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Have you ever heard someone say, “I’ve worked so hard to grow my nest egg and just can’t afford to lose even a portion of it in this market…but what can I invest in?” These investors are seeking an attractive return where there is a low risk of losing their principal. That’s the sentiment of many investors today, especially those within 10 years of retirement. With losses exceeding 30% over the past few years from the stock market, keeping an investment simple and objectively limiting downside risk is a priority now more than ever. This is why many savvy investors have left Wall Street and are utilizing self-directed retirement accounts to invest in private mortgage loans.

The challenge with most traditional Wall Street investments is that there is no limit to how much principal an individual can loose on any particular investment. Of course some investments are guaranteed by insurance companies, or even guaranteed by the U.S. Government via a mortgage backed security from Fannie Mae or Freddie Mac. In a scenario where the investment income stream is guaranteed, that guarantee is based on the credit risk and wherewithal of the entity guaranteeing the loan - it is not directly secured by a tangible asset.
 
While the current fiscal cliff and swelling federal debt are important issues, there’s not an imminent credit default risk for a mortgage backed security guaranteed by our government. Sounds like a reasonable place to park some excess investment dollars right? Suppose you do, and receive a 2%-3% return on a mortgage backed security. Your interest yield will soon be eclipsed by inflation as the U.S. government will print dollars to pay its obligations. When interest rates rise, more dollars will be printed because the government’s cost of borrowing will also increase. Inflation and interest rate increases will put downward pressure on the face value of longer term mortgage backed securities. This scenario will present bondholders with the proposition of selling their mortgage backed securities at less than face value - incurring a loss in order to liquidate their investment.
 
How is a private mortgage loan superior to a bond fund or other traditional fixed-income investment?
 
Less Volatile

Unlike the stock or bond market, there are not real time dynamic financial changes that affect the yield on private mortgage loans. Either the interest is paid as agreed by the borrower, which is typically the case, or if a default occurs there should be more than enough value in the asset to recover the principal invested plus a margin of profit.

Asset Specific

When you purchase shares in a mutual fund, your money is pooled with thousands of other investors, and is then spread out into dozens of different companies around the country or world. If there is a strong demand for liquidity by investors in the same investment, the value of that investment can fall sharply with a sell-off event. By investing in private mortgage loans, the indebtedness is secured to a specific asset, such as a commercial building or investment property. While private mortgage loans are less liquid than a publicly traded investment, investors have greater control to safeguard their original principal invested.

Income Generating Asset

Most traditional investments are primarily valued in relation to their liquidity and ability to provide an income stream in the form of dividends or interest payment, or for stocks the potential for equity appreciation. With private mortgage loans, the amount of rent and expenses for the property (asset) are known and taken into account during the loan underwriting process.

For example, our fund, Island View Private Loan Fund, LP, recently funded a $33,000 loan on a $60,000 townhome in the Washington D.C. metro area. Our exposure on this loan was 55% of the current appraised value, however, the property also generates over $13,000 in annual net rental income. This rental income easily covers the loan payment and expenses for the property.

So, in the unlikely event the borrower defaults on their loan payments, the property would be foreclosed upon. Once the foreclosure took place, assuming a $3,000 legal cost to complete the foreclosure, the total investment cost for us would be $36,000 ($33,000 loan + $3,000 legal expense). However, assuming it can produce rental income at its current level, the investment would yield a 30%+ net annual return on investment based upon the amount of capital invested. This 30%+ net annual return would be from rental income alone, and doesn’t include profit from the resale of the property. This return would more than make up for the lost time of interest income while the property was foreclosed on.

Cushion of Equity Value

Unlike paying the current value for a stock, bond or other investment, a private mortgage loan typically is not made above 65% of the value of the property. In the event of a default, the discounted value of the asset becomes the investment basis by the investor who made the private mortgage loan. This allows the private mortgage loan investor to inadvertently acquire the asset at a fraction of the actual market value. The excess equity in the property could be realized as a gain through a resale of the property.        

Shorter Term

Traditional mortgage backed securities offered by Fannie Mae and Freddie Mac offer low interest rate notes for up to thirty years at 2.50%-3.50%. This sets up a similar scenario as the Savings and Loan crisis of the 1980’s, where the banks had a negative yield on their investments as interest rates increased. If savings account rates go up to 7%, you will be selling a 3.0% 30 year fixed mortgage backed security at a steep discount from its face value and taking the loss as a private investor. There will be no subsidy by the U.S. government to recoup your loss. In contrast, private mortgage loans are less than ten years in duration, and carry a mid to high single digit rate of interest. Since there is no readily secondary market for private mortgage loans, though, an investor should plan to hold the loan without the need to liquidate the investment before the maturity date. There are options to resell existing loans, but often that requires the investor to sell the loan at a discount off face value.