This article appeared in the Australian Financial Review.

Specialist mortgage funds paying returns of up to 9 per cent are a magnet for income-starved investors seeking multiple times what they are earning from blue chip dividends or fixed term accounts.

Providers such as Australian Unity claim there has recently been a four-fold monthly increase in investments, particularly from retirees seeking low-risk, sustainable income sustainable income sustainable income sustainable income sustainable income.

So-called contributory mortgage funds allow investors to acquire a fractional interest in a mortgage to a developer building anything from townhouses and apartments to small commercial buildings. Developers keen to start or complete projects are willing to pay rates of about 11 per cent for loans they can’t get from the banks.

The negative economic effects of coronavirus have not as yet had a material effect on sector performance.
— Louis Christopher, SQM managing director

Contributory mortgage funds allow investors to choose a development, offering more control than a pooled fund where money is put in a large fund and spread across many investments.

But investors need to find the mortgage investments that match their goals and appetite for risk, and be aware that they could lose some – or all – of their money if something goes wrong.

Chris Andrews, chief investment officer at La Trobe Financial Group’s Australian Credit Fund, which has $5 billion under management, says investors need to be confident in the security of their capital and the sustainability of the return.

“Investors should be asking their provider or adviser about due diligence being done to qualify the borrower for a loan,” Andrews says. “Unlike funds that pool investments, a contributory fund invests directly into individual loans.”

A squeeze on savings is encouraging many investors to seek alternatives. Those relying on investments to generate an income, particularly retirees, are facing a crisis as returns from dividends, savings and fixed term deposits continue to shrink.

The Reserve Bank of Australia cash rate has fallen to 0.25 per cent and the 10-year government bond yield is 0.87 per cent. The top rate for a $100,000 12-month term deposit is 1.65 per cent from Judo, ME and Qudos banks. Returns on 12-month term average deposits average about 1.17 per cent. Dividends from blue chip stocks such as NAB and ANZ have been cut or suspended.

Investments in mortgage trusts – which include pooled mortgage funds, contributory funds and other related funds – have grown by between 30 and 40 per cent over the past 12 months to more than $15 billion, according to SQM Research, which monitors property markets.

These managers are exploiting a sweet spot for lending that was vacated by the major banks.
— Christopher Foster-Ramsay, Foster Ramsay Finance principal.

“The negative economic effects of coronavirus have not as yet had a material effect on sector performance,” says SQM managing director Louis Christopher. “This is quite a contrast to the global financial crisis in 2008 where there was a run on the sector, with many trusts suspending redemptions and distributions. In this downturn we are not seeing any significant outflows and so far distributions have not been cut.”

But crunch time for the property and mortgage sector could be from October to March, when government income support schemes lapse and home loan repayment suspension is lifted.The sector is also being hit by rising unemployment and falling immigration.

Investors in contributory funds have an exposure to the loan in the proportion that each contributed capital. They are entitled to interest income and a return of capital from the syndicate fund.

Key providers include La Trobe Financial Group, which has about $11 billion under management across various asset classes and is 80 per cent owned by Blackstone, the world’s largest alternative asset manager.

Products from other established providers include Australian Unity’s Select Mortgage Fund, Balmain Private’s Discrete Mortgage Income Trust and RF Eclipse’s Select Credit Growth.

“These managers are exploiting a sweet spot for lending that was vacated by the major banks,” says Christopher Foster-Ramsay, principal of mortgage broker Foster Ramsay Finance.

Finding bank finance has been difficult for developers who are looking for alternative sources, he says.

The loans are generally provided at a higher price than the bank would charge. After the manager has deducted fees, the returns should be between 5 per cent and 9 per cent per annum on conservatively geared loans, on typical loan to valuation ratios of between 50 per and 75 per cent.

For example, each Australian Unity individual investment – or syndicate fund – is secured by a registered first mortgage over real property assets, which means that if the investment gets into hot water the first mortgage holder gets paid out first.

Generally its investments are geared to a maximum of 70 per cent and each investment must receive credit approval from Australian Unity.

Take small steps and do not focus solely on yield.
— Chris Andrews, La Trobe Financial Group chief investment officer

Roy Prasad, general manager mortgages at Australian Unity, who has more than 30 years of experience managing projects, says: “Within the Select Income Fund there are a number of sub-funds so an investor can pick a project.”

Higher rates can be earned on second mortgages, or mezzanine finance, but risks increase.

Key questions investors should be asking their provider or adviser include:

• What is the manager’s criteria for lending money? How does it assess the borrower’s capacity to repay the loan?
• Details of the loan-to-value (LVR) ratio, including how the funds can be drawn down and dates of completion.
• What is the valuation policy?
• Check how often distributions are made and when capital is returned. Can you accept the risk of losing your capital?

Some investors may decide to invest in particular cities or in syndicates where the underlying collateral has an LVR of no more than 60 per cent.

La Trobe’s Andrews, who manages $500 million in contributory mortgages, says: “Sustainability is driven by the quality of the borrower.”

That means focusing on the “five c’s of credit” – borrower’s character, capacity to service the loan, collateral security, capital position and the conditions put on the loan by the manager – he says.

He also recommends investors build a diversified portfolio to spread risk. “Take small steps and do not focus solely on yield,” he says.

Investors should beware of fringe operators, many of whom use offers of lucrative returns to lure the gullible or desperate.

The Australian Securities and Investments Commission, the nation’s security regulator, has recently taken action against non-bank lending schemes promising high returns that attempt to create a false sense of security for investors by using phrases such as term deposit, certainty, fixed term and bank deposit.

“Investors should be wary of investments that claim they are an alternative to a bank ‘term deposit’. If an investment provides higher returns than a term deposit, it is likely to be a higher risk,” a spokesman for the regulator says.