Monday, 19 May 2008

Ins and Outs of Mortgage Investment Corporations

A reader brings up an interesting question:
"I'm interested in investing in real estate, but the market is pretty volatile right now and I don't want to put a large lump some of money into real estate at this point but still would like to 'play' the market. What do you think about mortgage investment corporations like ACIC? I found their website ( Could you do a review of ACIC or products like this?"

I must admit to not knowing about MICs before now, so I am approaching this cautiously and don't pretend to have a final answer or a blanket answer that applies to every MIC. A due diligence process is very much in order.

What is a Mortgage Investment Corporation? (good place to start, huh?)
A MIC is a corporate structure recognized in Canada's Income Tax Act (thus the use of MIC as a proper noun) that enables small investors to pool funds and invest in (i.e. act as a lender of) mortgages. The Act allows the MIC itself to be exempt from income tax as long as it passes along all its income to the investors, in whose hands it is, of course, taxed.

A picture is worth a thousand words (perhaps more, the way I write). Here is a good summary of the flow of various funds into and out of a MIC from one of these outfits Magenta Mortgage Corporation.

Just below the diagram on the Magenta explanatory webpage is a succinct summary of the Income Tax rules about what a MIC can and cannot do. Or you can try deciphering the ITA section 130.1 yourself. Here is Magenta's summary:

(btw, to me the availability on a company's website of clear and complete information is a good sign, though by no means a final answer)

MICs go back to the 1970s, that alone being a favourable point. If their format/structure itself were bad, they should have disappeared, right?

MICs are thus a legitimate investment vehicle, though naturally that doesn't mean every MIC will be successful and a good place to invest money.

The Prospectus and Audited Financial Statements
MICs are securities and as such, are bound by the securities regulator in its home province to send a prospectus to all potential investors. The Prospectus details everything about the MIC and is essential reading. Most of the MIC websites are coy and require you to give them your name and contact info before giving you a copy (no doubt so they can do some selling). One exception is Westboro, whose very readable Prospectus is on this Documents page.

The audited financial statements tell you how the company is succeeding, how much profit it is making, how big and diversified is its lending, how much leverage it is using, percent of loans in arrears and so on. It's necessary and highly useful reading to understand a potential investment.

Each to Its Niche
Within the tax rules, MICs vary quite a lot in the types of loans and borrowers they focus on. Among the possibilities: first mortgages, second mortgages, multi-unit residential buildings, construction loans, individuals or companies, commercial properties (up to the limit), people the banks won't lend to like poor credits, bankrupts, self-employed, undeclared income

Rates of Return
This is the big carrot, naturally. The historical rates claimed went from a minimum of 8% a year up to c. 12%! That's impressive! This is cold, hard cash either paid out, either monthly, quarterly or semi-annually, as a cheque / deposit into your bank account or reinvested. That's pretty darn good considering that these cash distributions have been steady for years. For instance, check out Cove MIC's table of its returns , which averaged 10.53% since 1999.

What are the Risks?
Check out the sensible questions that the OSC suggests you ask in this information page on the Westboro site.

- less likely since a MIC must produce audited financial statements every year. Check out the financial statements and see if the MIC is subject to any lawsuits.

Losing MIC Status
- failing to keep within the Income Tax Act rules would cause the MIC to have its income taxed before being distributed to shareholders and would lower returns considerably

Manager (In)competence
- the success of the MIC depends to a critical degree on the experience, expertise, judgement and good faith of the managers. Do they know the business, do they know their market and do they have a record of success? Can and will they find a steady flow of new mortgages to keep the income flowing in? Think of it as a job interview.

Leveraging - the rules allow the MIC to borrow money but some do more than others. The spread between the lower rate of the MIC's borrowing and the lending will boost the ability to generate shareholder returns but it also increases risk. The audited financial statements will show how much the MIC has borrowed. The prospectus will say if the MIC has a policy to cap what it will borrow. Many of the MICs are fairly short term lenders - 24 months or so - which reduces interest rate risk and should allow the MIC to continually readjust its lending rate to match increases or decreases in general interest rates and keep the spread between its lending and its bank borrowing rates constant.

Default on Mortgages
- mortgage borrowers may not pay back what they owe; all the MICs claim to be very careful about who they lend to but some are explicitly in a niche where the banks don't tread or in second mortgages. The MIC gets a higher interest rate but that is associated with the higher risk. At least one MIC - Cooper Pacific - has two funds, one that lends out first mortgages with an 8% return and another with second mortgages with a 12% return. "You takes your picks and you takes your chances."

Market Downturn / Geographical concentration
- some MICs, the smaller ones, are concentrated in very limited markets, like Westboro in Ottawa or Edgeworth in northern Alberta. Ottawa is a stable market but what happens to Edgeworth if the oil industry cools off considerably, as it has done in the past? A general economic recession would everywhere increase the number of borrowers having difficulty to repay.

Liquidity (Can't sell)
- the basic method to get your money back is not a sale in some market since MICs are not (with one exception, I found) publicly quoted companies but for the MIC to redeem the shares; the restrictions vary by MIC, whether funds can be sold / withdrawn immediately, or with 30/60/90 days notice; for smaller MICs, the Income Tax Act restriction that each MIC must have at least 20 shareholders might come into play;

A Partial List of MICs - there seem to be a lot of these around

Taxes and Which Account to Hold the MIC Investment
A registered account such as an RRSP or a RRIF is the natural place for a MIC investment since it will generate all its income only as interest (and not as dividends, despite some use of the word dividends to describe the cash distributed; and don't be fooled when they are called preferred shares - the dividends are interest for tax purposes), which is taxed at the highest rate. I don't know for sure but I would hope and expect that a MIC could also reside within a LIRA or an LRIF but that would need checking out.

Some MICs want or allow you to hold the MIC investment withing your own self-directed RRSP. Others want you to set up an RRSP with a connected financial services provider.

Minimum Investment Amount
This may be the key practical point that blocks the average investor from getting into a MIC. The lowest minimum investment I found was $5,000 at ACIC and that only for a non-registered account. There is the publicly traded Quest Capital whose shares sell for about $2.05-$2.10, so you can get in for less ... but is it a good MIC?

The MIC's Place in a Portfolio
A MIC is fixed income. But unlike a bond, the value of your principal stays the same. If you invest $10,000, that's what you get back when you redeem shares and cash out. Bond value will fluctuate with interest rates, which affects their return. The MICs return is only the interest. As for other asset classes, like real estate investment trusts (REITs), various types of equities, real return bonds (RRBs) and short term cash (i.e. things like T-bills and GICs), the MIC is most like latter - little or no variation in principal value or in returns. There is more risk however, due to the nature of the mortgage investment.

I would suspect there is little correlation of returns with any other asset class, which means that MICs offer the happy prospect of adding true diversification to a portfolio by either reducing overall variability or increasing returns, or a bit of both.

Being ever the compromiser, I would therefore tend to replace some of my cash-type holdings and some of my corporate bonds, perhaps up to 10% of my overall portfolio.

For others like retired folks who want a steady, high income stream and don't mind the tax rate, MICs may be a good vehicle.

As far as ACIC goes, I cannot offer an opinion since I didn't feel like giving them my name and details just to have a look at their prospectus and financial statements and get into their guts a bit more.

MICs are definitely worth consideration and will get a close look when I do my portfolio review shortly.

Thanks for the great question.


Preet said...

Excellent information Jean. Were you able to dig up any information on survivorship information? (i.e. have there been any catastrophes? or MICs that were wound up due to poor performance?)

CanadianInvestor said...

Very good question. Either I am putting the wrong search terms into Google, there haven't been any failures (hard to believe) or they have quietly gone away, I could not dig up any instances. Time for a post to ask about this in the Financial Webring!

gbebee said...

It's important for your readers to know that there are investor qualifications to invest in MICs and these vary by province. In Ontario, you must be an accredited investor. This means you have a fairly high net worth or high annual income.
The provincial securities commission in an investor's home province will be able to explain the relevant provincial requirements to be eligible to invest in a MIC. MICs themselves should have this information available to potential investors.

Incidentally, I do discuss MICs in my book, No Hype-The Straight Goods on Investing Your Money on page 129.

Gail Bebee
Author of No Hype - The Straight Goods on Investing Your Money

Anonymous said...

At Dolphin Enterprises as the leading software supplier to MICS is finding a growth of the creation of MICs specifically in Ontario. This could be due to the current climate change and consistent returns that MICs product

CanadianInvestor said...

Thanks Anon, for the comment. Maybe the banks aren't lending and the MICs are stepping into the gap. I've been reading lately that Canadian residential mortgage default rates are still very low / not climbing as in the USA so I wonder if the MICs are getting the benefit of higher interest without too much extra risk. Of course, we are still early in the recession and the effects of rising unemployment have yet to fully be felt.

Anonymous said...

Jean; as an investment information provider I suggest you give Don Bergman, President and Financial Manager at ACIC a call. I think you will find him more than receptive to your questions and comments. I also have no doubt that he will provide you a copy of the ACIC Offering Memorandum (not a Prospectus), Financial Statements and most recent Mortgage Portfolio. We are small but growing MIC (Since 1998)expanding our reach and believe in open and transparent dealings with our clients. You may also want to take a look at Kaufman's (Westcourt Capital) Alternative Investment series on BNN for his particular take on MICs.
Just let Don know that Pegasus sent you. Thanks a bunch for your information.

Munir said...

Readers should also be aware that MIC's operating in Alberta are under much more stringent securities regulations than other provinces. A MIC in Alberta needs to register as an EMD, and IFM and an RPA which is much more onerous than the registrations required in other jurisdictions. This has interesting implications for Alberta based MICs. 70% of MIC's in Canada are based in Alberta.

Munir said...

When reviewing the financial statements of a MIC, because it is a flow through entity it won't have significant retained earnings built up and it won't have significant income also because it distributes this income out to it's investors each year and deductes the dividends as an expense. This results in a zero or close to zero net income each year.

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