What GEMI Capital’s challenges can teach us about selecting mortgage funds

The mortgage fund asset class has grown and matured in recent years. For good reason. Mortgage funds often offer investors attractive risk-adjusted returns by virtue of their superior yields. But as with all asset classes, not all mortgage funds are created equal. The recent challenges experienced by GEMI Capital’s investors provide a timely reminder of what can go wrong in this asset class.

With outperformance in mind, we highlight below the 6 boxes mortgage fund investors should aim to tick prior to investment…

GEMI Capital’s challenges highlight the risks

Mortgage fund manager GEMI Capital has lent more than $3 billion to property projects since its launch and currently has more than $800 million of loans in the market. So they’re a reasonably large player in the mortgage fund sector.

Whilst there’s a scarcity of public information about what’s currently happening, we know that GEMI Capital’s interest payments and redemptions have recently been frozen.

The freezing of redemptions is sometimes understandable since mortgage funds are an illiquid asset class and fund cash levels often depend upon the timing of loan repayments. But the freezing of a mortgage fund’s interest payments is a warning signal that more significant problems may be afoot.

In the words of MC Lawyers managing director Milan Cakic: ‘These kind of events are a cornerstone of most investment failures. We’re concerned in due course there will be a corporate failure and an investment failure. When that occurs is anyone’s guess.’

Mr Cakic is concerned that GEMI Capital investors were ‘enticed into acquiring GEMI financial products based upon misleading and/or deceptive information from Information Memoranda or their broker/financial adviser.’

That’s a matter for the lawyers, but the case provides raises the timely question of what investors should look for in their prospective mortgage funds so as to avoid these types of challenges.

A role to play for income investors

Mortgage funds invest in a range of residential, commercial, and industrial property loans which haven’t been funded by traditional lenders. The yields on offer are generally higher than for traditional lending products, so these funds are often popular with income investors.

Investors can choose between contributory mortgage funds and pooled mortgage funds. Contributory funds are invested in the mortgages of a property developer, whereas pooled funds invest in a pool of projects managed by a fund manager.

The mortgage fund sector reinvented itself after the global financial crisis with regulators introducing tougher monitoring to better protect investors. In more recent years, it’s been common for financial advisers to recommend their clients invest up to 10% of their portfolios in well-researched mortgage funds due to the attractive yields on offer.

The mortgage fund boxes to tick

So what are the boxes mortgage funds should tick prior to investors committing capital? Here are 6 of the most important:

1. Solid manager track record – A fund manager’s track record is important in all asset classes but it’s particularly important in mortgage fund investing due to the unique complexities of project management, building approvals, and construction in general. So it’s worthwhile doing your research to find the managers with the necessary experience and market understanding to invest in mortgages which deliver on expectations. Tell-tale signs of high quality mortgage fund managers are: long term track records of generating solid risk-adjusted returns in high quality assets, deep connections and experience in the property development sector, and an emphasis on clear and open investor communication.

2. Conservative loan-to-value – Most mortgage funds maintain loan-to-value ratios of below 75% to ensure their funds aren’t exposed to projects which won’t ensure a return of the principal payment. Investors should keep a close eye on this ratio since it provides valuable insight into how risky the funds’ loans are.

3. Independent valuations – An arms-length independent valuation of the assets being mortgaged is an important box to tick, and one not all mortgage funds are able to provide. Without independent valuations, it’s impossible for investors to effectively gauge the risk of lending against those assets.

4. Well-communicated liquidity options – Not all mortgage funds are able to offer full liquidity for investors all of the time due to the timings of the loans within the fund. Some pooled mortgage funds maintain a minimum cash balance to allow limited liquidity for investors, although it may take up to a year to receive your funds back. The key for investors is to understand a fund’s liquidity options prior to investing. If the liquidity options are limited or non-existent, you’ll want to ensure that you’re only investing funds you can tie up for the fund’s entire investment timeframe.

5. Expected returns aligned with high quality assets – Investors are often tempted to invest in the mortgage funds which are offering the highest returns. This is not always the most prudent decision because higher returns generally reflect higher risks. In the property development world, the higher risk end of the market is littered with examples of project failures. As such, it’s often prudent to invest in the mortgage funds which offer solid risk-adjusted returns for investing in higher quality assets—but which don’t necessarily offer the highest available returns.

6. Diversification – Investing in a mortgage fund which is diversified across projects, asset sizes, geographies, and types of borrowers is generally a sensible strategy. If one project fails, these types of funds are generally well placed to continue paying interest to their investors.

High quality information on these issues is your friend during the due diligence process. The best starting point is generally a fund’s information memorandum or product disclosure statement. If you have outstanding questions after reading it, it’s generally worthwhile asking the fund manager.

A staple income-generating asset class

Mortgage funds are here to stay as a staple income-generating asset class. When you’re assessing prospective mortgage funds for your portfolios, it pays to do your research to ensure you’re investing with professional managers with the requisite experience. The mortgage funds which tick the above-mentioned 6 boxes are likely (but not guaranteed) to deliver on your expectations.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.