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How to earn passive income through mortgage fund investing

Alex Leduc, CFA and CEO of Perch Capital on mortgage investing and MICs, an alternative investment that’s growing in popularity

Connect with Alex Leduc on LinkedIn

With a booming real estate market, it’s no surprise that Canada’s mortgage market is a massive industry, valued at $2 trillion. For many Canadians, owning rental properties has been one of the most obvious paths to wealth. As we’ve seen over the past year however, property values aren’t linear and the market can take a turn fast when there’s a shock like rapid interest rate hikes.

What if there was a way to invest without the headaches of being a landlord and the stress of declining property values?

Introducing: mortgage investing, a relatively unknown opportunity compared to GICs and stocks. Perch Capital is making this investment class more accessible to retail investors.

Why isn’t everyone investing in mortgage funds?

Alternative investments were historically reserved for high net worth investors through private wealth managers. However, that has dramatically shifted in the past few years for several reasons.

There has been a proliferation of new alternative investment fund offerings due to rising demand from clients and advisors, making it more mainstream.

In 2021-2022, we saw bonds and equities both decline in value, which is not a common scenario. When investors saw that some alternative investments still posted gains during those years, it led them to re-evaluate their portfolios.

Wealth advisors will focus on the expected returns of investments, but also on the volatility of those returns. The goal with alternative investments is to increase or maintain the expected return of a client’s portfolio and simultaneously, reduce the volatility of those returns.

Mortgage investments are categorized as an alternative investment and have been around since 1973. Canadians have poured billions into mortgage investment corporations (MICs) for decades. The ability to generate passive income (most MICs pay dividends monthly) that have been very consistent through any market cycle, historically provides great risk-adjusted returns and can be a strong addition to most portfolios.

When you invest in a MIC, you are buying shares and your capital is loaned out to borrowers by the MIC in the form of a mortgage. Borrowers make their mortgage payments to the MIC, and a portion of those payments are then used to pay dividends.

Introducing: Perch Capital

Perch Capital is a mortgage investment corporation that holds a portfolio of residential mortgage loans. Our objective is to preserve capital and generate stable returns to shareholders.

We leverage the distribution network of our partner Perch Mortgage Brokerage, while also offering a way for retail investors to invest in the mortgage industry.

How does investing in a MIC compare to GICs?

1 to 5-year term GIC rates are currently paying 4.9-5.3% returns with a monthly distribution, whereas MICs are currently delivering net returns in the 6-10% range.

One of the most attractive components of a GIC is that they are guaranteed returns, whereas the MIC has a target return and may not ultimately deliver that return if performance suffers. This highlights the importance of choosing the right MIC, since the fund manager’s skill will be a key determinant in the consistency of your returns.

How does investing in a MIC compare to bonds?

Let’s start with returns over the past decade. MICs have delivered net annual returns of 5-9%, outperforming the annual returns of bonds that are in the 1-4% range.

Similarly to bonds, as an investor in a MIC you are exposed to borrowers going into default. Bonds are typically rated and have more transparency, whereas a private mortgage lender’s default rates are not readily available. The higher the default rate, the higher the expected return to account for the risk.

How does investing in a MIC compare to other real estate investments?

Compared with investing in a rental property, a MIC offers more consistent returns, with less hands-on effort involved.

Investing in a rental property involves considerable risk and highly variable returns. The expected net returns on a property are typically between 0-14% representing a huge range of potential outcomes, depending on how the real estate and rental market perform. Additionally, managing a rental property takes a lot of time and effort, even if a property manager is involved.

A MIC on the other hand provides more consistent annual returns, with exposure to the Canadian real estate market that doesn’t come with the risk of properties losing value.

Who is not well suited to invest in a MIC?

You shouldn’t invest in a MIC if you need immediate access to your capital. When you buy shares in a MIC like Perch Capital, these shares are not traded on a stock market and are subject to resale restrictions under securities legislation.

Redeeming shares require advance notice (typically 60-120 days) and will take time to convert into cash.

What is the level of risk with a MIC?

A loss may occur when two things happen simultaneously: a borrower stops making mortgage payments and the collateral isn’t sufficient to recuperate funds after liquidation. When a borrower stops making payments, the lender will try to work things out if possible and otherwise will initiate power of sale or foreclosure proceedings to seize possession of the property and list it for sale. Upon the sale of the property in default, the lender will aim to recuperate their mortgage, missed payments and all costs associated with the default incurred by the lender.

If the sale proceeds on the property aren’t sufficient to cover that, then the lender could experience a loss and the investors in the mortgage fund would share that loss based on their percentage ownership. That’s why it’s important to ask lenders what their default rates (proportion of their mortgage portfolio that is in arrears) and recovery rates (what percentage of their capital they recover on liquidation) are to get an understanding of their performance.

Keep in mind, a MIC generally offers shorter term mortgages to multiple borrowers, which helps reduce the risk of default.

Why Perch Capital?

There are two key advantages to investing in Perch Capital over other MICs:

  1. Technology: We leverage the technology we’ve built over the past 5 years for our mortgage brokerage to streamline fund operations. This enables us to process and service a larger portfolio, while keeping operational costs lower compared to other mortgage funds. Lower costs enable us to pay higher returns to investors.
  2. Comprehensive risk management: We consider the whole borrower profile in its entirety, in addition to the property value. Most private lenders strictly lend on property value, which we believe forms an incomplete picture. Perch Capital assesses a borrower’s potential to default at origination and after origination to constantly recalibrate the risk profile of their borrowers.
  3. Better risk-adjusted returns: Using standard metrics, our portfolio composition has a lower or comparable risk profile to our competitors, however we pay distributions that are roughly 2% higher than competing funds.

How do I invest with Perch Capital?

To learn more about mortgage fund investing, submit your interest to Perch Capital. You’ll receive additional information and be able to review the opportunity with your wealth advisor, if you use one.

Shares of Perch Capital are eligible for holding in a TFSA or RRSP, meaning you can include mortgage investing as part of your strategy in your registered tax-advantaged accounts.