Those involved in MICs should pay close attention to property values – especially if they begin to go into decline, says one industry analyst, who believes investors may be misinterpreting market signals.
Rob Wessel, a managing partner with Hamilton Capital Partners, has noted a fundamental misunderstanding among MIC investors as to what lower property values could mean to their investment – considering MICS could be viewed as the “canary in the coal mine” for Canada housing market.
“Of the several MICs that were reviewed, we observed two areas where a generalist investor may – incorrectly – surmise that a MIC investment has low credit risk,” says Wessel, “when in fact the opposite could be true. These potential misunderstandings are more significant in a market where property values are declining.”
Wessel says that over the past several months, there has been a lot of discussion about the potential impact of falling home prices on Canadian financial companies – and banks, in particular.
“Some have predicted that a correction in home prices could cause a credit downturn, or worse, some sort of systemic event – a view we do not share,” he says. “This issue has gained further investor interest given the recent rise in mortgage rates, which, if this trend continues over the next few years, could place stress on a housing market that has experienced a near vertical rise in prices over the past decade.”
According to Wessel, there are two fundamental misconceptions many investors have about their MIC portfolios.
“First, we suspect many investors may believe MIC portfolios are dominated by lower risk owner-occupied residential mortgages, owing to legislated minimum requirements on residential content,” he says. “However, for some MICs we found, the residential content was primarily, if not exclusively, higher risk residential construction/development loans, including the riskiest category of all – undeveloped land.”
The second misconception Wessel sees among investors is the overestimation of protection offered by a low loan-to-value ratio.
“It is not sufficient for investors to accept the safety of a MIC’s yield based on this metric,” he says, “which in many instances incorporates a significant number of subjective assumptions.”
Following Wessel’s review of the MICs that were studied, he found that for some “the risk profile of the underlying mortgage portfolios skewed overwhelmingly to higher credit risk,” be it through significant exposure to the most risky loan categories, excessive concentration in individual names/geographies, and/or subordinated collateral positions.
“This was particularly true for those MICs with outsized exposure to construction and land development,” says Wessel. “The significant risk of certain MICs has been obscured by a robust real estate market supported by large increases in home prices and property values.”