Mortgage Pools - Jump In, The Water’s Fine

I often get questions from potential investors about the basic functions of a mortgage fund (aka a mortgage pool). Therefore, I’ve decided to write about mortgage pools in general to clear up any misconceptions.

Mortgage pools are securities that are required by state and federal agencies to provide complete and full disclosure through an offering memorandum. A mortgage pool is a collection of capital contributions from many investors and is usually in the form of a limited liability company that sells shares. The investment pool of capital is then used to purchase a number of different loans, which are commonly called mortgages or trust deeds, and secured by real estate.

There are basically three ways to invest in mortgages, and regardless of a person's real estate or investment acumen, there is a mortgage investment option available today that fits their investment portfolio. The three ways are: funding a mortgage directly, participating in a multi-lender or syndicated specific mortgage, or by investing in a mortgage pool.

The purpose of a mortgage pool is to create a long-term investment vehicle that provides for the fund’s management and a favorable rate of return to investors, while providing them with a diversification of risk and stability. Also, mortgage pools are redeemable on relatively short notice so they offer more liquidity than a direct mortgage or syndication.

For investors who don't have the real estate expertise and don't want to commit the time and energy to learn, the best route is to find a company that offers mortgage pools, like The Grace Fund LLC. These companies employ the services of a manager and administrator of the mortgage pool on the investor's behalf who furnishes the investor with a monthly statement to keep them informed of their account balance, current yield and other details. The mortgage fund manager is paid a modest fee to research the proposal, make the lending decisions and handle all of the payments and administration. Fees earned by the manager are not paid by the investor, but rather a percentage of the income earned on the mortgages and servicing fees charged to the borrower.

These mortgage pools work through a four-step process: 1) investors purchase shares of a company; 2) the company purchases a number of qualified trust deed investments or mortgages; 3) the trust deeds and mortgages provide a return to the company and; 4) the company distributes a return to the investors from monthly cash flow, or growth through a Distribution Reinvestment Plan instead of taking a monthly payment.

Investing in the mortgage market can be a solid option for investors who want to benefit from the commercial real estate market without actually buying real property. In the past couple of years, returns of 10% to 12% or more in mortgage pools - compared to 3-4% for more mainstream investments - have been common. The pool is continuously managed with a primary objective of securing new mortgages to replace mortgages that mature, thus insuring investors a steady stream of passive income.

Monthly income from most mortgage pools usually varies as interest rates change or when mortgages are paid off. The returns to investors from the mortgage pool would follow market interest rate increases or decreases. The investor in a mortgage pool earns a blended rate of return on investment based on the interest earned from each respective mortgage. However, in the case of an investment in The Grace Fund, monthly distributions of 1.25% (15% annualized) are made to investors. To achieve the higher return, the Grace Fund mortgages are fixed at 15.5% annual interest to the borrower, an affiliate of Grace Realty Group. The higher rate reflects a premium to distinguish The Grace Fund from the many competitors vying for investor dollars in the marketplace.

I believe the most convenient, effortless and safest method for the average investor to invest in a debt instrument is through a mortgage pool. They pool their money by buying shares in the fund, and the interest earned from the mortgage payments received from the borrowers becomes income for the fund. All income earned is distributed to shareholders according to their proportional interest. Simple.

Similar to a mutual fund, a mortgage pool provides a vehicle to diversify a portfolio of investments - in this case, mortgages instead of stocks or bonds. Investing $50,000 in a mortgage pool consisting of 25 loans valued at $15 million provides better security through diversification than a $50,000 investment in a single loan secured by a single property.
Unlike a mutual fund, mortgage funds are secured by real estate and not subject to the same volatility as the stock market. Most mortgage pools are backed by well-underwritten and well-secured real estate loans. This is particularly true when the mortgages are secured by property that is financed at a very low loan-to-value ratio. To further mitigate risk, additional security is realized when the borrower purchases properties at a price far below their replacement cost with considerable value-added possibilities (buy low, fix up and sell strategy).

Another advantage to mortgage pools is that they are very suitable for most tax-deferred savings accounts including IRAs and 401ks, making them a good fit for future retirees or anybody else on a fixed income. An investment in a mortgage pool should be considered for inclusion in every serious investor’s portfolio.

CONTRARIAN (LOGICAL) COMMERCIAL REAL ESTATE INVESTING NOT FOR THE TIMID

After viewing the graph above, ask yourself these questions: "When the market is down (Recession Phase) what is the only direction it can go?" and "When the market is up (Expansion Phase) what is the only direction it can go?”

Some commercial real estate investors are able to consistently earn big profits due to the fluctuations common to the industry. Who are they and how do they do it? They are contrarian investors, who know when to buy and when to sell by identifying and understanding the phases of real estate market cycles. It also helps to have nerves of steel.

Like any business, real estate is subject to certain market forces that affect values. The life-blood of commercial real estate is affordable financing for the acquisition, development, redevelopment and refinancing of improved properties. The availability of financing is determined by the overall economy, overbuilding, interest rates, market perception (right or wrong), unemployment and, of course, local product supply and demand. Real estate prices can fluctuate wildly as these factors exert their influence. Historically, real estate cycles typically have an average duration of six to nine years. There are four distinct phases to a commercial real estate cycle including Recession, Recovery, Expansion and Contraction.

Recession. The Recession Phase follows a market contraction, when the availability of financing has dried up and property values have fallen. Properties experience vacancies and owners cannot sell or refinance as financing has become unavailable. Prices fall far below the cost to construct the same facility new (the cycle’s benchmark), resulting in many good buying opportunities for those with the liquidity to take advantage of market weakness. Foreclosures increase and property owners become even more motivated to sell as investors sit on the sidelines. The longer the Recession Phase drags on, the lower prices usually go. This is the time to buy.

Expansion. The real estate market is humming along and equity investors are plentiful.
Institutional financing is readily available and the price of improved real estate moves up well over the cost to construct the same facility new. Vacancies are at their lowest, prices are at their peak, and there is a general feeling of well-being, prosperity and abundance. This is the time to sell.

Contraction. It is during the Contraction Phase that reality sets in. The market has become overbuilt and vacancies are on the rise. Financing and equity investment withdraw from the marketplace as delinquency rates rise. Prices begin to fall from the peaks of the expansion phase. Investors rush to exit the market, causing prices to fall with increasing speed.

Recovery. In this phase, excesses have been wrung from the market and prices begin to recover, although most investors are still afraid to make a move. New tenants enter the market and property owners refinance as affordable institutional money becomes available. Prices begin to move up. This is the time for owners to improve their property, maximize rental rates and wait for the next phase.

The phases of a real estate cycle, as seen in the graph, are always in the same order, the only differences being the duration of a phase and longevity of a cycle. By determining the current phase and locating it on the graph we can logically anticipate where we're headed, taking a great deal of the guesswork out of the equation.

To the real estate investor the most important question is, "When do I buy and when do I sell?" This is the point where we find out if we are contrarian investors or just one of the herd. While the market is still in the Recession Phase the stage is set to reap the biggest profits later on, at or near the top of the Expansion Phase. Recognizing market trends will give us the confidence to move forward at a time when others in the marketplace are frozen with fear.

It's Like Deja Vu All Over Again

Baseball great Yogi Berra’s famous quote certainly applies to today’s real estate market. In the late 1980’s and early 90’s, the U.S. experienced a devastating downturn in the commercial real estate market. It lasted over five years and, although many investors lost huge sums of money, there were a few savvy investors who bought properties for pennies on the dollar. Sound familiar?

In the 1990’s, the government formed the Resolution Trust Corporation (RTC) to take over thousands of Savings & Loans, called their loans due and sold the ensuing foreclosures for chump change. Because there was almost no institutional financing available, investors with cash were able to take advantage of the opportunity this “down” market offered.

At that time, Chicago’s Sam Zell created a new investment product called The Vulture Fund with $409 million of investor capital to get ready for the buying opportunities to come (today this type of fund is known by its politically correct name: Opportunity Fund). He bought as much property as he could and made billions of dollars when he sold out in the late 90’s.

At the turn of the century there was another downturn and it was a repeat performance for Zell and others who again snapped up bargains. Prices shot up until 2006, and he sold out again. Now that we’re in another downturn, guess what Zell’s up to? He’s recently been in the news because he’s doing a repeat performance, buying well below the replacement cost of the property, a tactic that has served him well over the years. He knows that nobody can compete with the rents he can charge tenants and still maintain good cash flow. His winning strategy and track record speaks for itself. He simply takes advantage of a normal cycle in the real estate market.

Today’s cycle is a bit different, though. Commercial properties are not overbuilt (as in the 80’s), so occupancy levels are still high. However, institutional credit has dried up, even for commercial properties, because of the subprime mortgage mess. This lack of liquidity has created some very good bargains for those who can muster the cash. Motivated sellers are willing to provide affordable financing if the buyer can put a sizable down payment on the table. Cash is king these days.

I believe this market represents an extraordinary opportunity for investors to cash in big time. If you believe that the real estate cycle depicted in the graph above makes sense, and agree we’re now in the Recession quadrant of the current cycle, you now have the chance to put Sam Zell’s strategy to work.