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A mortgage investment corporation (MIC) is an investment structure that pools investor capital to fund mortgages that are originated and administered by an external or related company. This process creates a steady and reliable income stream for those who invest while providing borrowers a much-needed source of capital.
Capital preservation and a reasonable return are attainable because:
- Real estate prices have continued to appreciate.
- Borrowers take pride in home ownership and want to protect their investment to the best of their abilities.
- Generally, a low loan to-value ratio on an MIC portfolio creates a cushion if in case real estate prices fall and default rates rise.
- Strong regulatory oversight in Canada has enabled the country to make it through some of the more difficult economic and real estate related concerns in recent years.
- MICs are required to maintain at least 50% of their portfolio in residential-based mortgages.
A mortgage investment corporation is defined under the Income Tax Act (Section 130.1) as:
- A Canadian corporation
- A corporation that does not manage or develop property
A corporation whose property does not consist of:
- Debts owing to the corporation that were secured on real property outside Canada
- Debts owing to the corporation by non-resident persons
- Shares of capital stock of a corporation not resident in Canada
- Real property situated outside Canada
In addition, the corporation is required to have 20 or more shareholders and the entity must pass along 100% of its' net income to shareholders each year.
The MIC concept was defined in 1971 by the federal government to provide more funds to the mortgage market than banks were willing to allocate. The Income Tax Act deems MICs to qualify as investments for RRSPs, RRIFs and RESPs.
To be considered an MIC, the corporation must abide by the rules laid out in the Income Tax act; specifically Section 130.1: Salient Rules (See: What is an MIC?). However, the management and operation of individual MICs differ greatly. When performing due diligence on any MIC, it is important to answer the following defining questions:
- Who is the manager?
- What is their expertise?
- What is the main focus of the mortgages with which it intends to invest (geography, type, size, borrower profile)?
- What LTV (loan to value) ratio does the mortgage portfolio generally carry?
- What position are the mortgages (1st, 2nd, 3rd)?
- What fees are associated with investing?
- What are the historical returns?
- How is capital raised?
- What leverage is accessible and how is it used in the operation?
- Is the fund sold publicly (prospectus) or privately (offering memorandum)?
- What is the target return and what kind of volatility have returns experienced since inception?
Although MICs are similar in their foundation, the day-to-day operation and management of each heavily influences the risk profile of the corporation as a whole and the overall long-term success.
Leverage is a tricky thing. When used prudently, leverage can help generate increased revenues for a corporation, but not without added risk - sometimes significant risk if a great deal of it is used. Within the MIC structure, a manager can choose to employ leverage to help boost returns by borrowing money and mixing it with capital they have raised; the increase to the income stream from the invested levered funds increase the rate of return for the shareholder. The risks associated with this strategy include:
- Interest rate risk (Although, generally, many MICs are short-term in nature with their loans which allows management of spread between lending and bank borrowing rate)
- Decreased management flexibility with lending parameters due to constraints brought about by the lending institution (source of leverage).
- Significant downturn in real estate prices and significant increase in default rate could result in heavily levered MICs to experience greater shareholder loss.
Again, not all MICs use leverage and those that do use it in varying ways. Sometimes a relatively small line of credit is used to smooth over cash-flows that enables the fund to maintain “fully funded” status at all times. Whether or not leverage is used, treasury management within a MIC is a very sensitive and delicate task.
MICs were established in 1971 by the federal government to provide more funds to the mortgage market than banks were willing to allocate. By enabling citizens to pool their own funds together for the purpose of mortgage lending, a proper balance of supply and demand was created.
MICs fill a gap in the mortgage lending industry. They create opportunity and encourage growth by spurring development that may not have otherwise occurred, helping people consolidate bad debts and providing financing to those deemed too risky for one reason or another by larger institutions.
On the investment side of the coin, the Income Tax Act deems MICs to qualify as investments for registered accounts which creates a very attractive alternative investment opportunity for those seeking an income-producing vehicle while preserving capital. Currently, many fixed-income products are simply trying to keep up with inflation which is why MICs have become an increasingly attractive product for the fixed-income portion of an investment portfolio.
Each MIC has it’s own niche whether it be by property type, geography, or type of borrower. The type of people an MIC lends to may include self-employed individuals, business owners, construction companies, commercial clients and typical residential home-owners who are trying to consolidate debt.
A common misconception is that MICs lend to those with poor credit history and low income. Although in some cases this may be true, a large portion of MIC business comes from those with great credit and income, who simply do not qualify for traditional financing.
Over the past 30 years, the reasons for why someone may be declined for traditional financing have changed, and so have the lending parameters of MICs to match the supply and demand of what the market needs at any given time. Correctly adjusting the prices to correlate with the associated risk is the key to steady growth and profitability for shareholders.
There are endless examples of what MICs lend on throughout Canada as gaps are created when larger institutions change their lending policies. However, one thing is constant for MICs; they must invest at least 50% of their capital into residential mortgages. Beyond this requirement, MICs generally invest in a mixture of:
- Commercial properties
- Commercial developments
- Large residential developments
- Small residential developments
- Typical self-build residential construction projects.
- Agricultural properties
- Vacant land
The niche an MIC carves out for itself usually dictates its success. Typically, an MIC will diversify its lending parameters to match the current market needs, but will stick to a handful of core principles when considering stepping outside of its comfort zone.
Because most MICs are not tied in with major markets like the TSX, the returns they provide investors are not influenced by the volatility of traditional trading. For instance, when the economy collapsed in 2008, many MICs had a very productive year.
When the Bank of Canada sets its benchmark rate, it trickles down to large institutions and their pricing on most lending products, mortgages included. These institutions need to manage a spread while ensuring they are competitive enough to maintain market share and spur growth.
MICs, however, raise their own funds through investors while offering a target yield unrelated to the Bank of Canada benchmark. Their lending price is dictated very little by market conditions or competition, and instead is dictated primarily by supply and demand. Investors continue investing in these entities and making capital available to borrowers in need, as long as the return warrants the risk associated with the deals being presented.
Though one of the benefits of buying into mortgage pooling is that investors can avoid the volatility of stock markets, MICs do not exist in a vacuum, and can experience dissimilar rates of return at different times, albeit to a lesser extent than most types of ventures.
In Ontario, most MICs utilize the power of sale process on the property in question as a last-ditch attempt to collect outstanding debt owed by a borrower. In the event a borrower defaults and all avenues of working the client back to a position where they can meet their obligations or obtain alternative financing to pay out have failed, the home is typically sold through the court and funds disbursed through the ranking of mortgage priority and liens. Any left over equity from this process is returned to the borrower.
The underwriting process of loans is stringent and delicate for this reason. In order to avoid these situations, an MIC manager and administrator must understand what they are getting into prior to approving a loan for a property and borrower.