BUILDING A NEST EGG THROUGH PRIVATE MORTGAGE INVESTING
Investing in the future is a complicated process and a Canadian based Mortgage Investment Corporation is something to consider. Looking down the road ten, twenty or fifty years is both daunting and unfathomable to many. There is no way to know when an adverse event will put your investment returns at risk. Moreover, with numerous adverse financial events seared in our collective memory, this challenge is often top of mind for investors.
Especially those thinking seriously about retirement.
Is there a secret to investing for the future? Is there a way to diversify without losing your gains to volatility and irrational markets?
Like many, these are questions Roger and Chris Allinson have grappled with. Their experience and research lead them on a journey into real estate culminating in the founding of a private mortgage investing fund, Nest Capital.
Nest Capital Mortgage Investment Corp provides private investors with the opportunity to earn returns by investing in a fund that lends private capital to borrowers on residential mortgages.
Mortgage Investment Corporations provide investors with access to the real estate market using an investment product rather than outright asset ownership. This allows for interest returns while providing a portfolio diversification option.
The success of the Mortgage Investment Corps is driven by demand from an underserved market of qualified borrowers backed by assets. This growing number of borrowers are unable to access financing through legacy financial institutions due to stringent banking regulation.
I sat down with Nest co-founders and managers Roger and Chris to get to know more about them and their vision.
Tristram: Welcome to you both. Thanks for taking a bit of time to tell me more about what you are doing.
Roger: Thanks. Great to be here.
Chris: We’ve been looking forward to it.
Tristram: So why don’t we start by talking about what your business is. Can you define a Mortgage Investment Corp for me?
Chris: Yes, of course. A Mortgage Investment Corporation or MIC is a legal structure that allows investors to earn returns on a pool of mortgage investments. It’s a bit like a mutual fund. The MIC is managed by the Mortgage Administrator which is the investment and lending manager of the fund.
So we select and manage a pool of diversified residential second mortgages as the Mortgage Administrator, and pay the investors out of the Mortgage Investment Corporation based on the returns from the mortgages held in the fund.
So think of it as a pool of mortgages in the MIC being similar to a pool of stocks in a mutual fund. Same idea.
Tristram: Is there any particular reason why you chose this product to build a fund around?
Chris: It’s just been a natural evolution for myself and Roger based on our experience being landlords to doing private lending on specific residential mortgages over a number of years.
A Mortgage Investment Corporation is a commonly recognized vehicle for real estate exposure without having to own the underlying asset.
Tristram: And this investment fund is based entirely on private capital?
Chris: That’s correct, yes.
Tristram: I’d like to know more about the journey you went on to get here.
Roger: Sure. Essentially, I was looking in the mirror one day and realized that there was not going to be sufficient income in my retirement years to support what I was used to.
So I started looking for better avenues to increase my retirement resources. I tried traditional stock investing and quantitative investing.
After a bit of that, I decided I needed something a little slower, and more secure and real estate is the very definition of slower and more secure.
Now that thinking was part of my upbringing. I was always taught that real estate was highly valued as it is in many families.
So I started by buying a rental unit and eventually amassing eleven single family private residential properties in the Greater Toronto Area.
On that journey, we developed a stronger relationship with our mortgage broker. In addition to taking care of us he kept asking us when we were going to start investing in private mortgages.
After ignoring this question for many years, we decided it was time to branch out into private lending. It was a straightforward and easy to understand investment. A perfect fit for me and exactly what I was looking for. I absolutely loved it and still do.
We started a company, Rent to Buy Homes, Inc, which is the landlord company. Then we started an investment company called Lincolnville Inc. which specialized in private mortgage investing, growing to over sixty mortgages and $4.5 million over five years.
We learned a great deal about the business during that time. Real estate lending is one of the oldest businesses on the planet. So lending is easy for most people to understand.
Most of our friends and family wanted to know how they could get involved. So we had the demand for a type of fund before the idea of Nest, which indicated to us how good it was.
I brought Chris on board, and we investigated starting our own Mortgage Investment Corporation. That’s where we are right now.
So Nest as a name represents the nest egg that our friends and family have invested in the fund. It represents our investment as well.
Tristram: Great story. Now, you come from a sales background originally. How have you used that to help you in this business journey?
Roger: You know, I’ve never really thought much about that. However, I would say that in sales, you interact with all kinds of people and those interactions teach you a lot of different things.
One of the most important things you learn in sales is that it’s all about trust and relationships. When you look at Nest, for example, trust and relationships are the cornerstones of the business across the board. From partners to business associates.
For example, our mortgage broker and advisor we’ve known for over 25 years. Same with our accountant. Our lawyer, we’ve worked closely with for eight years. These are our core advisors and business associates. They provide key insights and care in our business decisions.
As a salesperson, you also understand people’s desires. People don’t want to be talked at; they want to be listened to and understood. They want a simple answer delivered clearly.
When you are communicating with investors, you try to think of what their concerns are, almost everybody has the same concerns we would have. They don’t want to lose their capital while they are trying to grow it.
Tristram: Tell me a bit more about how the Great Financial Crisis acted as a catalyst for this business.
Roger: Which financial crisis are you talking about? I think there were a number of “great financial crises,” the most recent being 2008. There was Dot.com, Long Term Capital Management, and back to ‘87.
All of them had a similar effect on investors. The reaction of many was also similar, something like: oh my gosh, what happened to my nest egg? This market is illogical…
Many people in 2008 saw on average, 20% to 50% reduction in their stock portfolios — years to generate those returns gone in a matter of months.
So it was that experience that made us realize there’s got to be a better way. So we opted for a less exciting option. Real tangible assets that people need to live in. That’s residential real estate. That’s why when people were hitting the panic button in 2008, we were buying the bulk of our residential properties.
Our thinking was that Canada had a more stable banking system and didn’t do all the crazy stuff the Americans got themselves involved in.
Tristram: So you’re providing the Mortgage Investment Corp both as a diversification product and strategy.
Roger: Yes. We decided to explore a different approach to making investment returns. We had already been a landlord and property owner, so mortgage lending gives you the benefit of real estate exposure without the “headache” of ownership.
Tristram: How big is the private lending market in Ontario where you’re operating?
Chris: Ontario’s private mortgage lending market was up 18% in 2018 over the previous year. Running about $10 Billion. That figure covers private lending across areas like development construction, commercial and residential. The demand is there and growing.
Roger: We are expanding our fund as a result of this trend. Our current target is $50 million in fund size. There is substantial demand for private money in residential real estate and the primary reason for that is the rules that the government has put in place. These place stringent restrictions on the ability of many people to borrow through schedule A banks.
There is more need for money than money available to many borrowers in the legacy banking system due to regulation.
Tristram: Can you elaborate on those rules for people that don’t know what they are?
Roger: Sure. One aspect is a rule that measures the ability of a borrower to qualify based on a two percentage point move higher in rates. It excludes some borrowers, as they should. However, there are others that are asset rich that should be able to access resources.
Tristram: What is the performance of MIC’s over the last number of years.
Roger: Overall performance across the industry is heavily dependent on the fee structure and the type of property lent against. Generally, returns across the industry are favorable and consistent. Our returns run at 10% net of fees and a bit higher if investors opt for the dividend reinvestment option.
Mortgage investment corporations themselves, just like the banks, have very low default rates averaging less than 1.5% over the history of all mortgage investment corporations.
And for clarity, default means if someone is late with a mortgage payment or their payment doesn’t clear, or if it’s gone to legal action or power of sale. All of those are definitions of default.
Chris and I studied the industry extensively before deciding upon the residential subset of this industry. The places where MIC’s seem to get in the most trouble is in commercial and development mortgages. We don’t do these.
Mortgage Investment Corps are based on standardized government rules, therefore variability of returns between funds are due to things like overhead, types of mortgages and geographic location.
Tristram: You said that there’s standardization of rules for MIC’s, what does that mean for investors?
Roger: There are a few things. As a Mortgage Investment Corp, you must have a minimum of twenty investors and no one individual can own more than 25%.
All mortgage investment corporations must have a significant component of their investment in residential real estate but not necessarily 100%.
A MIC can own actual real estate but only briefly allowing for a situation where a MIC ends up having to take over a property. However, it needs to be sold in a reasonable frame of time.
All payments of interest from the fund must be from earnings and not from new investors. So no Ponzi nonsense.
The activities of the Mortgage Administrator that runs the fund are regulated by three things: The Mortgage Act, The Bank Act and then there’s reporting we must file for all investors with the Ontario Securities Commission and the BC Securities Commission for investors in those provinces.
We are also required to have audited financial statements, and we must use regulated institutions such as trust companies if investors decide to use registered accounts for investing. These are reviewed by the Financial Services Regulatory Authority of Ontario (FSRA).
Tristram: So when Mortgage Investment Corporations are described as largely unregulated that’s not correct.
Chris: I am aware that the CMHC classifies MIC’s as unregulated in one of their old reports from two or three years ago and were probably referencing the borrower regulations.
Regulation generally defines the conduct of a given business or entity. Mortgage Investment Corps have a number of reporting and licensing requirements that define our conduct and activities.
So if regulation is rules and legislation that define conduct and activities, it would be more accurate to say that MIC’s aren’t regulated like typical financial institutions.
That gives MIC’s room to operate as a valuable source of financial liquidity for people excluded from the typical financial system. For a MIC to provide this important financial outlet, by definition, you can’t be regulated like a bank.
And further to Roger’s points, Mortgage Investment Corporations are defined under the Income Tax Act of Canada.
Roger: I think some people get confused sometimes with the term private lending. Private lending generally is largely unregulated, but a MIC is a form of private lending that is defined by legislation and is therefore regulated.
Tristram: Let’s talk about the kinds of risks that might be involved in an investment product like this. What are they and the next question would be, how do you manage those risks?
Roger: Excellent questions and that’s what we work at every day, mitigating risks. So I’m going to start by approaching the question from the point of view of the investor because we were first and foremost investors in mortgages before we started the fund.
One area of concern is liquidity because a private MIC doesn’t trade on an exchange. So when you need liquidity, you can’t just click a couple of times and sell it like on the stock exchange. This type of investment is designed with the longer term in mind, so liquidity isn’t a key benefit.
However, if liquidity is required, the investor can get it, but we charge a fee for that. The nature of this investment strategy relies heavily on planning around mortgage duration, which is a year. If the investor knows they will need short term liquidity, this isn’t a good vehicle for them.
Another more common risk related question we get would be: what if the borrower doesn’t pay?
Chris and I manage the business with a rigorous investment process for investment selection, and we follow each investment in real-time with advanced software.
For example, we know virtually instantaneously via electronic banking the status of a borrower’s payment. So if there appears to be a problem, we can look into it and address that issue immediately.
Chris: Another risk revolves around exposure. So in our case, we work to keep our loan to value around 70% on average as a part of our risk management approach.
Roger: No one borrower has enough weighting to impact the fund in the unlikely event a problem arises.
Tristram: If I recall, your mortgages range from $50 000 to $250 000.
Chris: Yes. We even consider some mortgages slightly below that if they meet our investment criteria, so we consider mortgages between $20 000 to $50 000 as well. Overall, the fund’s current average across all mortgages is $91 300 right now.
Roger: So to continue with risks that investors are interested in, there are a couple more that come to mind.
Investors are often concerned about transparency. So in addition to the legal requirements for audited financials and licensing we make sure we are available to address any questions our investors may have. Part of that is having business partners with extensive knowledge and experience in their respective areas of expertise.
The quality of your business partners can make or break a business like this. And remember, we have substantial assets in this fund, so we have a very high standard for whom we work with for that reason alone.
Another risk would be making exceptions for incomplete paperwork. Missing paperwork is an obvious red flag, and we never entertain any investment opportunity without complete and verified paperwork. When it comes to appraisals, for example, every mortgage we consider must be appraised within 30 days by independent accredited and also trusted appraisers.
Tristram: The one risk that some people may be wondering about is real estate prices. Do price movements have much impact in terms of defaults?
Roger: Excellent question. As I mentioned earlier, default risk across the entire industry as a whole is at less than one and a half percent. So, no, we have not seen any increase in defaults from real estate price fluctuations.
Now, one of the reasons for this is our modest LTV rate of 76% right now. And of course, another reason is our focus exclusively on residential mortgages.
Another factor that can influence price fluctuations is the region where your mortgages are focused. Ontario, particularly the Golden Horseshoe, up to Central Ontario and out to Ottawa is a region of stability with a relatively diversified economy. This is why our focus is in this area.
Other parts of the country are prone to boom and bust cycles. So for example, Alberta tends to have a highly cyclical real estate market.
We focused on Ontario because the demand is so high here and we know the cities we’re investing well.
Then we manage duration risk by having mortgages that are one year in length. Shorter duration mortgages allow for frequent revaluation and reassessment and hence risk reduction. It’s hard to dodge bullets with a five-year lock-in.
Tristram: Tell me about your investment process.
Roger: Our process is designed to mitigate risks while finding good investment opportunities that fit our investment criteria. So our business has an evaluation process for both the loans we invest in and the investors that we invest alongside.
On the investment side, we receive a complete file about the borrower and the borrower’s real estate. A complete file includes a full mortgage application form with all the details. We also require an appraisal done within the last thirty days and evaluate all credit reports associated with the mortgage in question.
The complete file is shared with our mortgage agent who reviews the file for underwriting accuracy. This part of the process is looking carefully for any red flags to be investigated.
If everything checks out, then Chris and I review it further, and if we decide the file meets our investment criteria, then the file is sent on to our lawyer.
The lawyer looks into things like liens against the property from CRA or taxes or property taxes and judgments against the borrower. Assuming everything checks out here, funds are delivered to the borrower’s lawyer.
The entire process from beginning to end takes inside of two weeks typically.
Tristram: There’s also an evaluation process for investors. What does that look like?
Roger: In addition to any discussions we may have with potential investors, our exempt market dealer handles onboarding and all the necessary KYC, AML and suitability matters.
The exempt market dealer is a regulatory requirement for all MICs.
The evaluation process helps to determine if the fund is suitable for the investor. Not all investors can or should be invested in some products. So it’s both a suitability evaluation and a means evaluation.
Tristram: I recall you mentioning that your fund started as a friends and family fund. So you’re invested alongside your outside investors and friends and family.
Roger: Yes, we are. We thought from the very beginning that this was really important.
Our investors include my parents, my mother in law, sister in law, etc. So this is a great check and balance situation. Because if anything goes wrong, everybody you know will be after you.
We believe that if we’re not willing to invest substantially in the fund we manage, why would we ask anyone else to? I moved out of the stock market entirely due to the volatility.
Chris: And my liquid assets are fully invested in the fund as well.
Tristram: Aside from friends and family, what kinds of people are investing in the fund?
Roger: Our primary investors are typically the pre-retirement to retirement cohort. A close second is accredited investors, followed by urban professionals.
Generally speaking, investors in Nest Capital are looking for some diversification and an alternative to the stock market gyrations. They like the simplicity of MIC investing, and they understand the product. They also value the fund’s focus on Ontario residential only mortgages.
So a number of investors in Nest are looking for an income stream that fits with their investment profile and retirement or pre-retirement needs.
Accredited investors in Nest value the diversification aspect, in addition to the risk-return profile.
Many of our investors use their tax-sheltered accounts like RRSP and TFSA to take advantage of the tax-free accumulation of returns as well.
Chris: Another subset of investors we see in growing numbers are individuals similar to ourselves. In the past, they had been private lenders on specific individual mortgages.
The challenge for the individual doing private mortgage investing is that to scale investment beyond one mortgage requires a lot of extra work. All the things we do in our investment process requires trusted partners and lots of specialized experience. Most individual investors don’t have access to that and frankly don’t want all the hassle.
Plus they’re having trouble finding good mortgages to invest in. Because if you’re a low volume private lender, meaning one or two once in a while, mortgage brokers typically won’t deal with you. So you don’t get access to deal flow. Especially the best deal flow.
So by investing in Nest, they don’t have to do all the vetting and evaluation, and they get indirect access to our deal flow along with all of our other investors. They earn a similar or sometimes better return than they were getting before.
We see an increasing number of private lenders that are kind of tired of private lending on their own and looking for a more managed approach.
And our low management fee doesn’t hurt either. Experienced investors don’t mind paying for returns, but some of the fees out there seem higher than they should be. Our historical return is 10% net of fees.
So these investors with idle cash sitting around, looking for a product to deliver a decent return have become investors in Nest.
Tristram: We’ve talked exclusively about the investment side, let’s talk briefly about the borrower. Why do borrowers consider private options?
Roger: Sure. One type of borrower is people seeking to improve their credit rating. So they use private capital to consolidate their consumer debt and cut their interest rate. Sometimes it’s on credit cards, or lines of credit and personal loans. So they use the equity in their home as collateral to improve their credit over time by getting a second mortgage and paying down that consumer debt.
After a year or two, they are back on side and can access better rates through the legacy banking system. It’s a very valuable service for this type of borrower.
Chris: Another borrower profile would be a new Canadian who doesn’t have a credit profile in Canada. They have substantial assets, and they are looking to buy a home but can’t access credit from the banks due to the lack of credit history.
Or sometimes the borrower is a self-employed individual or a couple that are having difficulty getting a business loan from the legacy banks. So we help them by providing a second mortgage backed by the equity in their home. That way they get access to capital and at a much better rate than the alternative.
Tristram: Let’s talk performance. What’s the performance of the fund?
Roger: Our methodology and fee structure has generated a return in the fund of 10% annually net of fees, paid monthly.
Tristram: And you have a dividend reinvestment program?
Tristram: And what is your anticipated return or what are you targeting?
Chris: As the fund grows it the dividend reinvestment contribution will continue to grow with it. Our current return without reinvesting is running at 10%. With dividend reinvestment, we are looking at over 10%.
The majority of our investors have opted for the dividend reinvestment program.
Tristram: What are the plans for Nest’s future?
Chris: We plan to grow with the rapidly expanding demand for private residential second mortgages driven by the current regulatory environment.
To meet the demand, we are expanding the fund to a targeted $50 million.
Tristram: Where can interested investors find out more about Nest Capital Mortgage Investment Corp?
Chris: They can go to our website: www.nestcapital.ca or they can contact us directly email@example.com
Tristram: Well, thank you very much, Chris and Roger for spending some time with me today.
Roger: Excellent. Thank you.
Chris: Thank you.
For more information on Nest Capital Mortgage Investment Corporation go to www.nestcapital.ca
If you have questions for Chris and Roger, you can reach them at 416-628-2033 or firstname.lastname@example.org