Adding real estate exposure to your portfolio can be an effective tool for improving diversification, reducing volatility, and enhancing risk-adjusted returns. One type of real estate debt investment that is not well known, but becoming increasingly popular with wealth managers, is mortgage pool funds. Mortgage pool funds are not a new concept, but many retail investors aren’t familiar with these products.

A mortgage pool fund is created by building a portfolio of real estate loans, which is owned collectively by the fund’s investors. Capital raised by the pool is used to fund loans to real estate specialists, who need the money to acquire, renovate and re-sell investable properties. The loans are secured by real estate, generally short-term in nature, and carry higher interest rates than the typical homeowner mortgage.

Investors are attracted to mortgage pool funds because of the product’s competitive returns, monthly income and low correlation with other assets, which improves portfolio diversification and reduces risk. Due to their lack of familiarity, however, many investors have misperceptions about mortgage pool funds. Three common misperceptions are addressed below:

  1. Mortgage pool funds are excessively risky. Any investment involves risk and investors should carefully assess their own risk tolerance and liquidity needs before investing. Real estate debt is viewed with suspicion by many investors because of the 2008 housing crisis, which caused the value of pooled mortgages used to structure collateralized debt obligations (CDOs) to plummet and as a result, triggered the Great Recession.

    However, there are major differences between the loans held by mortgage pool funds and CDOs. First, irresponsible bank lending was rampant in the years leading up to the crisis. Banks made mortgage loans to millions of “subprime” lenders, who could not afford the payments. The banks further compounded their error by using excessive leverage to amplify portfolio returns. It was not uncommon in the years leading up to the housing crisis for banks to be making loans at amounts that were equal to 100% of the value of the collateral property.

    On the other hand, mortgage pool funds are more conservative than banks, typically limiting loans to 70% or less of property value. Fund managers create a safety net by maintaining a spread between the loan amount and the property’s value. This cushion protects investors and often allows the full amount of principal and interest to be recovered if the loan defaulted and the property foreclosed and sold. Another characteristic of mortgage pool funds that reduces risk is the short-term nature of their loans, typically ranging from one to three years. Shorter-term loans are less affected by changes in interest rates.

    Even today, banks rely primarily on the borrower’s credit history to determine risk, but mortgage pool funds focus mainly on the re-sale value of the property. Mortgage pool fund due diligence begins with analyzing recent sales of comparable properties, inspecting the property to set a baseline value and then hiring a licensed appraiser to assess “as is, post-renovation and liquidation value. Liquidation value is what could be obtained from a foreclosure sale.

    Another key difference is that banks lend to owner-occupants, while mortgage pool funds serve professional property rehabbers. Lending to this business niche has enabled mortgage pool funds to become experts on profitable fix-and-flip investing. In addition, most mortgage pool funds are regionally focused and enjoy long-standing relationships with local fix-and-flip investors. Familiarity with the local market further reduces risk.

  2. Mortgage pool funds tie up capital for many years. Start-up mortgage pool funds sometimes have lock-up provisions that prohibit withdrawal of capital in the initial years of the fund, but most mortgage pool funds try to accommodate the liquidity needs of their investors by making invested capital redeemable on reasonable notice. The redemption provision offered by many mortgage pool funds makes the funds more liquid than direct real estate investments or real estate crowd funding deals.
  3. Rising interest rates make mortgage pool funds less appealing investments. Although rising interest rates hurt fixed income investments, mortgage pool funds have the ability to redeploy capital more quickly than bonds. Maturities range from 5 to 12 years for intermediate bonds and 12 to 30 years for long-term bonds. In contrast, mortgage pool fund loans typically mature in 12 to 36 months. There are short-term government bonds with maturities comparable to mortgage pool fund loans, but the yields on these are currently below 1%. This compares to 7-8% annualized returns available at present from many mortgage pool funds.

    Fixed-income investors who anticipate rising interest rates are likely to find mortgage pool funds more attractive than most bonds. Shorter loan maturities minimize the risk of being locked into an investment paying below-market rates or being forced to sell the investment at a loss.

    Rising interest rates often signal a strengthening economy, which in turn increases housing demand and profit opportunities for mortgage pool fund lenders. In addition, when interest rates rise, investors tend to re-evaluate portfolios by comparing returns available from various investments. Meanwhile, stocks haven’t always performed well during periods of rising interest rates. Inflation-adjusted returns for the S&P 500 averaged 6% annually between 1966 and 2013, according to the Wall Street Journal, but dropped below 1% during years when interest rates spiked. Short-term government bonds performed in a similar fashion, yielding 3% most years, but less than 1% when interest rates peaked. Lackluster returns from other assets may make mortgage pool funds the preferred investment.

    Mortgage pool funds may not be desirable holdings for every portfolio. For example, investors whose goals are capital appreciation or the instant liquidity provided by a money market account should not hold mortgage pool funds. These investments are most appropriate for those seeking monthly income, low risk and attractive risk-adjusted returns. Every investor should make the decision of whether or not to own a mortgage pool fund based on an assessment of the facts, not misperceptions.