Understanding how the debt hierarchy and loan-to-valuation ratios impact the risk of capital loss.
Investing for Income: An Overview
Generally, people invest to expose their wealth to capital gains opportunities, to generate income from their wealth, or some combination of the two. Recently, there is also a growing trend of mission-driven investors whose objectives include the advancement of social, environmental, and governance issues.
Investing for income is a strategy that primarily focuses on the assets’ potential for generating income, as opposed to the potential for capital appreciation. Income investors may have secondary objectives which can include several themes.
Income investing can involve a wide variety of assets, such as bonds, real estate, dividend-paying stocks, and managed funds, among others. Many of these assets do have the potential for capital appreciation, but they also have the potential to generate income. For example, bonds pay coupons, stocks can pay dividends and real estate investments can generate rental income.
While bonds are a well-known form of debt, they’re not the only way to generate income from debt. Some managed funds use money raised from investors to extend loans to borrowers for various purposes including building or buying homes, developing property and even to fund business operations.
Investing for income in a Managed Fund – what to look for?
Default risk
When assessing a managed fund, prospective investors should investigate how the fund manager assesses and monitors their loans to avoid default risk. With the Trilogy Monthly Income Trust, each loan is assessed by the lending committee on its individual merits. The performance of all loans is carefully and regularly monitored to ensure adherence to ongoing reporting requirements and individual loan covenants. The progress of all loans is monitored via the draw-down process and through regular contact with the borrower. This is an actively managed process to ensure that all projects are being run efficiently and in accordance with the lending criteria. Without these types of safeguards, a borrower may default on a loan which could flow through to capital losses in the portfolio and potentially, to the investor so it’s an important consideration.
Security or collateral gives the lender the legal ability to possess and sell the collateral to repay any funds advanced should a loan not perform. This gives the lender a way to recover what is owed if the borrower cannot repay the loan. Property, for instance, can serve as collateral for a mortgage. An asset’s effectiveness in loss prevention will depend on the extent to which the value of the collateral is sufficient to cover any outstanding loan amounts. Hierarchy of the loan is also a key consideration which we address later in this article.
Mortgages – a matter of security
Part of the appeal for mortgages, from a lender’s perspective and potentially an investor’s perspective, is the legal claim to the relevant secured property that the lender has in the event of default. This claim provides lenders with a degree of security. While the value of property has historically risen over the long term, they do also fall from time to time. While holding a mortgage on property offers a degree of security, it doesn’t entirely eliminate the risk of losses from default, necessitating the implementation of additional protective measures, which is why managing the Loan-to-Value Ratio (LVR) is another key information that investors should know.
The Loan-to-Valuation Ratio: A further risk management measure
In most cases, a lender will extend to a borrower a loan amount that is less than the valuation of the asset against which the loan is secured. That valuation may be made on an “as-is” basis (particularly in the case of a mortgage made on an existing dwelling or a block of land), or on an “as-if-complete” basis (often the case with respect to mortgages extended to finance a property development which relies on the uplift of the property once construction has finished). By extending to the borrower an amount less than the valuation, the lender creates a buffer that can provide some protection should property values fall.
The ratio between the amount borrowed, and the valuation, is called the Loan to Valuation Ratio, or LVR.
A higher LVR indicates a larger loan relative to the property’s value, which increases the risk for the lender or investor. A lower LVR provides a cushion of equity, reducing the likelihood of potential losses in the unlikely case of default or foreclosure. For example, the Trilogy Monthly Income Trust has a maximum LVR of 70%, based on the value of the secured property when the loan is first made.
The hierarchy of loans
Understanding the hierarchy of a loan is another important feature to consider when assessing an investment manager. Lenders offering first mortgages, take priority over all other claims (except for statutory charges) on the property in the event of default as this is the primary loan secured against a property. If the borrower defaults and steps are initiated to repay the loan facility extended by the lender, any recovered proceeds will first pay down the legal debt of the lender with the first mortgage prior to any further secured or unsecured debts. The extent to which the first mortgage lender recoups everything owed to them depends on the amount of net proceeds from the sale of the asset. A low LVR would result in a lower loanable amount relative to the property’s valuation. With a low LVR, the outstanding balance of the loan will likely be closer to the proceeds from a potential sale. Nonetheless, a specific LVR level alone doesn’t ensure that the primary mortgage holder will recover the full amount due to them.
A second mortgage is a loan that also uses property as collateral but is subordinate to a first mortgage (and any statutory payments). If the borrower defaults, the lender of the second mortgage is paid after the lender of the first mortgage recoups their legal debt from the sale of the secured asset.
Second mortgages inherently carry greater risks for both lenders and borrowers. They are subordinate to first mortgages, meaning they’re repaid only after the primary mortgage in the event of a default. This position, combined with the potential for reduced property equity and the historically higher default rate of second mortgages, heightens the risk. Lenders must also consider the combined Loan-to-Value Ratio (LVR) and evaluate the borrower’s overall financial health. For borrowers, there’s the risk of unfavourable loan terms and the potential for negative equity if property values decline.
Again, a low LVR is an additional risk management measure, however, it doesn’t guarantee that the first or second mortgage holder recoups what is owed – but the second mortgage holder is clearly ranked after the first. Given these distinct risks associated with second mortgages, they might carry a higher cost for borrowers compared to first mortgages. This is often reflected in the form of elevated interest rates due to the additional risk considerations and assessments inherent to second mortgages.
Unsecured Debts: The last to be paid
Unsecured debt is a type of debt that isn’t secured by any assets. This is in stark contrast to secured debts, such as first and second mortgages, which are tied to a specific security that can be seized and sold in the event of default. Investing in unsecured debt is entirely different from investing in secured debt, and it carries its own unique set of risks. If the borrower defaults, the lender does not have the option to seize and sell a specific piece of property to recover the amount owed. Instead, they must go through the legal system to attempt to recover their funds, which can be costly and time-consuming. In the event of bankruptcy, unsecured creditors are among the last creditors to be paid.
Unsecured loans often charge borrowers higher interest rates due to the higher risk associated with them.
Loans as an investment
Through managed funds, it is possible to invest in portfolios of first mortgages, portfolios of second mortgages, and portfolios of loans that are not secured against property. It is also possible to invest in portfolios that hold a mix of these loan types. As discussed above, riskier loans often charge borrowers higher interest rates. As a result, some funds may pay a higher distribution rate than others; however, whilst the distribution rates may appear higher, there could be loans with high LVRs within the portfolio or loans that don’t have any security. Given these loans are lower in the debt stack than first mortgages, recovering the legal debt where borrowers may have gone into default could be more difficult. In this respect, when considering a managed fund, it’s important to not just consider the distributions on offer, but the underlying portfolio mix, and the experience of the manager reviewing and managing these loans.
First mortgages, second mortgages, and unsecured loans – examples
The following scenarios illustrate the concepts of first and second mortgages and unsecured loans. The scenarios illustrate how first mortgages rank against second mortgages, how mortgages rank against unsecured loans, and the impact of LVR in the event assets are sold to recoup owed money in the event of forced sale. The scenarios below help to illustrate the features we have discussed earlier.
In each scenario, consider a property that achieved a valuation of $10,000,000 at the start of the loan. In each scenario, the borrower takes out two mortgages on the property: a first mortgage and a second mortgage. The borrower (property owner) also takes out an unsecured loan.
In all three scenarios, we assume a 70% Loan-to-Value Ratio (LVR) for the first mortgage and an LVR of 85% for the second mortgage. Each scenario will also have a $500,000 unsecured loan.
NOTE: These examples are simplified and stylised. In the case where interest is not capitalised, payments may be made during the life of the loan. In the non-capitalised interest model, borrowers are expected to pay accruing interest periodically, such as monthly. This model inherently demands a steady cash flow from borrowers, making it less ideal for development projects. The Trilogy Monthly Income Trust (Trust) allows interest to be capitalised on a case-to-case basis depending on the merits of the specific construction loan. Capitalised interest may enhance a lender’s returns and provide flexibility to borrowers.
Scenario 1
Sale Price = $9,000,000 (-10% fall from the $10m initial price)
The first mortgage will be paid in full, and the seller will have $2,000,000 cash left ($9,000,000 less $7,000,000) for both the second mortgage and the unsecured loan. The second mortgage will be fully paid $1,500,000 leaving $500,000 cash enough to pay the unsecured loan.
Scenario 2
Sale Price = $8,000,000 (-20% fall from the $10m initial price)
The first mortgage will be paid in full, and the seller will have $1,000,000 cash left ($8,000,000 less $7,000,000) for both the second mortgage and the unsecured loan. The second mortgage will be partially paid $1,000,000 (short of $500,000), but there will be no money left to pay the unsecured loan.
Scenario 3
Sale Price = $7,000,000 (-30% fall from the $10m initial price)
The first mortgage will be paid in full ($7,000,000), but there will be no money left to pay the second mortgage and the unsecured loan.
Source: Trilogy Funds
The domains of first mortgages, second mortgages, and unsecured debt stand as distinct territories in the investment space, each with its unique set of risks and rewards. A secured first mortgage presents the lowest risk of the three, secured by the property asset and any other collateral the lender may deem necessary. The secured second mortgage is still anchored by collateral but sits behind the first mortgage in terms of priority in the event of a default and process to recover loan proceeds. Unsecured debt is completely devoid of the safety net of collateral, making it the riskiest of the three. A borrower seeking a loan that represents a high risk for a lender will likely pay for that by way of a high interest rate. Conversely, the lender can command a higher interest payment in return for exposure to additional risk. By extension, an investor considering an investment that delivers high distributions may pay for those distributions by way of exposure to high levels of risk.
For investors venturing into pooled income investments, it is important to research on the points we have raised in this article. Investors should review the portfolio to understand the composition of assets and loans it contains. The balance between first mortgages, second mortgages, and unsecured debts can significantly alter the risk profile of the investment. In balancing the typical twin objectives for investors of maximising returns and minimising risks, knowledge remains the most potent tool. Investors should not only be aware but also be comfortable with the risks they are taking. When investing in unsecured debt or second mortgages, it’s crucial for investors to understand that their claim will rank second in terms of repayment. This doesn’t imply that their investment consideration is secondary in importance. However, investors need to determine their comfort level with their capital being in a subordinate position should loan recovery become necessary.
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This article is issued by Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) as responsible entity for the Trilogy Monthly Income Trust ARSN 121 846 722. Application for investment can only be made on the application form accompanying the Product Disclosure Statement (PDS) dated 30 September 2022 and by considering the Target Market Determination (TMD) dated 30 September 2022 for the Trilogy Monthly Income Trust ARSN 121 846 722 available at www.trilogyfunds.com.au. The PDS and the TMD contain full details of the terms and conditions of investment and should be read in full, particularly the risk section, prior to lodging any application or making a further investment. All investments, including those with Trilogy Funds, involve risk which can lead to no or lower than expected returns, or a loss of part or all of your capital. Trilogy Funds is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed financial adviser. Investments with Trilogy Funds are not bank deposits and are not government guaranteed. Past performance is not a reliable indicator of future performance.
