Investors must consider regulations, liquidity, taxes and other factors that impact the rate of return.
Options for investors clamoring for yields often include investing in individual assets. Those assets might be dividend-paying stocks, bonds, alternative assets such as mortgages and so on. But there’s another option: investing in pooled funds such as income mutual funds, alternative funds such as REITs, or mortgage pool funds.
Many people aren’t as familiar with the second option—the alternative market. Let’s look specifically at individual deeds of trust with mortgage pool funds.
Often, individual deeds of trust (DOTs) provide a higher coupon than mortgage pool funds (Funds), but there are some specific downsides to choosing individual DOTs instead of Funds.
First, choosing the right DOT takes due diligence and, in many cases, a certain amount of expertise. Investing in extremely conservative DOTs that have LTVs at lower than 25% may not require the investor to have a Ph.D. in economics, but the yields on these types of DOTs are usually much lower than an investor can earn in a Fund. So, an investor has to start looking at less conservative assets in order to produce the desired yield.
Regulations and Liquidity
Another advantage to investing in individual DOTs is the investor can pick and choose which DOT to invest in compared to having the Fund manager choose which mortgage fits the desired yield. This is not much different from an investor choosing to invest in specific stocks instead of investing in a mutual fund.
For some reason, however, the public seems to be more at ease trusting a mutual fund manager than a Fund manager. Could this be because mutual funds are regulated under the Investment Act of 1940? Could it be the relative liquidity of a mutual fund? Could it be the perception that mutual funds are considered regular investments as compared to Funds, which are categorized as alternative investments?
The answer is probably a combination of these. Although most, if not all, Funds are not regulated under the Investment Act of 1940, they are regulated, in most circumstances, by some division of either a federal government authority or the state in which they do business. It is rare that a Fund has no oversight.
Regarding liquidity, most Funds have a lock-up period in which liquidity is either nonexistent or comes with a penalty, similar to an early withdrawal penalty imposed by a bank CD.
After the lock-up period, withdrawals may be somewhat limited by the manager. Some individual DOTs may be able to be liquidated in a secondary market, but most offers, even for high-quality DOTs, are at a discount. A DOT that is 50% LTV or more usually has a substantial discount associated with it should the investor need to liquidate, making liquidation much less desirable and quite a hardship for many investors.
There are some advantages for investing in a Fund (as compared to an individual DOT) that may outweigh the negatives. For one, there is diversification in a Fund, so the risk is spread among many DOTs. Unless the Fund experiences a major disaster, distributions to the investor should be uninterrupted.
With an individual DOT, a default usually means months or possibly a year or longer (as in the case of a bankruptcy by a borrower). If foreclosure proceedings are necessary, the Fund will usually handle them without the investor needing to get involved or having to come up with money to pay the trustee, attorney or other costs. In the case of an individual DOT, the investor/lender has to front these costs. If regular distributions are a must, a Fund is a more conservative route.
Although individual DOTs usually earn a higher interest rate than a Fund (about 1-1.5% on average), Funds may offer the advantage of a reinvestment program. In a reinvestment program, the interest can compound, usually adding about 35 basis points. With an individual DOT, on the other hand, the investor has to take the monthly distribution with no ability to reinvest.
The gap between the interest rates of Funds and DOTs gets even narrower for most investors when income tax is considered. Under the Qualified Business Income Tax Deduction (QBID) introduced in 2018, Congress allowed Funds the benefit of reducing the income that must be reported on an investor’s tax return, subject to certain income limits.
Investing in individual DOTs does not allow for this tax benefit. This 20% reduction in reporting can have a significant impact on the after-tax rate of return of a Fund compared to an individual DOT. For example, if a Fund is paying 7% and an individual DOT is paying 8.5%, the after-tax return, presuming a 40% tax bracket, of the Fund is 4.76%, whereas the DOT’s after-tax return is 4.80%. This 4 basis point difference is not significant, especially if one were to reinvest the distributions in a Fund.
The most important factor nowadays, at least in California, is the continuity of investing in a Fund compared to investing in individual DOTs due to the downtime many investors’ portfolios experience when a loan gets paid off. In these circumstances, the investor usually calls the broker to find another DOT to invest in. The investor may be told there are no good loans to look at for the moment. The investor is asked to be patient or may be forced to look at lesser quality DOTs.
There is tremendous pressure in the market right now for loans to fund because there is significant capital looking for a home. This competition for loans has driven down interest rates and, therefore, what an investor can earn on a DOT. The competition has also added to the length of time needed to reinvest capital that has been returned due to payoffs from borrowers.
When you consider the time value of money, this delay in redeploying capital can significantly lower the net, after-tax, rate of return investors desire. Money that is not deployed in new DOTs and that sits idle in low-earning bank accounts brings the net yield down for the investor.
For example, if an investor desires an 8% return on an individual DOT, having money sit idle for three months at 1% produces a pretax return of 6.25% for the year. Money sitting idle for four months lowers the net yield to 5.67%.
In addition, in many cases, Funds snap up the better DOTs, leaving the loans of lesser quality available for individual investors. The main reason for this is that Funds want to produce steady, uninterrupted returns for their investors. They usually desire to avoid loans that have a more likely default rate, even if the yield could be higher by taking on a bit more risk. Some investors lower their quality investing standard in order to keep their money working. Investors therefore must carefully consider whether the benefits of investing in individual DOTs outweighs the benefits of investing in a Fund.