How to earn better returns by investing in residential mortgages

Financial planning Written by John Bolton, Oct 26 2020

Earlier this year we launched our P2P Home Loans and Business Property Loans that give investors access to residential first mortgage investments with returns of up to 5% p.a. As interest rates have fallen, investors are looking for better returns.

That might not be for you, but chances are you have a parent or know someone who needs a better return on their investments without increasing the risk. It’s a catch-22.

The benefit of our first-mortgage investment classes, is that investors are investing directly into loans secured by a residential property with a first mortgage. That affords lots of security whilst getting better returns. Squirrel assess the credit risk and manage the loans on investors’ behalf, and we are independent of the borrower.

The reality of property developers

At the moment there are property developers starting to raise their own funds. Generally speaking, the credit risk associated with property development is a lot higher relative to loans on existing residential property.

Where developers raise money directly from investors, they’re clearly conflicted, and incentivised to take risk. Where there are no controls over how funds are invested in the project, additional risk is created. Investing in large-scale developments has a very different risk profile to investing in loans on existing residential property, even if its brands itself as “mortgage-backed.” Put simply, if a developer is paying 10% p.a. returns there is a reason for that. One such developer already has a history of being bankrupted during the GFC and is now out there raising funds. But keep reading before you write developers off.

On our platform there are two mortgage options for investing in, and both are backed by first-mortgages over simple residential property.

Home Loans

The first option is investing into first-mortgages on home loans for borrowers who can demonstrate income and the ability to service the mortgage. This pays 4.00% p.a., paid monthly. It’s an investment for people wanting a longer-term and stable return and is our lowest risk investment option.

Construction Loans

The second option is residential construction lending, secured by first-mortgages over houses under construction. It pays 5.00% p.a., paid monthly.

Both of these investments have the benefit of first-mortgage security, loan-to-value ratios below 80% meaning property owners have real equity in the property, and both investments have reserve funds designed to help protect investors’ capital.

Residential first-mortgages provide a lot of security

For a start, borrowers have significant skin in the game both as equity and a roof over their head, which acts as a big deterrent to them defaulting. The lower the loan-to-value ratio (LVR), the lower the risk of default.

The second consideration is what happens if a borrower defaults and the property is sold.

We call this loss-given-default. At an 80% LVR if the property value drops by 10% and assuming about 5% of the sale price will be absorbed by costs, then an investor still gets a full return of capital and interest.

Even in an extreme scenario where 10% of borrowers default and house prices fall by 30%, the overall loss rate would only be 1.50%. This is a reasonably extreme example and yet the loss rate is still below the amount of interest collected by investors. In this example the mortgage fund would still likely to be able to absorb the losses with no loss of capital to investors.

Our mortgage funds have reserves set aside to provide additional risk protection

As an additional layer of security our residential mortgage investment classes, each have a reserve fund. If a borrower misses a payment it is covered by the reserve fund, meaning investors continue to get paid their regular monthly returns. If a borrower defaults on their mortgage the property is sold, and the reserve fund will help cover any deficit in the available funds to ensure that investors get their capital and interest back.

Ultimately the funds have a socialisation clause that means if there are not enough reserves to protect all investors, then interest returns can be shaved to replenish the reserves and so protect all investors. This ensures that all investors will benefit from the diversification of a portfolio of loans.

How risky are residential mortgages?

Residential property is a relatively low risk form of investment. As I pointed out earlier, it shouldn’t be confused with other types of mortgage backed investments. Other types of mortgage backed investments include loans over commercial property, agri property, and property development. When looking at a mortgage backed investment, it is important to look at what the investment is in, and who is managing it.

Back to residential mortgages, the expected loss rate used by banks is 0.05% (5 basis points). If a fund is returning 4%p.a. that reduces the expected return to 3.95%p.a. where credit losses are fully held by investors.

In reality borrowers rarely default and if they do default, lenders can typically recover their loan through sale of the property where they hold the first mortgage. Any shortfall will be small.

To put this in perspective, rating agencies like Standard and Poor’s typically rate 93% of a mortgage fund as AAA security – which is a better credit rating than most governments. That’s not saying an investor cannot lose money, but it is saying that the chance of a loss of capital is very low.

In Australia a number of mortgage funds are listed and report their results publicly. According to Standard and Poor’s, roughly one percent of Australian securitised prime mortgages go into arrears with a cumulative loss rate of between 3 and 5 basis points similar to bank experience. This data set goes back to 1996 and includes the Asian financial crisis and the GFC.

What about liquidity if I need to get money out?

Most investors want to be able to access their funds. We allow for investments to be sold on to a secondary market at face-value. This market is working well with over $2m of money per month passing through the secondary market and that is growing as our funds under management grow. In addition, a lot of the mortgage lending we are doing is short-term either bridging loans or short-term house construction. These loans typically last about six months and then repay which creates a lot of liquidity for investors.

Bringing it home

Investing in residential mortgages is an investment that is worth considering. It offers a good return relative to risk, you know explicitly what you are investing in, and it still has a level of liquidity that will give you flexibility to withdraw funds when you need it.

In a world of very low returns, it is worth a look as part of your investment strategy. As with any investment it is important to not put all of your eggs in one basket and to diversify your investing across a range of investments.

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