Look for exits when investing in contributory mortgages

By David McEwen

Monday 17th June 2002

Contributory mortgages are not necessarily the most risky investment available in New Zealand. It just seems that way because of poor quality ones making the news.

The concept is easy enough: A group of investors pool their money and lend it to someone to buy, build or develop a property, usually secured by mortgage.

The investor receives a relatively high return of between 9% and 12%, and when the development is complete or the property sold at some predetermined date, the investor gets back the capital plus any interest owing.

Every scheme is different, and it's in the detail where the risks lie.

Some are packaged to attract unsophisticated investors who think they are getting the stability of property, and a high yield they couldn't get elsewhere. The couple of percentage points that separates the yield of a quality mortgage bond, and that of a dog, are not worth having for the additional risk you have to assume.

Here are some simple rules to steer you towards the safest contributory mortgages.

- Lookout for adviser conflict of interest

Some advisers are also brokers for the contributory mortgage they want you to invest in, and they receive fees from those offering the investment. Given this conflict of interest, take any advice to invest with a healthy pinch of salt. Take the prospectus to an accountant or lawyer specialising in this field before parting with money.

- Don't invest in new developments

Only the brave or experience should invest in a building that has yet to be constructed. The valuation of such projects - on which lending is based - is particularly tricky, as assumptions have to be made of the state of the market well into the future. Property moves through cycles, and developers tend to build their hotel, office block or whatever, irrespective of the fact that several others are doing the same thing at the same time, oversupplying the market.

- Accept only first bond security

The second mortgage holder has little power and is at the mercy of the first mortgage holder. If something goes wrong, the first mortgage holder could take actions to get their money back that prejudices, the second bond holder. This can involve selling the building for just enough to cover their debt, leaving everyone else in the lurch.

- Look for a margin of safety

Those with experience in the market say investors should never invest in a property where the mortgages add to more than 75% of the total valuation. This means the value of the building can fall by 25% before the value of their investment is threatened. Some insist on a higher margin on safety, up to 50%.

- Ensure you have an exit strategy

Your exit strategy must allow for repayment of your investment in full. Answer such questions as; do the developers need to sell the building before repaying the mortgage? How likely is this to happen before due date of repayment? Have they set up finance to replace the contributory mortgage finance? Does a major lease expire before the due date for repaying contributory mortgage holders? The exit strategy is even more important if the building is still to be built. What happens if development is aborted? Is the value of the vacant land enough to cover the contributory mortgage loans that were intended for development after fees and costs have been extracted? Who is in front of you in the queue for repayment if the development is aborted?

By securing your investment against the worst-case scenario, you have a better chance of getting your investment back with a reasonable return to boot.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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