Can mortgages make you rich?

Investors I speak to these days aren’t too troubled by low interest rates or the inability to find safe, reliable income. That doesn’t mean they’ve parked their cash and let inflation erode their portfolios. Instead, they’re cashing in on the double-digit returns of Mortgage Investment Corporations, known as MICs (pronounced MIC as in Mick Jagger).

These investments aren’t new (having been created in the 1970s) but didn’t gain in popularity until recently because of the way they were sold. Only in the last few years have investors been able to buy MICs through a stock exchange. Previously, you had to be comfortable purchasing through an Offering Memorandum—legal documents that state the objectives, risks and terms of a private placement, such as a MIC. This meant few financial advisers suggested MICs to clients—why bother if there were no commissions flowing back to them?

Interest in MICs is on the rise because investors—retail and institutional—are hungry for fixed-income products that offer more than simply keeping up with inflation, and MICs fit the bill. According to a report from Miller Thomson LLP: “It’s quite normal for MICs to attain 9% to 14% returns, sometimes a bit more.”

So, is your investor sense tingling? It should, because who can’t help but wonder: How can consistent double-digit returns come without significant risk?

The risk is lower than you think. Since a MIC’s investment is directly in mortgages, the single biggest risk is default on this debt. Unfortunately, many investors associate this risk with the U.S. housing crash of 2008. It’s an erroneous association, says Jane Knop, the Harvard-educated managing director for First Swiss AM, a Toronto-based, privately-held MIC. As a uniquely Canadian investment product, MICs must keep 50% of their investments in CDIC-insured deposits or mortgages secured against Canadian residential property. “Canadian residential debt has one of the lowest default rates of any type of debt,” Knop says. Even in the 1990s housing crash, default rates for Canadian residential mortgages never topped 0.66%. Compare with default rates of North American corporate bonds, which averaged 1.01% between 1982 and 2010—reaching 5% in 2000 in Canada alone.

Diversification counts. There are hundreds of MICs across Canada, but not all are created equal. For instance, there’s increased risk of default if a MIC is too geographically concentrated. That means if a MIC invested only in northern Alberta mortgages, it could face diminished returns if oil prices were to drop (potentially forcing those homeowners into foreclosure). Also, some MICs opt for riskier types of residential debt. While construction loans or bridge financing for residential new-builds qualify as residential mortgages under the Income Tax Act, from a risk perspective, these loans are riskier. The key is to examine the underlying holdings, just as you would if you were buying a sector ETF or mutual fund. The more concentration, the higher the volatility and higher the risk of lower returns.(For more on choosing a MIC, see my blog at moneysense.ca/romanaking).

But how does it stack up? These investments shouldn’t replace dividend-paying equities or REITs in your portfolio because MIC holdings shouldn’t be treated as equity. While MICs are set up as corporations—with investors buying and redeeming shares—you don’t actually make money on the appreciation of those shares. Instead, investors earn regular payouts based on interest collected from a pool of mortgages owned by the MIC. The more shares you own the larger your payout, which is taxed at your marginal rate as interest income. Prudent investors use MICs to replace other fixed-income instruments like GICs, T-bills and government or corporate bonds, says Michael Nisker, managing partner of Trez Capital, which offers two of about a dozen publicly-traded MICs on the TSX. For those with balanced portfolios, this means investing no more than 10% of your fixed-income allocation in MICs.

Keep more of your earnings. Because 100% of the interest payout from MICs is taxed at your top marginal rate, consider holding MICs in registered vehicles like an RRSP, RESP, RRIF or TFSA. For private-placement MICs, shop around for one that offers economical administrative fees on registered plans—this should be easy, since MICs are available in every province. A typical cost for an RRSP holding will be $100 to $150 a year; expect to pay $25 to $75 a year for an RESP or TFSA holding. Also keep an eye on set-up, closing and redemption fees. Determine these fees up-front, so you can factor them into the cost of entering and exiting the investment.

It’s all about the long term, says investor D.G. Southen, whose MICs earned an annualized rate of return of 12% over the last 22 years. “I have not held a common share in my RRSP since 1991,” he says. “I make more money with debt investments than I ever would with common shares.”