Siddharth Rajeev, B.Tech, MBA, CFA March 1, 2018 · 2018. 3. 2. · Siddharth Rajeev, B.Tech, MBA, CFA March 1, 2018 2018 Fundamental Research Corp. “10+ Years of Bringing Undiscovered

Siddharth Rajeev, B.Tech, MBA, CFA

March 1, 2018

2018 Fundamental Research Corp. “10+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com

PLEASE READ THE IMPORTANT DISCLOSURES AT THE BACK OF THIS REPORT

Ryan Mortgage Income Fund Inc. – 9.7% Return for Investors in FY2017

Sector/Industry: Real Estate Mortgages www.ryanmortgageincomefund.com

*see back of report for rating definitions

Highlights

Ryan Mortgage Income Fund Inc.’s (“Ryan”) portfolio grew

by 25% YoY to $278 million, secured by 3,518 properties, by the end of FY2017 (November 30, 2017). We had initiated coverage on Ryan in April 2017.

Ryan is among the top 10 largest largest Mortgage Investment Corporation (“MIC”) in the country. The MIC is focused on first and second mortgages on residential properties. Borrowers are primarily homeowners.

Since our initiating report, the MIC has continued to expand

in Ontario (“ON”), while reducing exposure to Alberta (“AB”). At the end of FY2017, approximately 44% of the loans were in ON, 39% in British Columbia (“BC”), and 17% in AB. This compares to 26% in ON, 44% in B.C., and 30% in AB at the end of FY2016.

Rising bond yields, we believe, are a strong indication that

Ryan’s mortgage rates will rise this year. The realized losses remained flat at 0.4% of the mortgages in

FY2017. Investors’ yield was 9.7% in FY2017, up from 9.3% in

FY2016. The MIC has generated an average yield of 9.5%

since 2005 (range: 8.6% to 11.2%) – one of the highest

consistent returns for a large MIC.

We are raising our overall rating on Ryan from 2 to 2+.

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Background

Investment

Mandate

The MIC, managed by Alpine Credits Limited (“manager”), was incorporated in September 1984. Alpine Credits (primarily focused on home equity lending in BC and ON) was formed in 1969, and is a well-known brand in B.C. and Ontario. Alpine Credits is part of the Amur Financial Group Inc. - a privately held group based out of Surrey, BC, offering a wide range of lending and investment solutions. The Group operates

two MICs, namely Ryan Mortgage and Manchester Investments Inc. (formed in 2009). Ryan is focused on first and second mortgages, while Manchester is focused on first mortgages. Manchester currently manages a portfolio of $32 million, with a 39% LTV, and a five-year average return of 7.5% for investors. We consider this to be on the higher end relative to comparables, as most MICs focused on first mortgages generated returns of 4% to 7% p.a. in the past five years. Ryan has a five-member board of directors, of which, two are independent. Management

and directors own a total of 16.9 million preferred shares, or 7.8% of the total

outstanding shares. At the time of our previous report, the total ownership was 16.1 million shares, or 8.9% of the total. The high equity ownership (relative to comparable MICs) strongly aligns management and the board’s interest with investors. Also, the preferred shares have voting rights – a feature that further enhances alignment of interests. Most comparable MICs do not offer any voting rights to investors.

Source: Ryan

The manager’s objective for Ryan is to generate an average return of prime plus 3.75% p.a. for investors. According to management, since inception, the MIC has never had a

negative return.

Management’s key investment strategies for the MIC remain (listed below) unchanged:

The MIC’s primary focus is on first and second mortgages on already built residential properties to homeowners in BC, AB and ON.

At least 50% of the portfolio should be secured by properties located in primary districts. No single loan to individuals to account for over 1% of the portfolio. The primary focus is on mortgages with a term of 1 year, with a maximum term of 4

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Portfolio

Update

years. Maximum LTV of 75% at the time of origination; up to 2% of the mortgages (capped at

$40k per mortgage) can be invested in mortgages up to 80% LTV. Mortgages will not be offered on properties in which a director or officers has a direct or

indirect interest.

As mentioned in our initiating report, we believe management’s guidelines are in line

with industry best practices and indicate their intent to manage a portfolio with

medium risk levels.

As of November 30, 2017, the MIC had $278 million in mortgage receivables (net of provision for losses), secured by 3,518 properties, reflecting 25% YoY growth. The following chart shows the portfolio size at the end of ever year since 2007. The MIC has grown its portfolio every year.

Data Source: Ryan

Type of Mortgage: Approximately 99.2% of the mortgages (98.8% at the end of FY2016) were secured by residential properties at the end of FY2017. The MIC’s exposure to residential properties has averaged 98.5% in the past four years.

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Data Source: Ryan

Mortgage Size: At the end of FY2017, the average mortgage size was $81k ($83k at the end of FY2016), including $132k for first mortgages ($127k at the end of FY2016), $70k for second mortgages ($64k at the end of FY2016), $61k for third mortgages ($49k at the end of FY2016) and $261k for inter alia (security over two or more properties - $295k at the end of FY2016). We had mentioned in our initiating report that management expects the portfolio average to stabilize at $80k to $85k going forward. We consider a low average to

be highly beneficial for a lender as the risk is diversified across a large borrower-base.

Data Source: Ryan

Mortgage by Security: First mortgages had accounted for 21% (23% at the end of FY2016) of the portfolio as of November 30, 2017. Second mortgages accounted for 73% (57%), third mortgages accounted for 6% (4%), and inter alia mortgages accounted for 0.05% (16%).

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Since 2007, first mortgages have averaged 23% and second mortgages have averaged 60% of the portfolio. The significant increase in second mortgages in FY2017, we believe, indicates management’s increasing focus on medium risk levels and higher returns.

Data Source: Ryan

Mortgage Term: As of November 2017, approximately 83% (85% at the end of FY2016) of the portfolio had mortgages with terms less than 12 months. Since 2007, mortgages with terms of under 12 months have averaged 82% of the portfolio.

Data Source: Ryan

Loan to Value (LTV) – The portfolio's LTV dropped YoY from 55.9% to 54.3%, versus the historic average of 52.8%. Management estimates the LTV will stabilize at current levels.

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Data Source: Ryan

Geographical Diversification: The MIC focused 100% on BC and AB since inception until 2014. Management has been expanding into ON, while reducing exposure to AB, since 2014, to geographically diversify the portfolio. As of November 2017, approximately 39% (44% at the end of FY2016) of the portfolio was secured by properties in B.C., 17% (30%) secured by properties in AB, and 44% (26%) by properties in ON.

Data Source: Ryan

Areas with the largest exposure continue to be the Fraser Valley (BC) with 29% of the portfolio, and Greater Toronto with 28% of the portfolio.

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Recent Industry

Developments

Data Source: Ryan

Management expects the mix of BC : ON : AB to be about 38% : 44% : 18% by the end of FY2018. In summary, although the mix of first mortgages dropped this year (implying higher

risk exposure), we were pleased to see the continued focus on residential, and the

relatively flat average loan size, LTV and duration, despite a 25% increase in portfolio

size. We were also pleased to see the expansion in ON, which adds diversification

benefits to the portfolio.

In October 2017, the Office of the Superintendent of Financial Institutions (OSFI) announced new mortgage guidelines. Starting in 2018, all uninsured loans will be subject to a stress test. Previously, only insured borrowers had to undergo such a test. Sources indicate that the new policy could result in a 20% reduction in buyer’s purchasing power. We believe the new regulations clearly indicate the government’s intent to stabilize the real estate market in the country, and potentially avoid a major downturn. The tighter lending policies, we believe, are likely to encourage more borrowers to seek financing from MICs. The Bank of Canada has raised the overnight lending rate three times over the past 12 months – first in July 2017, second in September 2017, and the third in January 2018.

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Toronto RE

Market

Canada - overnight lending rate

Source: Bank of Canada

Rising bond yields, we believe, are a strong indication that Ryan’s mortgage rates will rise this year.

GOC Bonds – Average Yield – 1 to 3 years

Source: Bank of Canada

The Toronto MLS continues to drop YoY. Sales were down 23% YoY in January 2018. Despite the drop in sales, the average price was up 1% MoM, which is encouraging, as prices had dropped MoM in November and December 2017. The table below summarizes the key parameters.

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Vancouver RE

Market

Source: Toronto Real Estate Board

The sales to active listings ratio, which indicates the health of the real estate market in a region, was at 34% in January 2018 versus 103% in January 2017. The following table shows that sales dropped across almost all property types in January 2018.

Source: Toronto Real Estate Board

We have a cautious outlook on the Toronto residential real estate market. We believe that loan originations in Ontario could decrease in the near-term. However, we believe that any excess cash can be redeployed into stronger markets like B.C.

Vancouver’s real estate market continues to be strong. After experiencing a YoY decline in sales every month until July 2017, the market saw a strong turnaround in the second half of the year. January 2018 sales were up 19% YoY. Prices continue to rise both on a MoM and YoY basis.

Source: Real Estate Board of Greater Vancouver

The sales to active ratio was 26% in January 2018, versus 21% in January 2017. Sales continue to increase across all property types.

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Financials

Source: Real Estate Board of Greater Vancouver

The B.C. government recently announced plans to introduce new measures to stabilize housing prices. Among the new measures, the key ones include raising the existing 15% foreign buyer tax to 20%, introducing a new property tax targeting out-of-province home owners, and axing the program that offered interest-free loans to first-time homebuyers. We expect these measures to impact sales in the near-term. Note that the introduction of the foreign buyer’s tax in 2016, impacted sales in the first half of 2017. The offsetting aspect of the above is the tighter lending policies of banks, after the introduction of stress tests for home buyers with uninsured mortgages. A recent article in the Financial Post mentioned that mortgage brokers indicate the borrower rejection rate by large banks is up 20%, resulting in stronger deal flow for MICs. Ryan is registered as an Exempt Market Dealer in BC, AB and ON. As a result, 100% of investors’ capital is directly invested into Ryan (there are no upfront commissions paid to third parties). There is no market or exchange for the shares. The shares are non-transferable. They are eligible for redemption, at book value, at any time. However, management has up to 365 days to meet the redemption request. According to management, historically, the MIC has met all redemption requests within 60 days. Comparable private MICs tend to apply a redemption penalty in the first few years of investment. As per the OM, Ryan will not have to redeem if there are redemption requests totaling more than 5% of the total number of preferred shares outstanding. As of November 30, 2017, the MIC had a total of 214.40 million preferred shares, all of which were issued at, and currently priced at, $1 per share. The MIC raised $40 million in

FY2017 ($28 million in FY2016), excluding reinvestment of distributions, through the

issuance of preferred shares. Management’s goal is to grow its portfolio to

approximately $350 million by the end of 2018. Revenues grew by 23% YoY to $27.17 million in FY2017. We have reviewed all the

audited financial statements since 2000.

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YE – Nov 30th

Interest + Other income as a percentage of mortgage receivables dropped YoY from 11.1% to 10.9% in FY2017. Note that this figure, and the ones in the table below, may be slightly different from the actual figures due to the difference in the method of calculation. We used the average of the opening balance, and year-end balance of the mortgages outstanding, to arrive at the above figures.

Source: FRC

Operating expenses (management fees + general and administrative) remained flat at 2.2% of mortgage receivables. The manager charges an annual management fee (paid monthly) of 2% of the net mortgage receivables held by the MIC. Alpine Credits also charges an origination fee for each loan to borrowers, which are not passed on to the MIC. We believe the management fee is slightly higher than comparable MICs. However, unlike comparable MICs with a primary focus on second mortgages, Ryan does not charge any performance-based fee. Overall, we believe

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the management fee and operating expenses of the MIC are slightly higher than comparable MICs, which are typically in the 1.5% to 2.0% p.a. range. Net income was up YoY from 7.0% to 7.2% of mortgage receivables in FY2017. Dividends as a percentage of invested capital were 9.7% in FY2017, versus 9.3% in FY2016. The MIC has generated an average yield of 9.5% since 2005 (range: 8.6% to 11.2%). We estimate

that the annual returns have exceeded the BOC 2 year bond yields by 7.7% p.a. on

average from 2005 to 2017 (range: 6.1% to 8.7%).

Ryan’s Historic Returns

Source: Ryan

The following table shows the realized losses and loan loss provisions.

Source: FRC

We estimate realized losses remained flat at 0.4% in FY2017. The average annual loss

from 2005 to 2017, was 0.6% p.a. of the mortgage receivables (range: 0.0% to 2.2%). At the end of FY2017, the MIC had assigned a loan loss provision of $6.46 million, or 2.3%

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of the mortgage receivables outstanding. The provision has averaged 2.1% since 2005 (range: 0.2% to 3.1%). At the end of FY2017, the portfolio had nil in delinquent files over 90 days ($502k - 0.2% of the portfolio at the end of FY2016). The MIC also had $19.56 million (122 files / 7% of the portfolio) in foreclosure versus $15.87 million (80 files / 7.1% of the portfolio) at the end of FY2016. Management estimates the foreclosed amount will be in the 7% range going forward. We believe the historically low loan loss ratio reflects positively on the

management team considering the significant number of foreclosed / delinquent

properties. Note the decline in losses in the past three years in the chart below:

Source: FRC

A high percentage of distributions continue to be reinvested back into the MIC, which we consider a positive sign, as it indicates investors’ continued conviction in management.

Source: FRC

At the end of FY2017, the MIC had $278 million (net of provisions) in mortgages, at a debt to capital of 22%.

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Risk

Source: FRC

Line of credit – The MIC has a line of credit for $75 million, up from $50 million last year. The interest rate is prime + 0.75% p.a. As of November 2017, the MIC had used $61 million, reflecting a total debt to capital of 22%. MICs tend to have a debt to capital in the 20% to 40% range. Management intends to maintain a debt to capital ratio of 15% to 25%.

We believe the following are the key risks of this offering (most of the risks mentioned below are industry specific and impact comparable MICs as well): There is no guaranteed return on investment. Loans are short term and need to be sourced and replaced quickly. The operations in ON are relatively new. Timely deployment of capital is crucial. A drop in housing prices will result in higher LTVs, and higher default risk, as the value

of collateral decreases. Volatility in real estate prices. Shareholders’ principal is not guaranteed, as the NAV per share could decrease from

current levels (as a result of loan losses). The fund uses leverage, which increases the exposure of the fund to negative events.

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Rating

Second mortgages carry higher risks than first mortgages. Redemptions are not guaranteed.

We are raising our overall rating on Ryan from 2 to 2+ based on the latest results. We

have maintained our risk rating at 2. Although loan originations by MICs have been rising in recent times due to the tight lending guidelines of banks, we remain cautious on both the Vancouver and Toronto markets. A major slowdown in either of these markets will impact Ryan’s performance. Like any other MIC, Ryan’s performance will depend on its ability to deploy capital. For example, to understand the risk, if 20% of the capital was undeployed in 2017, we estimate investors would have received a return of 7.8% instead of 9.7%. Ryan’s low LTV of 54.3% is a major advantage as it provides a good cushion.

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Fundamental Research Corp. Rating Scale:

Rating – 1: Excellent Return to Risk Ratio Rating – 2: Very Good Return to Risk Ratio Rating – 3: Good Return to Risk Ratio Rating – 4: Average Return to Risk Ratio Rating – 5: Weak Return to Risk Ratio Rating – 6: Very Weak Return to Risk Ratio

Rating – 7: Poor Return to Risk Ratio A “+” indicates the rating is in the top third of the category, A “-“ indicates the lower third and no “+” or “-“ indicates the middle third of the category. Fundamental Research Corp. Risk Rating Scale:

1 (Low Risk) 2 (Below Average Risk) 3 (Average Risk) 4 (Speculative) 5 (Highly Speculative)

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Documents

Siddharth Rajeev, B.Tech, MBA, CFA March 1, 2018 · 2018. 3. 2. · Siddharth Rajeev, B.Tech, MBA, CFA March 1, 2018 2018 Fundamental Research Corp. “10+ Years of Bringing Undiscovered