Insights Series: Mortgage Funds – Income Backed by Property

Hello, I'm Darren Connolly, CEO at Investment Markets, and I'd like to welcome you to The Super Six. Six experts, six asset classes, and one outlook for your investment portfolio. Before we start, however, I need to remind you that this is all general advice and general information only, and nothing that you see or hear should be construed as an investment recommendation. You will need to decide what is right for you. With me today is our expert on mortgage funds, John Zanetti, Head of Investor Capital at 268 Fund. Welcome, John.

Thanks for having me, Darren.

Now, John, within mortgage funds, what have been the main themes in this asset class in the last 12 months?

Well, Darren, I think the main thematic has been the continued popularity of mortgage funds, and that's become, you know, by the tighter capital requirements on banks. We've seen the banks withdraw from the mid-market and the non-standard lending, and this has opened the door for non-bank lenders such as ourselves and mortgage funds to step in, particularly in the residential and small to mid-scale construction. The big four banks have dominated the commercial lending space in this country up until the Royal Commission.

Since forever.

Since forever, correct. But with the implementation of those tighter lending practices, many developers find it difficult now to secure the funding that they need and complete their projects. So the ecosystem has changed a little, and now there's different ways to attract that funding. Banks are still there, certainly, but other sources of capital come along via institutions, high net worth individuals, family offices and wholesale investors. And that's where 268 comes in to play our part. The new ecosystem has certainly created demand for alternative lending, particularly short-term bridging finance and bespoke construction loans. Our finance arm, which is called ACM Finance, they originate all the transactions for us and they see deal flows in excess of a billion dollars per annum.

That is a huge amount, John.

Especially for someone of our size, and we're one of many providers out there, so it's quite incredible, the demand for that sort of lending.

And if I can ask, how do the developers find you, or how does your team find the developers? How do people connect in this environment?

Yeah, a lot of it comes from brokers. So we get recommendations or introductions via brokers, but also platforms like yourself as well, Darren, which plays a big part in us bringing borrowers and investors together. So we love being part of your platform.

Similar mission, John. It's connecting capital and opportunity.

Yeah, absolutely Darren. And there are a lot of investors out there seeking high yielding income, which is secured by Australian property. And that's where mortgage funds play a great part.

What separates your approach, 268 Funds, from other players within this new ecosystem?

Yeah, what separates 268 Fund from other mortgage funds is we don't chase growth at the cost of risk. We prioritise capital preservation and that has to be the number one game for all mortgage funds.

It's certainly a focus for all investors in mortgage funds.

Yes, 100% Darren. All loans need to pass our quality assurance methodologies and they need to be stress tested as well. And this is all done by a very highly skilled team back at our office. And these are all, again, stress tested and gone through those methodologies before being released as a viable investment option. We align with our investors so we co-invest in every opportunity and we maintain full transparency of the loan for the duration of the investment. We don't pool your money. Each investment opportunity stands alone in a separate unit trust fund. And the investor decides if that investment opportunity suits their risk profiles.

So they get to actually pick the loan that they're investing in, is that correct?

That is correct, Darren. So we release a detailed information memorandum on every opportunity. and each investor gets to assess that document and then they decide whether they want to participate in that investment opportunity. So as a lender, you're not a passive observer. We're actively involved in structuring the deals. We're continually monitoring the underlying asset and we're also managing the risk. We're hands-on, we're transparent, and we want to ensure that there is a happy ecosystem from the borrower right through to the investor. So again, I can't stress highly enough how important it is for capital preservation to be the name of the game.

And I think the investors would obviously take comfort, John, in the fact that your team has skin in the game. They're involved. They are invested in the actual products themselves.

I think it's very important. You're supporting the product. You're putting your money where you believe it's a great investment opportunity. And it gives comfort to the investors. And it's generally around 20% of the total investment loan. So it's quite substantial.

There's a vested interested in making sure it all goes well, I think, John.

Yes, absolutely Darren.

How should investors think about mortgage funds within the context of their investment portfolio?

Darren, what investors should be looking for when investing in a mortgage fund is definitely a strong track record from the fund manager, transparency about the loan and making sure the investment fits within their risk profiles, which is really important. Other things that they potentially should consider is the experience of the lending team, especially in managing defaults and contingencies. It's really important. We've seen a few different situations arise over the last 24 months. Has the fund always returned investor capital and the interest owed?

Can I ask that question, John? Has the fund always returned the capital?

A hundred percent. So in the 20 years that the co-founders have been running managed funds, they've always paid investor capital and always paid the interest owed. So it's a feather in our cap to be able to get in front of clients and say, this has been the past and we believe it will last well into the future.

Fantastic track record, John.

Yeah, thank you. We don't take that lightly. A couple of other things that you could consider Darren is how frequently the fund pays income and whether returns are targeted, fixed or variable. Look at the valuation process. Does the fund get independent valuations? It's really important that we're looking at a value that is reasonable. And also ensure that the fund only lends to credit worthy borrowers. And also that the mortgages have, that the loans have mortgages over the security properties. That's really important.

And how would an investor find that out?

It'll be in the information memorandum that we issue and their questions that should be directed at other managed funds as well, if you're looking at another managed fund. So these are some of the considerations that they should get into detail, even with a borrower. Do your research, get on everyone's friend, Mr. Google, and put that name in there and if it comes up, it probably shouldn't be invested into. So creditworthy borrowers are certainly part of that healthy ecosystem that I was talking about.

So John, what should investors who may have a conservative risk profile, what should they consider when investing in this asset class?

Yeah Darren, it's important that everyone assesses their own risk profiles. So there is a risk reward in mortgage funds. And it depends where you invest in that capital stack. So you can have first mortgages, you can have second mortgages and you can have preferred equity transactions. So the higher up you go in that capital stack, it's more risky. So someone with a conservative profile should probably stay in that first mortgage zone where you have first mortgage over the underlying security. you rank ahead of anybody else before the developer, before any other creditors, if something goes wrong with that investment loan. So, they're generally returning anything from 8% to 10% in current market conditions, but you know where you sit in that capital stack. You're first in line if something goes wrong with the underlying investment.

What should investors who've got a more balanced risk profile consider when investing in this asset class?

Yes, Darren, I think when you've got a more balanced view on your portfolio, it's really important to diversify. And having mortgage funds as part of that portfolio really does contribute to that diversification. A lot of portfolios these days, in particular in wholesale investors that we actively work with, they're looking at having 20 to 30% of mortgage funds invested in their portfolio. They're secure by Australian property and they're also generating consistent monthly income if you're investing with 268. So having that diversification away from your standard bonds and equities provides you with the comfort that you're looking for as part of a very broad and rounded portfolio.

John, what is the outlook for mortgage funds as an asset class? What gets you excited about it?

Darren, I think the outlook for mortgage funds remains very strong. I think the potential to add to the growth that I mentioned earlier really excites me. Non-bank lenders are becoming a very important part of the ecosystem. Alongside the banks, they've had to de-risk, but they're still playing a part. If you look at the US and the UK, over 50% of lending in the commercial space is done by the non-bank.

That's a huge amount.

huge amount. Here in Australia, it's only 10%.

That's a small amount.

That's a small amount. So, with record immigration and under supply of housing and approval rates which are fairly low across the nation, I think the growth in the asset class still has a long way to go. Mortgage funds are one of those few asset classes where you can genuinely structure the downside risk through your prudential lending practices. You can take control of your entry point by adjusting the LVR. You can set the return upfront by the interest rate that you lend at. And you can even mitigate the volatility by short-term loans and asset-backed security on each loan. Uh so mortgage funds are definitely having a moment in the sun. Like other alternative investments. They offer portfolio diversification which I mentioned before. And we don't really see that catastrophic event that really impacts the industry. We've been through COVID, we've been through GFC, we've been through geopolitical events, and nothing has hindered property prices. We're also leveraged to our house. Would the government allow a catastrophic event? Probably not. Our analysis at this point in time says it's not happening. It's not happening in the future. So we're very, very bullish on the sector and the growth of the industry.

Looks like the asset class has got a long way to run, John.

Yes. If you look at those numbers that I rattled off earlier about our other countries, US and UK, I think if we take on that sort of growth, we're looking at some fun times for a long time to come.

A key role to play in investors' portfolios if they so choose to look at this asset class.

Yeah, look, they offer a great risk-adjusted return when managed well. They're income-generating, so there's a lot of smart money going into the industry and into the managed funds, so we see that continuing for quite some time.

John, great insights. Thanks for giving us a bit more about mortgage funds. Thank you for your time today.

Darren, pleasure being here. Thanks for having me.

Thank you for watching. For more insights from the Super Six and to search, find and compare hundreds of investment products all in the one place for free, go to investmentmarkets.com.au.