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episode # 332

The BEST Offence is a Good Defence with Justin Smith & Lisa Stewart

When it comes to financing, we all know that it’s not an easy time to be a borrower. But what if you could be a lender? This week, Justin Smith from Hawkeye Wealth, and Lisa Stewart, CRO at Neighbourhood Holdings, join Matt & Adam with a defensive strategy perfect for the moment we are in. Why is now the time to invest with alternative lenders? Why should this defensive strategy exist in every real estate portfolio? And how are some companies doing a better job of mitigating risk while offering consistent returns? This week, we bring you alternative lending simplified!

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Episode Summary


 

Who is Lisa Stewart?

I’m the Chief Revenue Officer at Neighbourhood Holdings, having been with them for about four years. Neighbourhood is a residential mortgage fund based in Vancouver.

Who is Justin Smith?

I’ve been in the business for over a decade, starting in pre-sales. From there, I began raising capital for private equity real estate deals. In 2017, I branched out and started Hawkeye Wealth. We find the best deals we can to deliver the best risk-adjusted return for our clients. We partnered with Lisa and her team to find defensively-positioned deals. We’ve been working together for about two years. 

Can you tell us about Neighbourhood Holdings?

Neighbourhood Holdings is a residential mortgage fund. The strategy was born out of a family business; they had been doing it themselves for over 30 years and turned it into a business in 2012. They found an opportunity in the Canadian mortgage landscape. 

Banks (aka A Lenders) and B Lenders are federally-regulated institutions and they have rules that restrict who they can lend to and how much they can lend. If someone doesn’t fit into the box for a bank, they’re forced to go to a B Lender, which means a higher rate. If they don’t fit the criteria for a B Lender, they then have to go to the alternative lending space, where there’s an even bigger increase in rate.

So Neighbourhood recognized that there was an opportunity to bring competitive rates into the alternative space for a short period of time, bridge the gap and allow Canadians to move into that prime space by the end of the year.

Today we manage over $400 million in residential mortgages across Canada. 

Who applies for mortgages with Neighbourhood Holdings?

Just because someone can’t get a mortgage from a bank doesn’t mean they’re not credit worthy. The federal bank regulator has certain rules to ensure banks don’t take on too much risk. They have a box ticking exercise that requires mortgage borrowers to have things like T4s and steady income. 

But if you’re new to Canada and don’t have a long credit history, you may not tick all the boxes. Or if you’re a business owner who doesn’t pay yourself a large salary, you may not look very credit worthy on paper. So that person might go and get financing from Neighbourhood, increase their income for a few years, and then reapply with the banks, which might make more financial sense in the end. 

The average credit score across Neighbourhood’s portfolio is 695. And with banks, they’re usually looking at credit scores about 600 or 650. Our ideal borrower is someone who is currently unable to borrow from the bank, maybe as a result of timelines. They can close with us sooner and then refinance with a bank a year later. 

How do mortgage funds work? 

Investors will pool their capital into an entity, like a corporation, and those funds are lent out to people who can’t borrow from A or B Lenders. The borrowers pay higher rates than they would at the bank and that interest is paid back into the fund. The fund distributes that interest income to the investors. So it’s great for the investors and the borrowers; it’s a win-win. 

Usually mortgage fund lending is a transitional period for the borrowers. You’re not trying to lock people into higher rates indefinitely. Typically people will be in for a year and then refinance with the banks. 

Does the stress test apply to Neighbourhood Holdings?

No, the stress test does not apply to Neighbourhood Holdings because we’re not a federally regulated lender. In times like these when the stress test restricts who can borrow from a bank, it does mean more borrowers flow into the alternative space for credit. 

With a bank, you can typically get 80% loan to value. With Neighbourhood, we are lower. We cap loan to value ratios at 75% and on average we’re at 58%. That’s important for us in terms of risk management for our investors. 

How can borrowers find Neighbourhood Holdings? 

You can find Neighbourhood Holdings through the brokerage network. We don’t work directly with borrowers; we work with mortgage brokers who can place their clients with Neighbourhood if it makes sense. 

What are the interest rates with Neighbourhood Holdings? How do those compare to rates from banks and B Lenders? 

Neighbourhood’s average interest rate across our portfolio is 7.75% today. That may seem high but when you compare it to a one-year rate at the bank, it makes more sense. People are paying for flexibility. You have the option with Neighbourhood to close out after a few months and move to another lender. 

There are also interest-only payments, which can ease the cost burden. 

What are the benefits for investors in mortgage funds?

There’s a fundamental difference between investing in the debt of the property and the equity of a property. Due to the nature of debt vs equity, lending is more stable. You have an agreed upon interest rate and income coming in. Everyone knows the lender eats first. 

When Hawkeye was looking for a mortgage fund to invest in, we looked at over 70 funds before partnering with Neighbourhood Holdings. We liked that Neighbourhood was defensively-positioned. Being residential-only was a big part of that, as was the average 58% loan to value. We wanted to work with a group with over $100 million in holdings so we knew they were quite established with systems that work. 

If a group employs a strategy like Neighbourhood, investors benefit from their defensive positioning and stability. Investors receive steady income and have less stress than with other investment avenues. 

How much do investors make with Neighbourhood?

Neighbourhood’s objective is to provide stable yields for investors. We ask investors for a one year commitment up front and distribute income monthly. You can expect to earn 7-8.5% net yield on a monthly basis. 

How does a high interest rate environment change how Neighbourhood operates?

In a rising rate environment, it is positive for our returns. 98% of our mortgages are variable rate; as rates increase, so does the profitability of our portfolio. 

The fact that our average loan to value is 58% is a great way for us to manage risk. We’ve funded over $1 billion over our years of operation, we’ve never completed a foreclosure and we’ve never incurred a loss. It’s not impossible, but our underwriting process helps us mitigate the risks. We want to know how the borrower will pay us and what the property is we’re lending on. If we need to foreclose, how much can we lend and still ensure we get our principal back? 

Sometimes it’s markets like we’re experiencing today that make people think. It’s always a good time to have defensively positioned stuff in your portfolio! You don’t know what’s coming so you need part of your portfolio in something more stable. 

How does Neighbourhood assess risk? 

Our core strategy can shift overtime but generally it stays the same; we want to be built to perform in any market condition. For example, in 2016 we actually moved out of Toronto and into Montreal, because Toronto was looking too frothy. We like to have many small loans in many places.

Our average loan size is $400,000 and we’re in BC, Alberta, Manitoba, Quebec and Nova Scotia. With our pricing curve, we drive demand towards the loans we want to fund. We have strict lending criteria that doesn’t change. The deals we’re doing today come to us based on our pricing. We’re competitive where we want to do deals. 

There’s not a market we’ve completely shut out. There are deals to be had in every market, it just comes down to the underwriting process. 

What are the challenges in the year ahead for Neighbourhood? What are the opportunities? 

The challenge and opportunity is really a double-edged sword. 

The challenge is market sentiment on the investor side. People need to be more educated about mortgage funds as a real estate play. 

With liquidity drying up in the market and banks tightening up, that allows us to take advantage of the opportunities. We can work with borrowers and grow our fund because we still have cash available. 

We want to manage our leverage to such a level so that we can make it through any upcoming challenges. It would be very damaging if we ever stopped lending altogether. We want to be consistent so we can get brokers’ best deals. We want to be their first call. 

What is the minimum to get involved with Neighbourhood? 

Hawkeye Wealth’s minimum for the mortgage fund is $50,000. 

What are the risks of getting involved in a mortgage fund?

The risk is in two different categories: loss of capital and liquidity. 

With loss of capital, there are a number of safety nets before you lose money. The borrower has to stop making payments, your asset has to experience a big market drop, and your borrower has to be in really rough shape because lenders get paid first. That’s why Canadians pay their mortgages! 

On the liquidity side, Neighbourhood Holdings has never had to deny a redemption request. Neighbourhood has a 90 day notice to redeem after your first year commitment is up. And they’ve never had to deny one. Of course, there’s not zero risk. If you had a lot of people trying to redeem at the same time, it might be possible that they’d have to deny some requests. 

But I think the liquidity risk is managed quite well. Neighbourhood is quite cautious and throughout the pandemic, they didn’t see a huge number of redemption requests. They’re constantly stress testing their portfolio. 

Justin, what are the challenges and opportunities you see in our current market?

One of the ongoing challenges in our market has been finding deals that make sense. And that’s been a challenge for a while now, at least since fall 2021. No one thought interest rates would move this much and this fast. 

The opportunity is how healthy this is. Maybe we start to see deals on the equity side that make sense. 

Increasing interest rates aren’t fun if you’re borrowing but they are fun if you’re lending. A mortgage fund is part of a well-positioned portfolio at any time but has an extra perk in high interest rate environments. 

I believe interest rates will come down again. 2024 is the next election cycle in the US and it’s common for rates to come down before an election. And we know that Canada follows the US with these moves. There might be some opportunities there. 

Find out more: https://www.hawkeyewealth.com/ and https://www.neighbourhoodholdings.com/

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