Does private mortgage lending have a place in your portfolio?
This blog post was originally published on May 16, 2022. It was updated on September 20, 2022.
Private mortgage lending investments can be an attractive alternative for today’s market
Recent headlines report a simultaneous decline in values for both stocks and bonds as the latest dilemma for investors. This phenomenon has led some experts to advise that the traditional 60% stock and 40% bond portfolio may be obsolete. While the 60% allocation to equities still works for many long-term investors, they may want to consider other options for the remaining 40%.
Allocating a portion of your portfolio to funds comprised of private loans can be a viable approach to generate returns differing from traditional fixed income and equity-like volatility.
The history of private mortgage lending
So how did private loans come to be considered as a valuable part of investors’ portfolios? And why does private mortgage lending even exist? A walk down memory lane can provide some context.
I started my professional career in commercial banking back in the dark ages – and amid the turmoil of the stock market crash of the late 1980s. As I think back to my early years of lending, I’m reminded of how much things have changed. It now feels like I was selling VHS tapes – a long way from modern-day streaming services. Today, business loans for $200,000 that once required hefty write-ups are approved through a computer algorithm, spreadsheets with thousands of rows of data are created by bots instead of by hand, and well-documented site visits that were once common practice may no longer have a place in a bank’s current delivery model.
Following the 1980s, I spent the next three decades in banking in a variety of roles, from senior lender to bank president to board member, watching the evolution of the lending industry firsthand. Private lenders were always somewhere in the marketplace; however, it was not always an organized part of the industry. These lenders were usually wealthy individuals lending money to other individuals that had circumstances such as poor credit ratings or other issues that prevented them from acquiring bank financing.
Like most industries, banking has experienced significant change in modern times. And the financial crisis of 2008, and the resulting regulatory impact has accelerated that change. The financial cost of regulation alone rendered certain types of loans as financially impractical for banks to provide. The industry has also seen significant consolidation in the past two decades. Since 2000, there has been a 46% decrease in the number of FDIC-insured institutions as former players have merged or been acquired and fewer new banks have joined the industry. In addition, many banks have increasingly focused on creating scale by gearing their process to deals that “fit the box.”
The result is the emergence of a trillion-dollar industry in private mortgage lending. In other words, it used to be the case that private loans existed mainly due to challenges facing borrowers. However, now they exist mainly due to challenges facing banks.
How does private mortgage lending work?
Private lenders operate much like a bank.
Banks take in funds from depositors paying as little as possible in interest and then lend these funds out in the form of loans for which they charge interest. The bank keeps the difference, generating return for their shareholders.
Private lenders take in funds from investors, lend out those funds, and charge a fee for operating the fund. Investors in the fund receive the difference between the rates charged to borrowers and the expenses to operate the fund.
Both banks and private lenders have written loan policies, systems for collecting payments, and audit firms that review their books. Just like any asset category, there is a risk spectrum, often (but not always) with higher returns reflective of higher risk and lower returns of lower risk.
Why private mortgage lending may make sense as part of a portfolio
While every investor has a unique set of circumstances and private mortgage lending may not make sense for every portfolio, there are some compelling reasons to consider this category as part of an allocation:
- Our expectation for yield is in the 8%-9% range, comparing very favorably to traditional fixed income (advisors may charge a management fee for including these assets as part of an advisory relationship)
- Some private mortgage funds are structured as REITs, providing an additional yield enhancement due to favorable income tax treatment under current tax law
- Private mortgage funds are not correlated to equity markets and provide a stable net asset value without fluctuations in market value
- Loans made by the fund are secured by mortgages against real estate recorded in the public record that can be verified by an audit firm
What are some considerations for private mortgage lending investments?
There are certain considerations advisors and investors should take when weighing these types of investments:
- Private mortgage lending funds range in size from tens of millions of dollars to funds in the billions. Bigger does not necessarily mean better. There are many criteria to consider such as management experience, lending policies, types of loans, where they make loans, type of collateral, and performance track record.
- Due to the nature of their operations, these funds have limited liquidity. This limited liquidity accounts for a certain portion of the return; hence, an illiquidity premium.
- Boutique-sized, non-traded, private mortgage lending funds may have voluminous subscription documents and private placement memorandums, and investors must meet minimum net worth or income requirements for accredited investor status.
Most importantly, investors should confirm that their advisor has the knowledge and expertise to perform the necessary due diligence for this type of investment. Not every advisor has the resources to properly evaluate funds that make loans.
As investors look for ways to mitigate risks presented by today’s dilemma of a simultaneous decline in value for both equities and fixed income, private mortgage lending may be a viable option. Investing in private mortgage lending provides an alternative to traditional categories that is relatively low-risk and provides returns significantly higher than fixed income without the market volatility of equities.
Contact us to learn more about private mortgage lending investments and whether they might be a good fit for your portfolio.