Property-backed lending remains a compelling asset class for investors seeking both high yield income and the security of bricks and mortar. But within this asset class, the choice between 1st and 2nd mortgages can have a significant impact on returns, risk profile, and overall portfolio strategy.

Understanding the Asset Class

At its core, a residential mortgage investment is a secured loan backed by property. This means that if the borrower defaults, the lender has a registered legal claim over the asset.

1. 1st Mortgage: Primary claim on the property in the event of a default. Lower risk, but generally lower yield.
2. 2nd Mortgage: Secondary claim behind a first lender. Slightly higher risk, but generally higher returns to compensate.

Both can play an important role in a diversified portfolio — the key is aligning them with your investment objectives, time frame, and appetite for risk.

Strategy: Diversification vs. Single Asset

1. Diversified Portfolio: Lower risk, more stable returns — typically around 8% p.a. net for well-structured funds with a spread of loans (potentially hundreds or thousands) across multiple assets and locations. Highly diversified portfolios offer both reduced risk and the flexibility of asset redemption in as little as 2 to 4 weeks. Of course, there would typically be a discounting of the yield to compensate for such early redemption.
2. Single Asset Investment: Higher potential returns — a single, well-chosen mortgage can deliver around 12% p.a., provided due diligence confirms a reliable exit strategy and robust security. The returns available for a 2nd mortgage on an equivalent asset can be higher still. Single asset investments generally require a minimum term of 6 to 18 months, with restricted access to your investment before the maturity date.

Loan-to-Value Ratio (LVR) – Managing the Safety Buffer

LVR is a critical risk metric. Investors should typically focus on 1st mortgage investments not exceeding a 70% LVR and 2nd mortgage investments not exceeding a 75% LVR. This means the borrower contributes significant equity, creating a cushion that protects investors should the property’s value fluctuate.

Valuation Accuracy

Equally important is the quality of the valuation methodology adopted to ascertain the true value of a real estate asset. The LVR is only meaningful if the valuation attributed to a real estate asset is credible.

Conclusion

In summary, property-backed mortgages can provide:

1. Security: Registered mortgage and tangible asset backing.
2. Income: Regular monthly distributions.
3. Flexibility: Choice between diversified or concentrated single asset positions, and between 1st and 2nd mortgages.