With term deposits now cut further still, it is inevitable investors will turn to high-yield opportunities outside the sharemarket.
Traditionally, one of the most common alternatives is what are called "mortgage funds", where the investor directly funds property mortgages and gets rewarded for that risk. There has been a sharp increase in advertising for high-yield, mortgage-backed investments in recent times, but how do you look at it and judge it on its merits? Unlike the sharemarket, which is transparent, there is a dangerous spectrum of risk in this area.
Financial adviser Xavier Lo says: "Mortgage investments are offered by firms that provide loans to property owners, and fund these loans by monies provided from investors, who are paid a regular amount of interest.
"There are typically two ways investors can participate. Either in pooled or stand-alone managed fund trust structures. When you invest in a pooled mortgage fund, your money is exposed to a portfolio of loans and you receive the average interest from all the loans less management fees. Under the stand-alone structure, your investment is made into an individual loan."
There are benefits and drawbacks to both the pooled or stand-alone approach but it really comes down to diversification versus control. In a stand-alone mortgage fund, you must make decisions about the individual loan you wish to invest in, but with a pooled fund (which can be made up of hundreds of loans) you rely on the fund manager to make those decisions on your behalf.
Stand-alone first mortgage offers may have higher rates of more than 7 per cent, pooled funds may be a little lower in the order of 6 per cent or higher - minimum investments vary from around $20,000 to much higher amounts.
Given the onus on the investor to make decisions in the stand-alone loan structure, how should an investor weigh up risks?
Lo says: "The two main risk areas revolve around manager risk and loan quality."
In other words, you need to weigh up the stability and reputation of the organiser of the loan investment, as well as assess the risk of the loan itself.
Tom Sherston, head of sales at the Balmain Group, Australia's largest property debt provider outside the big four banks, says: "There have been several companies that have popped up in recent times offering loan investments and targeting retirees. The problem is that although on the surface they appear more or less the same, consumers need to appreciate the stark differences in who you're handing your money over to.
"We settled over $1 billion in property loans during the past 12 months and have been trading for over 40 years, in which time we've never had a financial loss given default."
The other risk is in the quality of the loan itself. Unlike the sharemarket, where it's easy to distinguish the risk differential between a microcap stock operating at a loss versus a blue-chip company that pays a strong dividend, on the surface, loan investments can appear homogeneous.
This is somewhat due to the marketing, which tries to underplay the risks and rather focuses on the return on offer. There are two typical scenarios in the loan investment market.
This is where a property owner has cash, usually up to 50 per cent of the purchase price, and wants to acquire an old house on a large block of land. The loans are usually for a short period of time (up to two years), to give the owner enough time to seek planning approval to redevelop the property, at which time the loan is paid out. The loan is provided on what's known as a first registered mortgage, which means if anything goes wrong, the first registered mortgage holder has first rights in repossessing and selling the property to recoup the loan. Guarantees are usually taken over other assets of the borrower.
This is much riskier and involves lending money against property that already has debt against it, and usually over property developments. If something goes wrong, you're not first in the queue to get your money, instead you get whatever (if anything) is left after the first lender has recouped its loan and penalty costs. Also, the risk of something going wrong is heightened as your exposure is not usually just over a raw property asset, it's over a construction project.
Lo's top tips for anyone considering investing in the mortgage market are:
- Assess the loan ranking. First registered mortgages are far superior to mezzanine loans in terms of risk control. Mezzanine loan investments should only be considered by those who possess an extremely high capacity for investment risk.
- Ask what additional guarantees the borrower has provided such as a corporate guarantee or general security agreement. Also, ask about the borrower - are they a property developer? How long have they been doing it? What has their track record been like?
- Consider the loan-to-value ratio (LVR). The higher the number, the riskier the loan. Under a 50 per cent LVR, in simple terms the property would need to drop by 50 per cent in value if a default occurred and the property was liquidated before a capital loss occurred. But if the LVR was 80 per cent, a drop of more than 20 per cent in value would potentially trigger a capital loss.
- Make sure you are comfortable with the resale value and liquidity of the property the loan is secured against A freestanding house in inner Melbourne is more likely to be liquidated quickly compared to 1000ha of farmland in far-north Queensland. The loan term is also important as they can vary from three months to three years.
- Ask about the company arranging the loan. Do they have skin in the game? How long have they been operating? How many loan defaults have they had? What external audit and compliance measures do they have in place? Have they had any breaches with ASIC?
- Is the loan investment offered via a retail managed fund, which has a higher level of consumer protection, or is it offered on a wholesale basis, under which the investor assumes more risk (that is, less consumer protection) given they are deemed to be sophisticated enough to assess the investment
- What is the net interest margin? That is, what is the interest rate that the borrower pays versus the interest rate the investor gets. This margin, which is paid to the loan manager, is typically 1.5-2 per cent. If the borrower pays interest of 10 per cent, the loan investor should expect to be offered roughly 8-8.5 per cent interest.