Assessing Risk and Return of Investments

Investors make decisions by assessing an investment’s return versus its potential risks. A higher yield is expected of a riskier investment, and conversely, lower returns are associated with low-risk ventures.

For example, a downtown premium office in Vancouver returns between 3.75% to 4.0%, while a suburban office in Calgary is priced to provide a return of 7.75% to 8.0%. The premium office, which is located in the downtown of a major metropolitan area, would be deemed to be a lower risk investment, thus its lower rate of return. An experienced investor will understand this tradeoff, employing more caution with the Calgary office, whose higher yield rate suggests a riskier market.

The investment characteristics of bonds and equities further illustrate the interplay of risk and return. Bonds are a form of debt that provides investors with a fixed return over a set period, regardless of a bond issuer’s performance. In the event of trouble, a firm typically pays bondholders first. Bonds, therefore, are generally considered to be lower-risk investments, with returns that are commensurately low.

On the other hand, equities allow an investor to participate in the earnings of a company through dividends. However, the payment of dividends is dependent on the performance of a firm, and their values are not guaranteed. Preferred shares, for example, have a negative correlation to interest rates; the value of preferred stocks fall when interest rates rise. Common stocks, on the other hand, feature share values that depend on market supply and demand. Common stock dividends are not guaranteed as they are declared by the board of directors; in fact, it is fairly common for common shareholders not to receive dividends at all. Despite these risks, however, equities remain attractive to many investors because they are also typically associated with higher returns.

Choosing which investment to make depends on the investor’s objectives and risk appetite. A risk-averse investor might prefer to invest in bonds, while an investor seeking to grow his or her wealth quickly will probably select equities. But what if an investor seeks higher returns without exposure to the volatility of equities? If this is the case, then investing in a mortgage investment corporation may be a good alternative.

Mortgage Investment Corporations

Mortgage investment corporations (MICs) provide stable returns that are higher than many fixed-income investments available in the market. MICs primarily invest in residential mortgages, which offer financing to borrowers who are unable to obtain funding from traditional sources. Interest rates are higher than those of conventional lenders, which is meant to compensate for the additional risk undertaken by their private counterparts. However, this does not mean that investing in MICs is inherently risky.

MICs conduct due diligence on their borrowers but can be flexible in their criteria for approval, especially as people who obtain financing from MICs may have been affected by recent regulatory changes instituted by the Canadian government. Moreover, property backs mortgages undertaken by MICs. Lenders can repossess properties in case of default. In addition to these defences, MICs have several forms of risk mitigation strategies.

The act of pooling mortgages into a portfolio mitigates risk by spreading the effects of defaults across several inflows. Default by one borrower can be offset by the inflow from the other mortgages in the portfolio. A larger pool of mortgages can better absorb the effects of defaults by borrowers.

Diversifying the mortgage portfolio is another strategy for mitigating risk. MICs can invest in different geographical locations as each housing market may be in a different stage of the housing cycle, thus having different dynamics from each other. MICs can also invest in commercial mortgages and land-development mortgages. However, the MIC must have the necessary expertise to underwrite the various property markets or mortgage types properly.

The types of mortgages undertaken and the amount of money can be managed as well. The MIC can choose to exclusively take first and second mortgages while minimizing or avoiding third and fourth mortgages. MICs also mitigate risk by controlling the loan-to-value ratio, with MICs providing for loan coverage between 60 and 80% of the asset value.

The MICs’ underwriting teams ultimately manage risk. They use their extensive knowledge in different real estate markets to take calculated risks and optimize returns on capital.

Real Estate Investment Trusts

Real estate investment trusts or REITS are an alternative investment to MICs. Most REITs are publicly listed organizations that primarily invest in commercial real estate. Like MICs, REITs are required to distribute all of the net earnings to their shareholders and are only taxed when this disbursement occurs.

REITs are equities that derive earnings through the rental income generated from ownership of commercial property. These enterprises may have a diversified pool of commercial properties or may opt to focus on specific sectors, depending on the strategy and expertise of the firm.

Investors may also gain returns through capital appreciation of the security. However, this asset class is subject to the volatility of the stock market, especially in the short term, which creates a different risk profile versus MICs.

The choice between MICs and REITs is still dependent on the objectives and risk profile of the investor. Does the investor feel better about the housing market, or are their better returns to be earned from commercial property? WIll an investor prefer to invest in debt or equity? Does having both create a well-diversified portfolio?

Conclusion

If investors are looking to acquire debt instruments that provide returns that are higher than average, they should consider mortgage investment corporations. Thanks to the several risk management tools utilized by a MIC firm, investors can mitigate their downside risk. To select the MIC that matches the investor’s objectives, the latter must be able to assess the expertise of the MIC’s management team, the types of investments the firm makes, and the risk and return profile of their portfolio.