Last week while checking my email, I spotted an enticing subject line that read; “Learn how YOU can get an 8% secured annual rate of return! Register TODAY!” As a curious investment professional I decided to check this out.
Many of us are familiar with the popular saying; “there’s no such thing as a free lunch”. Essentially, to get one thing that we like, we usually have to give up something else. In finance, the trade-off is between risk and return. For example, the day to day fluctuations in the value of a stock are much larger than those of a government bond. Risk is typically compensated through a higher expected return. The ultimate goal is to have a portfolio of investments that obtains the best return for the amount of risk you are taking.
If I gave you the choice between two guaranteed investment options, one with an annual rate of return of 2.51% and another yielding 8%, which would you choose? I am certain this answer is an obvious one. We all want high returns and low risk.
2.51% is currently the highest 3 year GIC rate available in Canada, as per ratesupermarket.ca. The 8% on the other hand is the highly marketed expected return that relates to a product called a syndicated mortgage investment. If both investments are deemed to be secure, than why is there such a large discrepancy in their projected returns?
The truth is this is nothing more than a clever play on the word “secure”. A syndicated mortgage is an investment that is in the literal sense “secured” by a property. As we have seen in the past decade, real estate has done quite well in Canada. A TD housing report stated that in the past decade, Canadian home prices have risen 7% per year on average. The strong real estate sector has propelled developers to aggressively build properties to capitalize on this trend.
This strong real estate market has also given a boost to syndicated mortgages, which are a method used by developers to finance a portion of the costs associated with the development of new projects. As an investor in a syndicated mortgage, you are acting as a lender to real estate developers. The funding is usually registered against the land on which the property is being built to add security to the investment. In contrast to a regular mortgage, syndicated mortgages usually have a structure similar to a bond, whereby interest is paid yearly and principal is only repaid at maturity.
As an investor this seems like an attractive asset to hold in a diversified portfolio, but this investment should in no way be compared to a “risk free” government bond or a guaranteed investment certificate. As described earlier, in an efficient market there is always a trade-off between the rate of return and the asset’s risk. Evidently, with a return of 8% a year, an investor should be aware of the many risks associated with investing in syndicated mortgages.
The investments “security” is dependent on a strong real estate market
With a booming real estate market these investments have a good probability of paying their promised rate a return, but what if prices stagnate or decline? As we have seen in the US, a drop in real estate prices is a possible scenario. After all, similar to every market, there are peaks and valleys. Something cannot go up indefinitely. Even if the investment is secured by tangible property, if prices drop below the loan value they are unlikely to recover their whole principal. Investors should always look at the loan to value ratio to see how much financing is used in comparison to the projects value, the lower this ratio the better. When there is less leverage, investors in syndicated mortgages can more easily recuperate their funds in the event of a large price crash or liquidation.
Like a corporate bond, default is always a risk.
As is the case for any bond, the promised return is contingent on the company being able to make its interest payments. In the case of a syndicated mortgage, the credit worthiness of the developer is highly important given that the risk of the asset is dependent on the company being able to continue as a going concern and successfully execute its business plan. It is important to analyze the developer’s track record and its history as this will insure your money is going into credible hands.
Investors typically have a choice in regards to the project they wish to help fund. The expected returns are correlated to the risks associated with the chosen real estate venture. Many things can interfere with the developers’ dreams of building the most majestic skyscraper. Before investing, make sure the builder has already received the proper bank financing, zoning rights and government approvals to build. Furthermore, you may want to choose a project that is in a well desired location which improves its chances of success.
Now that you have a more detailed picture of syndicated mortgages, the next time you see a headline offering abnormally high “secure” returns you will be able to take an educated decision that will fit within the context of your portfolio. Always make sure to understand an investment product before signing on the dotted line. If something seems too good to be true, it probably is…