Understanding Defaults in Private Mortgage Funds: Asking if there are any defaults is not the proper question!

One of the biggest misconceptions about private mortgage funds is that defaults are somehow a reflection of the risk within a mortgage portfolio—they’re not. The term default itself is highly subjective in terms that it can mean a lot of different things. Often, investors ask, “Are there any defaults in the portfolio?”, but that’s the wrong question. Most loan documents allow the mortgage fund manager to unilaterally give the borrower a loan holiday such that if payments are not being made it is no longer deemed a default. It is a loan holiday and bingo, no defaults. 

Another important aspect of lending on real estate is that many mortgages, such as ground up construction, might have any payments structured into the loan agreement.  The cost of the loan is just added to the principal amount each month and the loan simply grows in size. The borrower is therefore not making monthly payments and this is referred to as ‘Payment in Kind” (PIK for short).  Defaults in private mortgage funds aren’t always about missed payments, there could be other types of defaults.  

Construction loans might also include an interest reserve account which is a pool of money set aside to cover the monthly mortgage payments. This is great, except that the reserve account is typically funded by the face value of the original loan that they are paying themselves back. Flexibility is often built into loan agreements, allowing managers to navigate payment issues without officially incurring a default.

Instead of asking about defaults, advisors and investors should ask: “Have any loan terms been modified?” or “Is any part of the loan book on payment in kind (PIK), where no physical payments are made?”. These questions get to the heart of the loan quality, revealing if issues might be accumulating even if defaults aren’t recorded. Additionally, it’s crucial to know if the fund manager has taken provisions—essentially reserves—on loans they don’t expect to recover fully, which directly impacts the fund’s bottom line.

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At Steepe & Co., we believe in transparency and strive to help educate advisors on how to better assess the real risks in a private mortgage portfolio.

Want to learn more about what questions you should be asking about private mortgage funds? Contact us at Steepe & Co. for a deeper dive into smart mortgage fund investing.