things that could go wrong within a longer timespan, so I would be biased towards shorter loan duration. Personal preference is only up to a year and would be hard pressed to look at anything longer unless there is a huge margins of safety.
  4. Valuations – Or what is commonly termed out as ‘LVR’ (Loan to Valuation Ratio). Anything above 75% are automatically out of the picture for me, as I would demand and prefer higher margins of safety for obvious reasons. But more importantly, take a good look at the valuation reports being done, whether they are using reasonable assumptions and of a decent quality. I would also usually pay attention to the time of the valuations. For example, if a loan was valued during the property downturn (price trough), it would be favourable since it should provides you with more margins of safety as opposed to if it was valued during peak/boom times. There are opportunity for value to rise in the former, which would effectively lower your LVR and provide you with more margins of safety.
  5. Reasons for Borrowing/Borrower Quality – I would also look to try to establish borrower’s motive in borrowing from such arrangement. I am sure, if given the chance, they would rather borrow at a more competitive rates. So why haven’t they done so? Typically, your commercial loan manager will provide a quick snippet of the borrower’s profile. Common reasons are because they are not able to get full doc loans (i.e. lack of payslip/overseas income) or because they need to satisfy few conditions before being able to obtain lower rate financing (waiting for approval, etc).
  6. Conditions Imposed by Loan Manager – The more punitive it is, generally the better it is for you. Just remember, more margins of safety are always going to be welcomed in the debt market. But do not forget to ask the questions as well why is it so punitive. Whether it is just standard operating procedures for such type of loans or if there is anything potentially wrong with the borrower.

    Typically, if a borrower is late in their repayments, they will be punished with what is called a default rate (higher than agreed borrowing rate) before the loan manager can claim the borrower has defaulted. On top of that, look out to make sure that your commercial loan manager has the right to revalue the loan security at anytime and demand borrower to stay in line within their initial agreed LVR. For example, if property price drops, then borrower is mandated to repay their outstanding principal to get the LVR in line again. This is especially important if you are expecting a property downturn.

Remember, each loans are unique in their own way, always go into the process of analysing a loan with the worse case scenarios in mind and thinking outside the box helps a lot too I suppose!

Alternative in the P2P Space

If you mention P2P investments, probably the first thing that comes to mind is consumer lending on platforms such as RateSetter and many others. Personally, I have only used RateSetter, so I can’t really speak about others. I have nothing bad to say about them and my experience has been flawless so far! I am a big fan of using their 1 month rolling investment option. It’s only currently going to get you about 3%+ (used to be able to get up to circa 4%), but it is still miles better than your typical online saving account/term deposit returns. Given maturity is very short (within a month as implied by the name), I’m quite comfortable in deploying my cash this way.

However, once when we look into the risk-reward equation and realised that the 3-year loan duration in RateSetter is only currently going to yield you about 4-5%, the Direct Mortgage option looked much more appealing to me in risk-adjusted return sense since you can get between 5-7% for duration between 6-12 months under Direct Mortgage (higher return for shorter duration – always favourable).

In terms of collateral, P2P loans provider typically have what they call provision fund. This is the fund where excess returns/portion of interests paid are stored by the loan manager to compensate for any bad debts that might be experienced from other loans in the pool. So far, I have seen that they have been working as intended and I know plenty others out there that have been using such platforms and are not having issues in getting their money back (including when investing into longer term loans).

However, my logic is that in the event of a downturn, people would probably default on their personal loans first before giving up their property (especially if it is the place that they currently lived in!) On top of that, I am sure you are all aware/have heard of the stereotypes/obsessions that Australians have with property as an asset class (e.g. they’ll rather eat two times a day than losing their property, and many other phrases I’m sure?!)

Yes, they are stereotypes and generalisations, but they existed in the first place for a reason, no? Again, this is just strictly my oppinion and might not be true for all occassions.

Happy investing!

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