Many investors are looking for a decent yield beyond the 1-2% available in the government or the 3-4% in the corporate bond market. After some research they usually stumble upon MICs. Wow, they say, some yield 8 or even 11%. Let’s buy some. Not so fast I’d say.
How do you evaluate a mortgage investment corporation (MIC) that by law is required to pay most of its profit to investors on a monthly basis ?
Public vs. Private MICs
First of all there are two types of MICs: those that are publicly traded, and those that are private.
Of the publicly traded ones, three fairly large ones are Timbercreek (trading symbol TMC), MCAN Mortgage Corp. (MKP) and Firm Capital Mortgage Investments (FC). They all yield around 6% depending on the price you buy them. Below is a 3 year chart, from August 2010 to August 2013. What you see is that most of them have initially risen, then fallen in price since their peak about two years ago. Thus, you get the same volatility as a dividend paying stock, more or less, but with a slightly higher yield as they do not have an active business. Lending their money is their business. So, you collected 6%/year in yield, before taxes btw, but now the stock is 10-15% lower. Are you any further ahead ? Obviously not, as the yield barely made up for the price decline. Will they fall further as interest rates rise somewhat over the next few years ? Or will they stabilize and provide a good perpetual income ? Read on, as the analysis is the same compared to a non-publicly traded MIC, a private MIC.
Income Producing vs. Construction Loans
MICs invest in three types of assets: income producing existing assets, under-performing assets being rejuvenated or assets that are being built, i.e. construction loans. As such, you have to look at the underlying philosophy of the MIC and ask the management what they invest in, or what percentage is in either of these three asset classes.
Construction projects are more risky, as the asset to be constructed does not yet exist. As such the yield ought to be higher, and usually is, if the project is executed on plan. It is per se not a bad investment, but it is highly dependent on the quality of the builder and the demand for the product being built. As you can see from the graph below, in a typical construction project of say a high-rise tower or a mid-rise condo building, hard construction costs make up only about 30-35% of the actual costs. There are also land acquisition costs, land servicing costs, planning, permitting and design costs, sales & marketing costs, contingencies and interest reserves for the first mortgage lender, as the MIC is often in second position.
1st or 2nd Position ?
As such you have to understand the position the MIC is in: in first position, or in second (or worse: in third). If the MIC is not in first position it means that on a severe construction delay or slow condo sales process the first mortgage lender takes first dabs on the asset, leaving the second lender with nothing in many cases. As you can see, the developer or investor (or MIC) profits are often very small, sub 20% in total in many cases and that means that construction delays or a drop in sales price by only perhaps 10 or 15% directly impacts the developer and the investor. If the MIC is the investor in second position, or even in first, there is severe risk that not all principal invested can be paid back, let alone the agreed upon interest. As such, you have to look at the underlying asset quality, the operator and the location very very carefully in a construction MIC, or a MIC that invests mainly in construction. A look at their track record helps, such as the default ratio in the 2008-2009 recession that saw many foreclosures not only in the US but also in Canada.
Keep in mind that your upside, say 8% or 12% is capped, but your downside might still be 100%, unlike a direct ownership of the underlying real estate.
If the MIC is not in first position, you have to understand the loan-to-value (LTV) of the first mortgage and its interest rate. If the interest rate on the first mortgage is above current commercial terms (say 3% on an apartment building, 4-4.5% on a quality industrial or commercial asset, or 6-8% on a hotel) you have a high risk project and your MIC money is at risk, too. Of interest is the LTV of the first mortgage. If 50% or lower, the MIC might still yield the target return if the operator / borrower executes as planned, as the MIC usually does not want to take over the asset in a semi-finished state.
OK, what about MICs with money only in first position ? Well, first of all this is far safer, but you will see lower yields. CareVest, one of the premier MICs in Canada currently has two MICs, one in first position which yields around 6 to 7%, and one in second position yield 9%+. You decide what risk you wish to take. One MIC I know of lends only to large commercial operator and never over 60% LTV. The MIC yields 4% or so, basically what you can get in a commercial grade corporate bond, too – and that is what I would expect as the risk is similar.
Some MICs lend on distressed or turnaround assets, but only in first position. Some have build a niche in certain markets or certain assets types, say distressed hotels, trailer parks in rural areas or defunct resorts. In these cases it is important tolook at he track record of the lender, as some of these MICs are decent performers despite the risk they take on.
Cash-Flow vs. Net Income
Then, if you have a portfolio of projects in a large MIC, look at the net cash-flow vs. the stated net income. Often the net income is higher as some of the interest is accrued, but not collected. This takes a bit of math or accounting skills, as some MICs lend money and insist on a monthly payment from the borrower, while others, typically in construction projects, allow accruing of interest, which is income, but not cash. He more accrued income you see on the balance sheet the more risk the MIC has taken. The projects might still pay out, so this is hard to gauge without detailed project-by-project updates.
There you have it: four criteria to evaluate MICs.
Much like REITs, a higher yielding MIC usually is a riskier one. Ensure that you do not blindly follow just the marketing brochures, but also look at the quarterly or annual financials, and you can get a decent 4-7% yield with low to modest risks, or one with juicier yields but substantial risk in the high single to low double digit range. As always, look not only at a return on your capital, but also at a return of your capital !