Diversifi’s due diligence process
Many different factors are taken into consideration when conducting independent due diligence on a MIC. We elaborate below on a few of these
Size of MIC – as measured by the average annual net return to investors
The size of the MIC, as measured by their Unit (Share) Issuance varies widely across the MIC Industry. Larger MICs would generally have somewhat of an advantage in terms of resources and access to deal flow, however the advantage does diminish above a certain point.
One advantage where size can be of benefit would be in situations where there may be problem second and occasionally third mortgages underwritten by a MIC. As the first mortgage holder is usually in control of the foreclosure proceedings, they are not as concerned with any losses by second or third mortgage holders if their mortgage obligation is satisfied in full. Assuming a MIC was well funded, they could intervene in such circumstances and purchase the liability of the first mortgage holder. Thereafter they would then control the foreclosure process themselves.
Net Yield – as measured by the average annual net return to investors
MICs generally have a Preferred Share which is available for investors to purchase. These are referred to as Class B common shares in the case of AP Capital MIC. All net profits from the MIC’s are distributed to investors and all distributions are fully taxable as income.
Loan-to-Value Ratio and Risk-Weighted Yield of MICs (Net Yield to LTV) – as measured by the total mortgage encumbrances divided by appraised value
The loan-to-value (“LTV”) ratio is the ratio of the mortgage advanced (or the sum of all prior encumbrances if the mortgage is a second or third mortgage and has a higher-ranking mortgage ahead of it on title), divided by the value of the property. The value of the property is generally the appraised property value as determined by a professionally qualified (accredited) Appraiser through the Appraisal Institute of Canada.
Management Agreement
Management agreements comprise various forms of compensation to managers. The first is the straight management fee. These can range in the industry from 1.5% – 2%.
Mortgage fees, (or fee income), are also a component of how income and expenses are allocated to MICs. Usually when a loan is underwritten (or renewed) by a MIC, certain fees are charged to the borrower. These can include a fixed advance and variable underwriting fees, with the largest component generally being a commitment or advance fee, charged as a % of the mortgage loan. Standard industry fees are in the 1-2% range.
Managers also have the discretion to waive a portion of their fees where appropriate.
Management Expertise
This category is important, as ultimately Investors in a MIC provide all the capital but have no voting rights as to the operation of the MIC. Therefore, there is a large degree of trust cast upon the management of a MIC. Well qualified staffing is essential to manage high growth and/or mitigate potential problems. Ownership and track record is important and a manager that has been in business longer generally would have more resources to put into their business. Relationships with sources of business, borrowers and also capital raisers are relevant to this assessment.
Liquidity & Redemptions – as measured by the MICs ability to meet redemption requests in a year of high redemptions (2020) solely from credit facilities
A major concern amongst investors in MICs can arise due to redemption policy language in the Offering Documents (OMs) of Mortgage Investment Corporations. Language often includes only quarterly or annual redemption periods, a full quarter to make redemptions (if at all), and a maximum threshold in a given month, quarter, or year. Given these policies, investors not familiar with the space may assume it is difficult or nearly impossible to get their money back in a timely fashion.
However, running a MIC has become a competitive business and not making redemption requests in large amounts, or even small amounts, could have a very negative impact on capital raising as the reputation would spread amongst the investment community. The year 2020, which encompassed the initial stages of the COVID 19 pandemic, was a good test case of MIC business models.
Many investments generally, (including MICs), experienced outsized redemption requests in 2020.
In terms of liquidity, while real estate and mortgages generally have very low liquidity, MICs have several sources of liquidity. These include: 1) Cash-on-hand 2) Mortgage maturities – MICs generally have target terms of between 6 months to 24 months, with an average of ~12 months. This is much shorter than traditional mortgage loans, (the most common term being 5 years), resulting in monies being available on a regular basis through frequent maturities. 3) Mortgage interest – while all (net) interest earned is required to be paid out by the MIC, a fair portion of MIC investors reinvest, or DRIP their distributions, thus reducing the cash burden on a month-to-month basis. 4) Lines-of-Credit – MICs have been able to obtain large lines of credit, up to 3-5x net book value on very favourable terms. 5) New investor monies
Analyzing and comparing MIC’s
Some additional considerations
Geographic Diversification – as compared by Provincial geography of loan portfolio
Generally, the greater the geographic diversification, the better, if the diversification doesn’t significantly exceed that Province’s contribution to the economic base. An important consideration however, in assessing geographic diversification, is to test the expertise of management in different areas. Often, diversification within one or two geographic areas may be sufficient to satisfy this criterion, assuming management has sufficient knowledge and expertise in those areas.
Investment guidelines are general risk-management policies. While all MICs have policies that they follow, some are not disclosed to investors, and some policies are more stringent than others. In other cases, the maximum thresholds never come close to being breached. We always attempt to analyze MICs based on available information. Policies analyzed include maximum loan-to-value ratios, maximum loan limits to single borrowers expressed as a percentage of the overall loan portfolio, and to a lesser extent maximum second mortgage limits and commercial loan limits.
Percentage of Portfolio Invested in First Mortgages – as measured as a percentage of the loan portfolio
First Mortgage Percentage refers to the percentage of a MIC’s mortgage portfolio that is underwritten and secured by a mortgage in the first position. First position mortgages are the most secure and allow for the strongest likelihood of full collections through direct borrower negotiations or ultimately in the foreclosure process as the MIC would be in full control of the proceedings.
Percentage of Portfolio Invested in Commercial Loans – as measured as a percentage of the loan portfolio
The percentage of commercial loans is the percentage of the MICs loan portfolio that is invested in loans secured by commercial, as opposed to residential properties. Commercial loans generally tend to be riskier than residential mortgages as the underlying properties are less liquid, require more ongoing maintenance, and require more time and effort to realize proceeds in adverse situations. Certain Mortgage Investment Entities specialize in commercial mortgages to strong Institutional Investors, but this is not generally the case for MICs.
Percentage of Portfolio Invested in Land Loans – as measured as a percentage of the loan portfolio
The percentage of portfolio invested in land loans is the percentage of the MICs loan portfolio that is invested in bare land or has some residential or commercial structure that is not the intended final use of the property. Generally speaking, land loans tend to be riskier than residential mortgages as there is no underlying property to be sold with the land or to generate income. This makes this type of real estate less liquid and more cyclical in nature, as developers often purchase land after a significantly long uptrend to replenish inventory for future projects.
The shorter the term of the mortgage, the lower the risk of loss as the probability of market conditions changing materially during the term of the loan increase with longer periods. MIC’s usually issue mortgages of durations with less than 24 months and on average, loans would typically be for a 12-month period. This allows fund managers to react swiftly to changing market conditions.
Loan Loss Provisions and Mortgages in Foreclosures – as measured by valuation policy, arrears, and foreclosures as a percentage of the loan portfolio
We analyze disclosures with respect to each MICs risk model, arrears, and foreclosure history.
The number of mortgages in foreclosure gives an indication of the riskiness of the mortgages underwritten, but not necessarily of actual loan losses. Management expertise and the pro-activeness to address situations may vary as well as their general “comfort” level with foreclosures.
One of the most important analyses in considering a mortgage portfolio’s risk is to assess the various sizes of loans made, relative to the total capital available. The larger the loan, the greater the concentration risk. Another factor relevant to concentration risk is whether any one entity (person, corporation or otherwise) has perhaps loaned multiple amounts, on different properties, from the same MIC.
