By Carlos Salas, President, The Change Company CDFI LLC
Fed tightening and an inverted yield curve have cast a spotlight on a persistent problem for investment advisors: the challenging search for attractive yield investments. Over the 25 years preceding 2022, interest rates have been on a downward trend, leading to a scarcity of yield in fixed-income investments. However, the recent spike in interest rates has produced attractive risk-adjusted returns from certain products. First lien mortgages, in fact, are yielding 8-9% and can offer adjustable-rate features with inflation-protected returns. In contrast, the traditional low-risk options of treasuries, CDs, and municipal bonds now yield negative real returns. And while other traditional yield investments such as real estate investments trusts (REITs) and mortgage-backed securities (MBSs) offer higher returns, their fees and expenses moderate yields and, because these are levered, they represent a significantly higher risk in an uncertain economic environment. Publicly traded REITs, for example, are permitted to lever up to 300% of their net asset value under SEC rules. MBS funds are similar in employing leverage to improve yield on their underlying assets. This additional leverage makes them susceptible to broad economic risk, as demonstrated in the 2007 financial crisis. And the value of these assets generally declines in an environment of increasing interest rates.
Meanwhile, there is an asset class that offers attractive yields in the current environment, that is straightforward to underwrite, that is indexed to rising rates, and that has a deep market. These are direct investments in first deed-of-trust residential mortgages. First lien residential mortgages are a type of direct investment that involves lending money to a borrower to purchase or refinance a property. In return, the borrower provides the lender with a first lien, which is a legal document that gives the lender the right to foreclose on the property if the borrower fails to repay the loan. This means that the investment is secured by the property and offers the potential for a stable return with limited downside risk, provided the loan is overcollateralized (as residential mortgages are in most cases). Currently, first deed of trust residential mortgages can yield upwards of 9% and are typically overcollateralized a tangible asset underwritten to regulatory standards.
Private-label mortgages are the preferred assets of insurance companies, large asset managers, and banks. However, they have historically been off-limits to retail and family office investors looking for a passive return profile. Advisors did not have the capability or interest in servicing the loans, managing any potential foreclosure process, or dealing with loan modifications. Today that has all changed. The Change Company has launched xChange (www.xchangefi.com) -- an online marketplace for first-lien mortgages that addresses these traditional barriers to investment. Investors can select loans one by one and ask Change to handle the servicing and the infrequent modification and foreclosure processes so the investor simply receives a check each month. By offering the servicing, selection, and purchase options of private-label mortgages enjoyed by institutional investors, Change has opened this attractive asset class to these smaller investors.
Direct investment in mortgages is materially different from investing in REITs or MBSs from a risk and return standpoint. REITs are investment vehicles that own and operate income-generating real estate properties, while MBSs are securities that represent a pool of mortgage loans. Both of these are typically levered and pursue a “gain on sale” investment thesis, which adversely changes their risk profile, and are subject to fees and expenses. In contrast, direct investment in mortgages involves owning the debt secured directly by a real estate asset, which means that the investor has direct ownership of the loan and the associated risk, and is ideal for “held to maturity” strategies.
An additional and important benefit of direct ownership of mortgage debt is that it offers more control over the investment. The investor can choose the borrower and the property and can decide the terms of the loan that matches their risk profile. This means that the investor can tailor the investment to their specific risk tolerance and investment objectives. Investors who believe forward rates will be declining might look for a thirty-year fixed mortgage, while those concerned about inflation could invest in an adjustable rate loan that has its rate reset every six- months. The investor can also select investments that generate positive social impact for specific classes of borrowers or communities if these goals form part of their investment criteria.
In contrast to traditional fixed-income products, first deed-of-trust residential mortgages offer the potential for inflation protection. As inflation rates rise, the returns from traditional fixed-income investments can be eroded. In contrast, first deed-of-trust residential mortgages have the potential to provide inflation-protected returns. This is because the interest rate on the loan is often tied to an index, such as the prime rate or SOFR, which can increase with inflation. This means that as inflation rises, the return on the investment can also rise.
xChange allows smaller investors direct access to these products by offering for individual sale a rolling inventory of of prime mortgage loans through an online marketplace that provides detailed, searchable data for each loan and allows investors to sort by criteria that include rate, loan-to-value, borrower FICO and geography. xChange offers investors access to an inventory of prime loans originated by its sister company Change Lending before these are bundled and sold on to institutional partners, and provides purchasers the option of having Change administer the servicing of purchased loans. Servicing includes the administration of non-payment and liquidations where necessary, so providing this capability is a significant benefit to the investor. In this way, xChange tames the complexity of direct mortgage investment, making the asset suitable for a broader range of investors.
Because xChange’s affiliates are Community Development Financial Institutions (CDFIs) certified by the U.S. Treasury to serve target markets of underbanked borrowers, xChange’s inventory of prime mortgages also include a relatively high number of loans to Black, Hispanic, and other underbanked populations. For an ESG or other investor seeking to positively impact these communities and enable homeownership, xChange offers a unique opportunity to invest directly in this effort.
The day has come when responsible investment advisors consider the inclusion of first-lien residential mortgages as a component of an income portfolio for family offices and retail investors. With the potential for attractive yields and inflation-protected returns, they offer a unique opportunity for investors seeking to diversify their portfolios and achieve their investment objectives. And perhaps most compellingly, they permit the retail investor a seat at the table without intermediaries and with a superior risk-adjusted return in an otherwise uncertain economic environment.