As wealth managers seek higher yields for their clients, real estate has returned to the table as an option. For wealth managers, the question then becomes which investment vehicle will work best for each client.
For many clients, investing in mortgages and deeds of trust may be the best option. Unlike the more traditional and higher risk real estate opportunities such as new developments, acquisitions of existing properties, or REITs, investors in mortgages are more likely to achieve an excellent passive, ordinary income return on their investment.
The higher risk options may be of interest to some clients, but for those clients seeking consistent, steady returns through real estate investment, wealth managers should understand the options for investing in mortgages, as well as the risks and rewards for each option.
Investing in Individual Mortgages
An investor in an individual mortgage may hold the entire beneficial interest or a fractional interest along with other investors.
If the investor selects a single beneficial-interest mortgage investment, he or she is entitled to 100 percent of the reward, while also shouldering 100 percent of the risk. Single beneficial-interest mortgage investments are best suited to individuals seeking more aggressive, hands-on investment opportunities.
Investing with fractional interest is a more conservative choice, allowing investors to share the risks and rewards with others.
With an individual mortgage, whether it’s a single beneficial-interest or fractional investment, success is typically dependent on the performance of a single property and an individual borrower, as well as general market conditions. Moreover, single mortgage investors must sacrifice liquidity for the duration of the loan, and understand that if the loan stops performing, the revenue stream stops as well.
Investing in a Mortgage Pool
Mortgage pools provide investors with the opportunity to share risks while increasing the probability of uninterrupted returns.
This type of investment is equivalent to a mutual fund where investors share returns and risks on a pro rata basis in a portfolio, or “basket”, of assets.
For example, Lone Oak Fund gives investors the opportunity to invest in a portfolio of first priority deeds of trust on over 800 properties. The Fund is comprised of more than 700 high net worth investors, retirement funds and institutions.
Like a mutual fund holding different equities, investors in a mortgage pool are protected by risk diversification. If any one or more loans ceases to perform, the effect on the yield will be minor. For instance, the average loan in Lone Oak’s portfolio is less than 0.20% of the total loan volume. The result is a steady stream of income, delivered within a predictable time frame.
Investing in mortgage pools also gives investors increased liquidity. Subject to SEC and IRS regulations and availability of capital, investors may be free to redeem all or a portion of their investment on their own timing, rather than having to wait for all the loans in the pool to be repaid.
Selecting a Mortgage Pool
In order to select the right mortgage pool for a client, wealth managers will want to consider a sponsor’s track record, underwriting criteria, and “skin in the game.”
For established mortgage pools, the best gage of performance is the fund’s historical record, especially during and after the recent economic downturn. For start-up funds, wealth managers should examine the experience of the sponsor both in real estate investment in general and lending in particular.
A client’s appetite for risk can be matched to that of a mortgage pool by examining the fund’s underwriting criteria, usually found in the operating agreement or prospectus. The main points to look for are loan-to-value ratios for different types of property, geographic sphere, and perhaps most important, loan priority position (senior loans only, junior loans, both). Reward and risk can be calculated and weighed in this process.
Finally, is the sponsor itself invested with cash in the fund? Lone Oak’s principals, for example, hold approximately 15% of the Fund’s $430,000,000 capital. The sponsor’s contribution is an indication of its confidence in, and accountability for, each loan.
An investment by a client in an individual mortgage or mortgage pool can be a secure and rewarding alternative investment in his or her portfolio.
James Rothstein is co-founder and a major investor in Lone Oak Fund, LLC. He is an attorney and current member of the State Bar of California.