Optimizing mortgage investment corporations

by Gord Lemon26 May 2011
Have you ever been looking at a deal which at first glance seems like it will turn out to be really profitable?

You know the drill; crunching the numbers, finding a great margin or cash flow, you start salivating onto your calculator and then inevitably... the "F" word comes up...by that I mean financing of course. Most successful investors use OPM to leverage their own capital and risk in order to get their deals completed.

When an investor has a deal to be financed in hand, the preverbal questions are; where is the best source of funds, what is needed to qualify, what is the cost of the money and how soon can I get the money? In April 2010, Canadian real estate investors were thrown a couple of curves from the finance minister to "rein in" any undue risk to the Canadian banking system.

Individual mortgage qualification got more difficult and down payment increased to a 20% minimum on non-owneroccupied properties.

This resulted in fewer investor approvals through the traditional lending system. An issue for a lot of investors and mortgage brokers alike is, the banking system is the only method of financing they know and, as a result, many more investor deals are being declined. Some investors and mortgage brokers are able to get deals funded by using private sources.

This is an excellent way to get deals done however, to make a profit you must make sure the margin is large enough to pay for the upfront fees and much higher rates. An alternative source of funding which seems to be a "best kept secret" in Canadian lending is the mortgage investment corporation, commonly known as a MIC.

These niche market entities, although not well advertised, are used by many individuals because they will lend where the banks often won't. MICs are organizations that take in funds from investors and turn around and lend those funds out in the form of mortgages.

As real estate investors, it is prudent to understand how these MICs work, how they can help us do more deals and how we can perhaps utilize them in more ways than just a great source of funding.

What is a MIC?

A MIC is similar to a bank, but there is a major difference. Banks lend out money on deposit from its account holders for loans, lines of credit and credit cards, make a huge profit and, in turn, reward the account holders with a measly return for the use of their money.

MICs pool money together, lend it in the form of first or second mortgages and share 100% of the net profits to its shareholders.

Projected returns are typically around 6-11% per year. These returns are often paid out quarterly in the form of a dividend and taxed to the individual as interest income, which can be received in cash or reinvested back into the MIC. Mortgage investing used to be a more "exclusive" vehicle reserved only for the sophisticated.

Today MICs offer both the sophisticated and non-sophisticated investor a "hands off" way to balance a portfolio as an alternative to the bond/ fixed income market. With a typical minimum investment of $5,000, most investors appreciate the stability and security coupled with a nice return.

Specifics and operation of a MIC

Because investing in a MIC is a security, MICs are carefully monitored and controlled by the CRA, the Securities Commission and FICOM, which is the Financial Institution Commission of Canada. In order to issue shares or securities, companies need to go through an arduous and expensive prospectus.

Fortunately, MICs rely on an exemption from this by providing an Offering Memorandum (OM) and a warning statement to all of their prospective shareholders. The OM describes the vehicle you are investing in, the names and backgrounds of the management team, some tax information and the warning statement explains the risks to investing to the prospective shareholder.

MICs must follow the guidelines set by the Canadian Income Tax Act, Section 130.1: Salient Rules. The following are a few pertinent highlights:

a) There must be a minimum of 20 shareholders

b) No individual shareholder can hold more than 25% of a MIC's total capital

c) Shareholders can invest from RRSPs, RRIFs, RESPs and TFSAs

d) A MIC must invest a minimum of 50% of its capital in residential mortgages and/or cash and insured deposits at Canada Deposit Insurance Corporation member financial institutions

e) All MIC investments must be within Canada but can accept investment capital from outside Canada f) A MIC itself is a tax exempt corporation

g) A MIC is considered a "flow through" investment vehicle and as such must distribute 100% of its net income to the shareholders

h) Dividends received with respect to directly held shares, not held within RRSPs or RRIFs, are taxed as interest income in the shareholder's hands. Dividends may be received in the form of cash or additional shares

i) A MIC may invest up to 25% of its assets directly in real estate but may not develop land or engage in construction. This ceiling on real estate holdings does not include real estate acquired as a result of mortgage default.

j) A MIC may distribute income dividends derived from mortgage interest, revenue from property holdings, and capital gain dividends from the disposition of its real estate investments.

k) A MIC may employ financial leverage by using debt to partially fund assets. l) A MIC is subject to an annual audit of its financial statements Risk, reward and redemption

An investor in a MIC is able to minimize risk by the fact that they are invested in a pool of funds, which are in turn invested in many mortgages.

MICs mitigate risk by excellent underwriting practices, via thorough assessments of both the property as well as the borrower, although having significant equity positions in good marketable properties is most important.

If there is a default on any mortgage, it is prudent for the MIC to be able to quickly dispense of the property to recover the loan amount and even make a profit. It is comforting to know however, that as of the end of Q2, 2010, the Canadian Bankers Association reported; "the default rate on prime residential mortgages in Canada is 0.42%."

Currently there is over a 99% recovery rate on principal interest and legal fees as a result of a foreclosure. If a lender does not recover their full principal, interest and legal fees in the foreclosure process, often the mortgagor has recourse to go after the borrower by attaching any other property they have, plus garnishing their wages for up to 10 years or until full recovery is completed.

Borrowers from MICs are informed of this process and generally do not default. MIC investments have varying degrees of risk/return for an investor to choose from.

The highest security/ lower return investments are in residential first mortgages; higher yielding/ medium security would be invested in second mortgages and high yielding/lower security investments could be in construction projects.

Based on market conditions, returns can fluctuate slightly and the overall performance of the portfolio may change accordingly, however in a well-managed MIC, an investor's capital should never be in jeopardy.

A good management team will also ensure a stable revenue stream to its investors by setting aside some income out of the revenue in the case of potential loss within the funds.

The bottom line is; because the investment is in mortgages which are due and payable by every borrower every month, the growth is steady with only small fluctuations in return. In terms of redeeming your investment dollar, as in most investments, there are fees for pulling your money out prior to say, a one-year commitment.

These redemption fees decrease the longer your money in working in the funds.

How do I choose the right MIC to invest in?

As a real estate investor, we are used to doing proper due diligence when checking out any property. This is no different. When investigating a MIC, one must get acquainted with a number of key factors possessed by a successful MIC in order to make a confident investment decision.

Here are some key questions one should ask prior to making the decision to invest:

How long has the MIC been in existence?
What is the MIC's history of performance?
What is the experience of the managers?
What is their process of creating deal flow?
Does the MIC currently hold any physical properties?
Is there a particular niche market you go after or specialize in?
Are you speaking to the person who will be making the investment or a salesperson?
Can you call up any time to ask about decisions that have been made?
Does the MIC offer complete disclosure of its mortgage investment details?
How does the MIC diversify its mortgage investments to protect investors?
Is there a provision for losses and liquidity?
What is the minimum investment amount?
What is the fee to redeem early?

As a real estate investor, here's where the rubber meets the road. I want to get my deals funded quickly and easily. Fortunately MIC funds flow better than conventional lending institutions.

Management is usually in-house, so the underwriting, approval and funding can happen much quicker than through other conventional lending sources. Qualification is generally much "smoother" through a MIC as the property or project is the emphasis.

Typically the types of deals that will get funding have a number of common factors.

The properties must show either good income, have a strong equity position, display excellent growth or forced appreciation and have good marketability.

MICs generally are used for short-term lending. Anywhere from three months to a year is typical. As a real estate investor, one can use MIC mortgage loans to fund fix and flips or as short-term money to procure buy-and-hold deals or lease options, which can be refinanced later using cheaper money from institutional lenders.

Construction and development financing is approached with the MIC's own advances, draws and inspections so the timelines to get projects underway are much faster than working with conventional institutions.

In general, MICs can be used much more by the Canadian real estate investor as a tool to grow a healthy portfolio of rental properties, renovation properties and even construction projects as well as a great place to park your real estate profits until you are ready to do your next project.

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