Prime position for first mortgagees

When clients insist they want the higher fixed-interest returns offered by mezzanine finance, debentures and the like, and think the extra income is worth the risk, advisers should draw their attention to two recent court actions.

In one, the receiver of Estate Property Group (EPG) is seeking breathing space from the Federal Court so it can work out the best way of paying back as much as possible to all creditors of EPG and its financing operation Australian Capital Reserve (ACR).

This action is in response to Investec Bank, the prime lender, seeking a much quicker process that would enable its own loans to be repaid.

Another, unrelated court case should be of even greater concern to investors with second mortgage products such as mezzanine finance.

A company won the right in the NSW Supreme Court in May to go ahead with a sale that raised enough finance to pay out the first mortgagee but left second mortgagees out of pocket.

This is despite the mezzanine lenders arguing that a different approach should be taken.

These two court actions, taken for different reasons, show the vulnerability of second mortgage holders and emphasise the superior position of people who hold first mortgages.

They also highlight the difference in control of first-ranking mortgage holders over other creditors such as second mortgagees.

The simple fact is that, although most take a realistic approach, not all first mortgage holders consider the plight of second ranking mortgages and nor do they need to.

Quite properly, a mortgage holder’s primary obligation is to their own investors and shareholders, and their priority must always be to get the capital back so they can get it working again.

The basic difference is that first mortgage holders usually have no reason to wait to get repayment if things go wrong, but second mortgage holders usually need time if they are to maximise their return.

It is usually true that, as long as there has not been dishonesty or excessive borrowing against a property that has had its value inflated, property lenders should eventually be able to get most or all of their money back.

It is the ‘eventually’ that creates the problem for second mortgage holders.

First mortgage holders want to get their money back as soon as they can to protect their own investors, and are not usually interested in any excessively long-term schemes of arrangement or proposals for deferred sale.

On the other hand, in times of distressed sales, or property developers going into receivership or schemes of administration, second mortgagees must hope for time being granted for an orderly sale.

This is about the only way that will give them a reasonable prospect of recouping their investment, and if they are lucky, also some of the interest they expected to earn.

However, the NSW Supreme Court decision indicates that first mortgagees need not always consider the interests or concerns of second mortgagees or other creditors.

The decision reinforces the risks involved for investors chasing the extra couple of percentage points offered by high-yield mezzanine products.

Investors in mezzanine finance products and debentures issued by companies such as Westpoint, Fincorp and ACR have discovered the real cost of risk the hard way.

In the current climate, any investor who is considering investing in income earning products that are only, or mainly, secured by second mortgages should do their research first.

They should understand, among other things, what their entitlements are in the event of a default or collapse, and the true financial strength of the property developer involved.

Even if investors in products issued by companies that get into trouble do eventually get most of their capital, and even some of the interest back, nearly all will bear some financial cost.

The loss of regular income when they need it is nearly always a major burden, as a continuing income stream is the main reason people invest in income-based products.

Just as critical is the worry and stress; a price that all investors in Westpoint, Fincorp and ACR will pay, regardless of the ultimate financial outcomes for creditors of each company.

The returns provided by more established mortgage funds (including high-yield mortgage funds from well-regarded managers with established track records) that invest only in first mortgages are more secure for a number of reasons.

It is not just the security of being the first ranked lender (usually controlling the sales process if any default does occur) it is also the diversity and variety of borrowers and properties against which mortgages are held in a mortgage trust.

This clearly affords a much greater level of security than products that are invested in one property developer, one property, or even one geographic region.

If one loan in a mortgage fund does become a problem, the fund manager has the time to work out a solution that retrieves the capital and earnings for investors. This is something second mortgage holders are usually denied.

Unlike mezzanine finance, any difficult loan in a mortgage fund usually represents only a small percentage of the total loans on the fund’s books.

Basically, first mortgage holders (in this instance the fund manager acting on behalf of investors) are in control of any sales process and second mortgage holders relinquish control.

Mortgage funds also offer an independent assessment of the risks incurred in a property investment on behalf of the underlying investors.

Such funds will have a team of lenders assessing the commercial sense of a loan made on behalf of a fund. They are not involved with the property developer or the property owner.

On the other hand, most mezzanine and debenture-type products are offered by companies that then use the money for their own or the related party’s property development activities.

Roy Prasad is head of mortgages at AustralianUnity Investments .