Tuesday, November 25, 2008

Mortgage Investing Attractive Option to Stock Market Investing

Given the recent upheaval in the global stock market, many of us who thought their investments were safe because they own balanced mutual funds and blue chip stocks have of late, found that a substantial amount of their life savings has eroded. If you’re one of these people, what should you do? Should you cash in your mutual funds, sell your stocks and instead buy bonds and GICs? Selling low and locking in your losses is never a good strategy, but if you’re someone who has been losing a lot of sleep at night, and if you find you’re a bit frantic about checking out the daily financial reports, you may want to consider balancing out your portfolio with good quality, income producing mortgages.

One of the purported benefits of the mutual funds that many of us currently hold in our investment portfolios is that investment professionals take care of the stock picking for you. The average person doesn’t have the time to analyze individual companies and then figure out if the stock is underpriced or overpriced. An investment professional will take care of balancing your portfolio too, making sure that you have a balance of stocks and bonds, to level out the performance of the portfolio. Your mutual fund is probably also diversified by industry. The theory is that when one sector goes through a slump, better performance in another will keep your portfolio from bottoming out. Recently I have spoken with a lot of people at a loss, who have seen the value of their balanced, diversified portfolios shrink 30, 40 and in some cases as much as 50% since their peak.

Let me explain how mortgage investing works, what kind of returns you are likely to achieve and what the risks are. With mortgage investing you can see and touch the underlying asset that your loan is secured by, and without a lot of training and expertise, you can make a reasonable assessment about the value of the property. Where is the property located and what is its’ use? What condition is the property in and how much income can the property generate? You will also want to know something about the borrower and his or her ability to repay.

Private 1st mortgages will usually generate a return of around 8-9% while higher risk, second mortgages will give you a return of 10-12%.

There are risks associated with mortgage investing that you should know about. If the borrower stops making his mortgage payments and if in an economic downturn the value of the property drops below the sum of the mortgage(s) on the property, you could lose part or all of your investment. Second mortgages are a higher risk than 1st mortgages because the 1st mortgagee has the 1st claim to the property. As a rule of thumb, you should not lend more than 75% of the value of the property. That way, even if the property drops in value by 20%, your investment is safe, allowing an additional 5% margin for legal and selling costs.

It is important to note that if the property owner stops paying the mortgage, the mortgagee (the investor) has a right to foreclose on the property. In the late 80’s when interest rates were as high as 18-20% and a lot of people could not afford to pay their mortgages, a number of mortgage investors acquired substantial real estate holdings. When real estate values eventually started to go up, they made a nice profit on their holdings.

Although from a tax perspective mortgages are the least desirable because the income is 100% taxable in comparison to stock dividends and capital gains, you can defer the taxes by putting your mortgage investment into your RRSP. Jason Heath from E.E.S. Financial in Markham says that as a rule of thumb, given the costs involved in setting up a mortgage in your RRSP, the investment should be at least $75,000 for it to be worthwhile. The downside of putting the mortgage in the RRSP is that if you lose on the investment, you won’t get that RRSP room back.

If you would like to learn more about mortgage investing, call me at 416 876 2031, or send an e-mail to david@mortgagemensch.ca, and I'll keep you up to date with investment opportunities as they arise.
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