The investors who bet on a real estate boom – and lost
Saturday, April 1, 2017 TAMSIN McMAHON, TIM KILADZE
As he prepared for retirement a decade ago, Michael Weintraub was unexpectedly blessed with a sizable inheritance he wanted to sock away.
The investment he settled on was a real estate fund that seemed to be a sure bet.
The Vancouver retiree can’t quite recall how he came across the CareVest family of mortgage investment corporations. But he admits he didn’t know much about the Alberta-based business, other than its broad connection to real estate. It didn’t matter. He was looking to diversify to his portfolio and was attracted by the promise of enticing, yet steady, annual returns.
Lightly regulated, alternative mortgage lending has boomed in the years since the 2008 global financial crisis. Tighter government rules and more stringent bank underwriting have made it more difficult for some homeowners and many developers to qualify for conventional bank loans.
That has helped push some borrowers into the fringes of the mortgage market, where they typically find short-term loans at far higher interest rates than what the banks and other traditional financial institutions offer.
Like virtually all mortgage-investment corporations (MICs), the CareVest MICs pooled money from thousands of small retail investors to lend to a variety of real estate borrowers, both large and small. In exchange, investors were promised stable returns that were much better than those provided by traditional fixed-income securities. CareVest advertised returns as high as 9 per cent in small-town newspapers across B.C. and Alberta, an enticing number at a time when government bonds pay virtually nothing.
Because they are sold as steady, bond-like investments, MICs are particularly attractive to seniors and Canadians nearing retirement.
Only a handful of MICs are publicly traded, allowing their investors to sell their shares in the stock market. For the majority that are private, investors are often told they can cash out by paying a small fee.
“I really didn’t know what the risk was in that type of investment,” Mr.
Weintraub says, adding that he deployed about 10 per cent of his retirement savings into CareVest. It was real estate and “with the assurance that you could get your money out of it, I didn’t think I could lose that money.”
He wasn’t alone in his blind faith. By 2014, CareVest’s assets ballooned to $570-million, making it one of the country’s largest mortgage-investment firms. Its rivals’ balance sheets also swelled, largely driven by Canada’s real estate euphoria. Official figures on the exact size of the mortgage-investment industry today are hard to come by, but it is estimated to be as high as $25-billion.
MICs like CareVest are believed to comprise the largest share of that market. Once marginal investment products, they are quickly becoming more mainstream. How fast they are growing isn’t clear, however, as even basic, official data about the size of the private-mortgage industry is near impossible to find.
In a series of studies commissioned by Canada Mortgage and Housing Corp., Fundamental Research estimated that lending by MICs grew by 13 per cent between October, 2015, and January of this year – or nearly twice as fast as total residential lending in Canada. The researchers also estimated there are as many as 200 to 300 MICs operating across the country. The independent Vancouver research shop is one of the few who to have attempted to collect data on the MIC market as a whole.
“There are no good statistical numbers on how many MICs there are and how much they have in their mortgage portfolios,” says Susan Han, a securities lawyer with WeirFoulds LLP in Toronto, who has worked with MICs and has tried unsuccessfully to get data on the industry, including from Statistics Canada and the Canada Revenue Agency.
The mortgage-investment industry has also flourished amid a complex and often contradictory patchwork of mortgage regulations across Canada that allow ordinary investors to buy highly complex private investments, often using money tucked away in their registered retirement accounts.
While federal institutions such as the Bank of Canada believe this industry is too small to threaten the financial system, the scorching mortgage-investment sector poses risks to thousands of unsophisticated retail investors.
That’s troubling because while many of these funds have paid healthy returns for over a decade, and can boast they have never lost money on their mortgage books, others lately have faced serious problems – including CareVest. Since the start of 2014, at least a dozen MICs and sister real estate investment funds have either shut down, gone bankrupt, been forced out of business by regulators or started winding up. Some have even been accused of orchestrating frauds.
In Alberta, the provincial securities commission has alleged mortgage investment firm Base Finance Ltd. operated a Ponzi scheme, while OmniArch Capital Corp. filed for bankruptcy protection. Crossroads-DMD, a MIC, was forced to limit how much money its investors could withdraw after suffering losses on its mortgage portfolio during the province’s real estate downturn.
The Financial Services Commission of Ontario (FSCO) shut down Tier 1 Transaction Advisory Services last year, warning that investors in the firm’s syndicated mortgages were at high risk of losing their money in a series of student and seniors residences that were in various stages of development. (Syndicated mortgages are investments similar to MICS that deploy their funds into single projects instead of portfolios of loans.) Fortress Real Developments, another firm involved in syndicated mortgages, is facing legal battles with some investors over developments that have run into delays or financial problems. And in B.C. last fall a group of investors forced construction lender Trez Capital to wind up its two publicly-traded MICs after years of poor performance.
( Skip ahead to read about some mortgage-investments firms that have run into trouble.) More problems may emerge in the sector now that Alberta’s real estate market is depressed, British Columbia’s is cooling and Ontario’s market could be reaching its peak. There has also been intense competition in the mortgage lending market, dampening the once-attractive returns many MICs offered to their investors. Some funds have been forced to make riskier loans simply to offer the promised high yields.
“If you’re trying to generate double-digit returns, it’s more difficult” today, says Andrew Jones, chief executive of Timbercreek Financial, Canada’s largest MIC. “There are some really good managers that know what they’re doing, but it is getting tougher and tougher to generate that kind of yield.”
When things go bad, unsophisticated investors who were sold on promises of secure, stable returns are often those left holding the bag. The watchdogs that are supposed to protect them offer little help – they’ve barely kept tabs on the industry to begin with.
The dire situation at CareVest illustrates what investors are up against. After years of strong returns, the company reported that two of its MICs were facing rising levels of defaulted mortgages and has also had to take over some projects after the borrowers had run into problems. By September 2014, the share of troubled mortgages in the two MICs had risen to more than 50 per cent.
It turns out the MIC’s assets weren’t so safe.
Among the loans that caused CareVest so many problems was a mortgage to a condo and townhouse development outside of Collingwood, Ont.
When the project failed, a court-appointed receiver estimated that the dozens of unsold units would have to sell for “more than two, and in some cases, three times” their market value to repay the CareVest’s $40-million loan.
CareVest had also loaned more than $100-million on several projects owned by Edmonton-based developer VIP Developments, which ran into problems as Alberta’s oil-based economy nosedived. One of the loans to VIP was for $35-million on a large tract of pristine land the builder was planning to develop outside of Calgary. By 2015, the property, still untouched, was worth just $17-million, according to court records.
Spooked by the mounting problems, many investors rushed for the exits.
Yet when they did, CareVest capped how much they could withdraw annually. So far, individual investors have received, on average, less than 2 per cent of the money they try to withdraw each year.
For Mr. Weintraub, it has felt like a never-ending nightmare. Now 72, he worries he may never recoup his investment. “It’s like a dead end,” he says. “I’ll never get [all] that money out before I die.”
How the industry grew
In spite of their recent popularity, MICs got their start amid roaring inflation nearly 50 years ago, when the federal government was scrambling to spur private-sector investment in residential housing. The
goal: To build enough affordable homes to meet the demands of middle-class, Baby Boomer families pinched by double-digit interest rates.
By allowing everyday Canadians to buy into portions of larger loans, through a mortgage company, Ottawa hoped billions of dollars in savings would be unleashed into the housing market.
The bar to qualify as a MIC was set low – the funds had to invest at least half their assets in Canadian residential real estate, cash or insured-deposits, and the definition of “residential mortgage” was left broad enough to include loans made to developers who were building a wide variety of accommodations, from houses and rental apartments to student residences and retirement homes.
What made MICs unique was their income-tax treatment. Unlike ordinary corporations, MICs pay no tax so long as they pass all of their profit onto their shareholders. Investors are taxed on distributions as interest income, as if they directly owned the underlying mortgages themselves, but if they invest through their registered retirement accounts they can defer paying such tax.
Despite Ottawa’s early efforts to spur more private investment in the mortgage market, MICs never really took off until the dust settled on the 2008 U.S. housing meltdown. The same is true for similar mortgage funds, including real estate mutual-fund trusts.
Keen to avoid a U.S.-style real estate crash, Canadian policy makers brought in stricter rules for banks and federally regulated mortgage lenders, such as requiring higher down payments and restricting loans to more creditworthy borrowers. That limited who they could do business with, opening the door for alternative lenders. The financial crisis also curbed demand among investors for commercial mortgage-backed securities, which had previously been a source of financing for real estate developers.
Amid all of the change, MICs and syndicated mortgages filled the void left by more conventional lenders. They also often approved loans faster than the big banks and were a lucrative source of commissions for mortgage brokers.
But there was a tradeoff for borrowers. MICs and other similar firms often charged annual interest rates between 5 per cent and 15 per cent, which meant they provided expensive debt. By contrast, the weighted average mortgage rate that RioCan Real Estate Investment Trust, Canada’s largest REIT, pays on its domestic properties is only 3.55 per cent. The higher interest rates allowed MICs to promise enticing annual payouts, sometimes above 10 per cent.
Investors salivated. As rates plunged in the aftermath of the crisis, MICs became especially attractive to retirees who were in search of solid, dependable returns – especially after former federal finance minister Jim Flaherty famously clamped down on income trusts in 2006.
MICs were one of the few investment vehicles given permission to keep using the old flow-through tax rules.
As investor demand soared, MICs expanded into vastly different business models. Early on, some were nothing more than small groups of private investors that might lend a few million dollars to a handful of higher-risk homeowners, while others offered second mortgages to help home buyers amass a large enough down payment to avoid taking out mortgage insurance.
Over time, though, loans to individual homeowners grew less popular.
Today, they comprise only about 30 per cent of total MIC assets, according to Sid Rajeev, head of research at Fundamental Research, which examined the market for CMHC. The Big Six banks and large alternative lenders such as First National simply got too good at sourcing these types of mortgages.
To survive, MICs and other similar mortgage investment vehicles found a niche market to exploit: Lending to less-experienced developers or real estate investors, such as the owner of an apartment building in need of short-term cash to repair units. Sometimes they lend to developers betting on high-risk projects that can take forever to get off the ground. Some developers have even set up their own mortgage investment corporations, essentially raising money for their own projects.
Veteran lenders with solid track records can help mitigate these risks.
Yet Canada’s fervor for real estate has allowed small bit players to flourish.
“It’s really just turned into a cottage industry of non-bank lenders out there,” says Zachary George, a Canadian activist investor at FrontFour Capital, based in Greenwich, Connecticut.
“You go to any city, whether it’s Montreal, Edmonton, Calgary, Toronto, Vancouver and there are these family offices and syndicators or small groups where they could have portfolios that are $10-20 million dollars in size,” he adds. “They could be $70-million in size and I guarantee you that in many cases, you and I have never even heard of them.”
As this industry flourished, former Bay street analyst Rob Wessel did some digging in 2013. He walked away shocked by what he found.
Because he had covered banks, and now runs an asset manager that focuses on financial institutions, Mr. Wessel is particularly familiar with real estate lending. Through his research, he learned that MICs operate on a similar model as U.S. banks that specialize in construction lending, rather than that of run-of-the-mill residential mortgage lenders.
This is troublesome, he argues, because construction loans are usually the first to show losses amid economic stress. “Construction lending is one of the riskiest loan categories,” Mr. Wessel warns. It is incredibly sensitive to economic changes, and future real estate developments or those under construction are the easiest to ice when things go bad – which is precisely what happened in 2006 when construction lenders ran into serious trouble before the U.S. housing market collapsed.
Given this risk profile, as well as the current state of the Canadian market, investors should want high returns on some of these projects, argues William McNarland, managing director of Vancouver-based merchant bank Eiffel Peak and an expert in private investments. For riskier syndicated mortgage investments that raise money for development soft costs, such as marketing and consulting, Mr. McNarland says he would expect returns of between 20 and 30 per cent. Yet many such companies offered investors only 8 per cent to 12 per cent – sometimes even less today.
“I have no problem with development financing,” he says. “But I would be very concerned about someone coming to a naive retail investor and telling them that development financing is safe and secure way of investing their registered retirement money.”
Yet that’s exactly how many real estate funds are promoted. They pitch themselves as safe alternatives to the volatile stock market, anchored by Canada’s no-fail housing market. It is common to see them advertised as a secure, low-risk way to invest with above-average returns to help build wealth and financial independence.
“The actual retail investor, I think they pick up on terms like: ‘safe, real estate, yield, mortgage,’” argues Mr. McNarland, who was sued for defamation last year by one failed mortgage company after he published a critical post about the firm on his website. “It’s hard for them [investors] to decipher between the excellent ideas that are out there and some of the poorer opportunities.”
Private MICs also often emphasize that their shares don’t fluctuate in value, unlike publicly-traded stocks. But that’s only because the companies themselves control the price of their shares and, unlike the stock market, investors often can’t easily unload private MIC shares at a moment’s notice.
Timbercreek, which manages over $1-billion, sells investors on its “low risk, high yield” portfolios, but by their very nature fat returns are tied to taking on extra risk.
This fundamental principle often flies over investors’ heads. The idea of risk-adjusted returns is “the most difficult concept that we have to try and explain to people,” says Hilliard MacBeth, an Edmonton-based portfolio manager and author of When the Bubble Bursts: Surviving the Real Estate Crash. “Even some people in the investment industry don’t understand it.”
Mr. MacBeth speaks to a few prospective clients every year who come into his office boasting of earning double-digit returns investing in mortgage companies that have never lost money. He typically challenges them to look into why a borrower would have to pay 12 or 13 per cent interest on a mortgage when banks are offering prime mortgages below 3 per cent.
Asked about its marketing line, Timbercreek chief executive officer Andrew Jones argues the depth of the firm’s management team is what makes the funds low-risk – not necessarily the loans themselves. “If you’re going to invest in a MIC, you need to look at the investment performance and track record of the manager,” he says.
Investors looking to understand mortgage fund risks should also study the locations of the properties. A seniors’ housing project on the outskirts of Victoria, a retirement mecca, has a radically different risk profile than a new condo building in downtown Toronto, where a much younger demographic is found. Geographic diversification is just as important. The oil price crash proved that a MIC specializing solely in Calgary properties can be dramatically more risky than one with a mix of assets across cities, or even better, across provinces.
The types of mortgages matter, too. Loans for complex projects are sold in tiers, and a ‘first’ mortgage is the safest, because it’s the first to get repaid in the event of a default. A ‘second’ mortgage only gets back whatever money is left after all of the first mortgage lenders are repaid in full. Some private mortgage investments can ultimately end up third or fourth in line behind other lenders.
And then there are cash reserves. MICs don’t always have deep enough pockets to endure rough patches in the market. Their requirement to pay out all profits to investors, to avoid paying taxes, coupled with their need to generate a steady stream of high returns, can encourage them to keep their cash levels as low as possible. This, in turn, limits the financial cushion they have to absorb bad loans.
The rapid decline of Trez Capital serves as a cautionary tale of how that business model can go wrong.
After launching two publicly traded MICs in 2012, the high profile B.C.-based lender raised more than $230-million in less than a year.
Shortly after, the company started struggling with high levels of arrears. By 2015 nearly a quarter of its portfolio was made up of mortgages in foreclosure or loans to borrowers who were behind on their payments.
At least some of the troubles stemmed from Trez’s dealings with a Toronto real estate investment company called The Rose & Thistle Group, operated by lawyers Norma and Ronauld Walton. According to court records, Trez loaned at least $50-million to the company’s various real estate investments, including toward the purchase of the former Toronto headquarters of Postmedia, which publishes the National Post and other Canadian newspapers. When the media company moved offices in 2014, the building lost its only tenant.
The Trez mortgages got caught up in a bitter legal spat between the Waltons and their business partner, well-known weight-loss physician, Dr. Stanley K. Bernstein. The dispute pushed many of the Waltons’ real estate investments into receivership and the couple has since been charged with fraud over allegations they siphoned money from their companies into other business endeavours. The case is still before the courts. (Court records show CareVest also previously lent money to the Waltons.)
With more money flowing out to Trez shareholders than coming in from its borrowers, investors grew frustrated with the company’s poor performance. By 2015 its stock price had fallen so far that the total value of the MICs’ shares were worth less than the estimated value of their mortgages. That attracted the attention of a group of hedge funds and FrontFour, Mr. George’s firm, was among those who moved in and forced the company to wind up its MICs altogether.
In an interview, Trez chairman Gary Samuel argues the mortgages to high-risk borrowers such as the Waltons weren’t a major factor in its decision to shut down its MICs. Instead, he pointed to the stock price’s disappointing performance. There was a “persistent differentiation”
between the stock price and the value of the company’s assets.
He also says the market has evolved, making it more challenging for MICs to generate results.
“Clearly for all public and private MICs, the yields they’re [now] able to deliver are lower,” he notes. “The interest rates that they are able to charge on loans are less than they were, because interest rates generally are much lower and because there’s a lot of competition.”
Indeed, some larger MICs have shifted away from riskier loans, adopting a more conservative approach of late. Timbercreek is one of them. In
2016 the firm merged its two MICs and promised to chase safer deals.
However, the new, lower risk profile means Timbercreek likely can’t generate the same high returns it once enjoyed. Instead of cutting its payout, which would upset investors, the MIC has consciously taken on more debt to fund the shortfall.
Atrium MIC, which manages more than $530-million in mortgages, has deployed a similar strategy. Robert Goodall, a former head of real estate lending at Royal Trust, started Atrium in 2001 and he says he is conscious of the hard lessons learned through decades lending into real estate booms and busts. “Anybody who has only been lending for 10 years has really never seen a severe downturn,” he says.
Where regulators fail
Even for experienced investors who know better than to fall for marketing tag lines, sorting through the scores of mortgage lenders to find one with an appropriate level of risk isn’t an easy task. While larger and more established MICs typically provide more disclosure to investors – particularly if they are publicly traded – for the hundreds of smaller, private mortgage investment firms, the industry’s disclosures are notoriously weak.
“This market is very opaque,” says Reid Duthie, who used to be a senior vice president at Edmonton-based KV Capital Inc., which runs a MIC, and is now chief investment officer at JayCap Financial, which lends to commercial mortgage borrowers. “It’s very hard for investors to understand the difference between a good [mortgage] company and a bad one… The disclosures on MIC financial statements aren’t adequate for investors who want to look at the portfolio and determine the health of the real estate.”
Often, funds don’t break down which properties and developers they’ve lent to, which means investors struggle to know what they’re supporting – a loan to an apartment building owner that is backed by monthly rental income or one to a high-risk developer that has yet to put a shovel in the ground.
Regulators also don’t vet the many private MICs. Most provinces allow MICs to raise money under a document known as an “offering memorandum.”
Unlike companies that raise money through a prospectus – a detailed disclosure document that can run hundreds of pages and must be approved by a regulator – an offering memorandum is far less detailed and isn’t reviewed by any authority. It is designed to make it cheaper and easier for small businesses and start-ups to grow, but has become a popular way for mortgage investments firms to raise money.
The laws that govern who can sell mortgage investments, as well as who can buy them, also vary dramatically from one province to the next. “The rules surrounding how you can buy [mortgage] investments are just the poster child of the failure of securities regulators to provide consistency and uniformity in the rules across the country,” says Ms.
Han, the securities lawyer. “It really is an embarrassment that there are different regimes regulating the way in which MIC investments can be sold and marketed to investors … in B.C., Ontario and Alberta,” she says.
In Ontario, ordinary investors can put no more than $10,000 into MICS, while wealthier investors and those who receive suitability advice from a registered portfolio manager or dealer have higher limits. In B.C., home to roughly two-thirds of the country’s MICs according to Fundamental Research’s analysis, anyone can invest in MICs and there are no restrictions on how much individuals can invest, beyond the limits that some funds set themselves.
B.C. is also the only province that doesn’t require MICs and other mortgage investment funds to register as investment or exempt market dealers. That means the companies and their employees are not subject to the same standards and oversight as others in the investment industry.
Many are instead regulated as mortgage brokers, whose lobbyists have successfully pushed back against several attempts by provincial securities commissions to add another layer of regulation to their industry.
As recently as 2013, the province backed off moves to introduce new disclosure rules after a backlash from the industry.
Asked about its minimal restrictions for MICs, the British Columbia Securities Commission wrote in an e-mail: “We believe that a successful capital market regime needs to find a balance between facilitating capital-raising opportunities with investor protection,” adding that its offering memorandum “was designed with investor protections.”
Ontario has another glaring exception to Canada’s mortgage regulations.
Although the province has tighter rules for MICs, the provincial securities commission does not regulate syndicated mortgages. Instead, this market is overseen by the agency that regulates mortgage brokers, the FSCO.
This loophole is a large reason why Ontario has become the centre of the country’s burgeoning syndicated mortgage industry, worth an estimated $6-billion in the province alone. (MICs, meanwhile, have traditionally been more popular in Western Canada.) In an e-mail, a spokesperson from Ontario’s Finance Ministry says the rules around syndicated mortgages, which date back to the 1930s, were intended to allow regular investors – like parents lending money to their kids to help buy a home – to avoid facing the same securities regulations as professional investment firms.
Yet last year an independent review warned of the “regulatory gap regarding syndicated mortgages” and recommended the industry be regulated by the Ontario Securities Commission. The Ministry of Finance says it expects to release additional recommendations on the industry “in the coming weeks.”
According to court records, MIC Trez Capital loaned at least $50-million to the company’s various real estate investments, including toward the purchase of the former Toronto headquarters of Postmedia. When the media company moved offices in 2014, the building lost its only tenant.
According to court records, MIC Trez Capital loaned at least $50-million to the company’s various real estate investments, including toward the purchase of the former Toronto headquarters of Postmedia. When the media company moved offices in 2014, the building lost its only tenant.
Alberta has taken the stiffest approach to regulating mortgage investments, requiring MICs and similar mortgage companies to register as dealers and fund managers, meaning the securities regulators can keep closer tabs on the individuals selling these investments. Yet even with those safeguards, the province has been home to several high-profile mortgage investment blow-ups in recent years. The main culprit: A volatile real estate market whose fortunes are closely tied to commodity prices.
While they can’t control the economy, regulators can make sure investors are aware of the risks before they invest. For all its rules, the Alberta Securities Commission still had to stop a MIC named Crossroads-DMD from raising new money for two years starting in 2013.
The ASC had concluded that Crossroads failed to disclose that almost all of its loans were second mortgages, meaning they were less likely to get repaid than the first mortgages on the same projects.
Some CareVest investors have also begun questioning whether regulators are asleep at the wheel. Recently, several said they were shocked to start receiving e-mails that pitched them on a brand new MIC-operated by the same company behind CareVest.
Valmor Mortgage Investment Corporation launched in August, 2016, seeking to raise as much as $20-million with plans to lend money to the same types of projects that the company’s other MICs do. It offers investors targeted yields of up to 5 to 6 per cent a year.
The Alberta Securities Commission declined to discuss CareVest or Valmor specifically, but said in general that mortgage investments raising money through an offering memorandum don’t face the same kind of scrutiny as other securities, which could include being restricted from raising new money because of past financial problems with the company or its executives.
Indeed, no CareVest MIC or company employee has ever been accused of doing anything that would prohibit them from starting a new MIC – beyond disappointing its existing investors.
Roy Goddard, president of Carecana Management Corp., the manager that runs the CareVest MICs, wrote in an e-mail that the company’s high level of struggling mortgages could be “directly and indirectly” attributed to the real estate downturn following the 2008-2009 global financial crisis.
A new MIC will be free from those historical woes, he said. The company operates three other MICs besides CareVest and Valmor. They were started more recently and have only “small amounts of non-performing” mortgages, although all but Valmor have stopped raising new money, Mr. Goddard said.
“Each fund operates its own portfolio of mortgage investments and they do not impact each other, either to the positive or the negative.”
That argument does little to mollify Edmonton’s Doris Gordon, who estimates it will take her 18 years to withdraw all the money she invested in CareVest, based on the company’s annual redemption limits.
These days, Ms. Gordon is done putting her savings into exotic mortgage investments that she doesn’t understand. “Now all we do is buy GICs,”
she says. “The returns are terrible, but at least we have what we started with – which is more than we can say about this.”