What You Need to Know About Mortgage Funds

by Kevin S. Kim

Mortgage funds or pools were once a top-tier vehicle for real estate investing reserved primarily for institutional investors and hedge funds, but recently, more private lenders are incorporating mortgage funds into their operational portfolio.

Here’s some insight into mortgage funds.

Why You Want to Open a Mortgage Fund

The primary reason that mortgage brokers and lenders choose to build a mortgage fund is to increase revenue.

Lenders make significantly more money with a mortgage fund. While mortgage brokers receive origination fees and points, mortgage funds provide the opportunity to earn origination fees, plus arbitrage or income participation from the fund, and additional fees, such as management and servicing fees.

Mortgage funds also significantly increase production, as fund managers are allowed to choose, approve, and fund the loans themselves, without individual investor approval. This process provides managers with the flexibility to quickly fund more deals and increase production and revenue, typically growing their income by 20-30%.

Mortgage funds are also a benefit to lenders because they offer more protection against risk exposure. A mortgage fund requires detailed risk disclosures to prospective investors that protect lenders from the legal risks associated with these types of investments.

Why Investors Prefer Mortgage Funds

Investors prefer mortgage funds to direct investing because it provides a passive investment into multiple types of real estate assets, without the headaches typically associated with directly purchasing notes or funding deals.

Mortgage funds provide investors the option to invest in various types of real estate that offer different returns, diversifying their portfolio as a hedge against risk. Investors can typically receive better returns through diversification than they would otherwise see with direct investment.

With a diversified pool of properties, it means the investors’ money is working around the clock. It also provides more insulation from risk because the money is invested in a pool of loans rather than just one loan. This setup leads to better returns in the aggregate.

A fund structure also protects investors from the risk of loss by defaulted borrowers, borrower lawsuits, and other foreclosure-related risks. In a pool, a default usually doesn’t affect an investor’s capital, unlike a direct investment, where the entire amount of capital invested and revenue stream is placed at risk during a default.

How a Mortgage Fund Works

A mortgage fund or mortgage pool is typically constructed as a Limited Liability Company which sells membership interests in the company. Investors into the fund receive revenue from the returns of the fund’s loan activities.

The LLC is typically operated by a management company that brokers loans to the fund and oversees day-today operations and assets. In exchange for management services, the company is compensated with management fees, origination fees, servicing fees, while also participating in the interest income.

The majority of mortgage funds rely on federal exemptions to avoid registration with the SEC. Although not typically considered a security, shares of an investment pool or fund can sometimes trigger SEC or state regulatory oversight. Specific federal rules allow exemptions to these business models, with the four most relied upon exemptions being:

  • Reg D Rule 506B – Allows up to 35 non-accredited investors nationwide. Prohibits advertising.
  • Reg D Rule 506C – Permits advertising but limits the fund to raise capital nationwide from verified accredited investors only.
  • Reg A Tier 2 – Permits funds to advertise and raise capital from an unlimited number of non-accredited investors with SEC approval of offering docs and periodic reporting
  • Reg S – Permits American funds to raise capital overseas. Advertising overseas is permitted.

    The Risk and Challenges of a Mortgage Fund

    First off, running a mortgage fund is NOT a part-time job. A mortgage fund is critical to scaling and growing a private lender’s business. This growth may require more staff, software, vendors, and additional marketing to fully advance the opportunity that a fund presents.

    Some key mortgage fund pieces include upgraded accounting and legal help, loan servicing software and service provider, fund supervision, staffing, and investor relations and marketing to ensure you have a steady pipeline of investors ready to help grow your fund.

    Funds may also face obstacles related to liquidity, cash flow, and liability. Typically, mortgage funds establish set reserves, along with cash-flow guidelines that help protect the fund in case of defaults. Funds usually task CPAs with putting safeguards in place to protect the fund from leveraging too much capital or funding individual loans above 10% of the funds’ portfolio.

    Starting a Mortgage Fund

    Private lenders, brokers, and other nonconventional lenders seeking to create a mortgage pool should begin by evaluating the information on how to best proceed. The starting point includes consulting with a law firm that understands the complexities involved with setting up a fund and the law surrounding securities offerings and exemptions on both a state and federal level.

    A mortgage fund can significantly increase revenue, create new opportunities, and scale production and originations, but without the proper guidance, a mortgage fund not established correctly, could cause headaches, both financially and legally, for both the fund manager and investor.