Another high yield mortgage style trust has gone down the gurgler, threatening $300 million of investors’ funds. Australian Capital Reserve (ACR) offered its mostly elderly investors aggressive rates of returns on investments that it then lent on to other companies to invest in residential property stgelopments. Investors have been told that all their investments are frozen, that they will no longer receive quarterly interest payments, and that their investments, including any unpaid interest, will not be paid on its maturity date.

As they say, one such collapse may be an unfortunate accident, two is carelessness, but three is looking like a trend. After the collapse of Westpoint, Fincorp and now ACR, investors in similar trusts must be feeling decidedly uncomfortable. If it wasn’t for the fact that their investments are locked in until their ‘maturity date’, they may well have been stampeding en masse to withdraw their funds before another collapse. Even so, every one of the high yield trusts that have been spruiking their so-called ‘secure’ (but too often unsecured) fixed income payments are going to have to work very hard now to ensure investors don’t withdraw their funds the moment their investment ‘matures’.

Even conventional mortgage funds (that don’t offer a particularly high yield) will have to work hard to make sure they don’t get tarred with the same brush, says Dugald Higgins, of Property Investment Research, which researches mortgage trusts and property debt securities. Higgins says a worst case scenario could be a collapse along the lines of the unlisted property trust crash in the early 1990s. “If those funds haven’t carefully matched their loan terms with their fund maturity dates, they may not be in a position to withstand the wholesale withdrawal of investor’s funds.”

The fact that investors may have been receiving interest payments like clockwork is unfortunately no assurance that a trust is healthy and likely to return their capital, Higgins points out. A trust that is in trouble can continue to fund its ongoing interest payments from new investor inflows. But that can only go on for so long and the whole thing can fall apart if a stgelopment project is delayed for long enough, or the borrower defaults.

“Westpoint and Fincorp were cases in point,” Higgins says. “Up until the latter stages, when the cracks started to appear, neither company had ever missed an interest payment to investors. Very laudable, but cold consolation if you lose 100% of the capital you put up in the first place.”

So how can you tell if a mortgage or high yield trust is risky?

As with any investment, one clue is the yield being offered. Given the bank mortgage rate of roughly 8%, any mortgage trust offering more than that is deriving the extra yield from at least a number of higher risk loans paying a higher interest rate. As Roy Prasad, the head of mortgages at Australian Unity, points out, the quality of the deals drops off dramatically when you’re lending at higher than normal rates. “Sure there are borrowers who are prepared to pay 15%, but they tend to be rather desperate, which raises the default risk dramatically.”

But the yield being offered doesn’t have to be exorbitant to make an investment risky. It seems that operators who were offering yields of 11% or more in recent years have gotten wise to the fact that their high yields were raising alarm bells amongst commentators. Many are now offering more moderate rates of 9% or so, even though in many cases they are lending the same funds to borrowers at much higher rates. In these cases, says Higgins, many operators are under-pricing the risk their investors are taking. “Sometimes they’re lending out at 25% while paying their investors not much more than the rate on a first mortgage,” he says.

Which makes it essential to look at what the funds are being lent for, and what form your investment is taking. Regular first mortgages against established property are the least likely to be defaulted on, while a high proportion of mortgages on construction and stgelopment projects immediately ups the risk. Mezzanine finance that covers the extra, often short term, finance required by stgelopers to fund a project earns a higher interest as a trade-off for the fact that the borrower is carrying a much higher loan to value ratio on the project and that you as investor stand next in line to the ‘senior debt’ of a first mortgage.

At least with a mortgage (even in the form of mezzanine finance) you have a call against the property assets if a trust should fall over. Increasingly however many so-called mortgage trusts are not in the form of property backed investments at all, but are in fact debentures or unsecured notes in a company that then lends to another company – sometimes a related party – for property investment. This is how such operators manage to be able to get the word ‘property’ or ‘mortgage’ into their promotional materials, even though you have no claim against the property your money is funding should the trust fall over. (This is the case for the 7000 or so ACR investors, whose money was lent to another related company Estate Property Group.)

Finding out whether a high yield trust is in the form of unsecured notes or mezzanine finance often requires some detective work, says Higgins. “You often have to wade through the whole spiel to get that information, and even then it is sometimes not clear what exactly it is investing in, and who it lends its money too.” Given that many high interest bearing loans are short term, the make-up of a trust’s loan book can change dramatically from month to month, Higgins points out. Investors also need to look at what a trust’s mandate allows them to invest in. The prospectus may allow the operator to put 70% of the funds into second mortgages for instance, changing the whole risk profile of the trust.

Even traditional mortgage trusts need to be sufficiently diversified. Prasad says that a simple rule of thumb for a mortgage trust is to diversify across geographical location and sectors in proportion to their representation on the market. As such, the greatest number of loans should be against properties in New South Wales, then Victoria, then Queensland and so on. A high proportion of stgelopment projects also makes for a risky investment. If a stgelopment application falls over, it may be difficult to sell the site on, risking a large proportion of the trust’s income and capital.

That should make alarm bells ring loudly when a prospectus lists its loans as solely concentrated in residential stgelopment projects in Queensland, for instance. They may do just fine while the sun shines, just don’t throw your entire retirement savings their way.