With falling interest rates compromising fixed income returns and bank hybrids gradually being phased out by 2032, income investors have a greater appetite for asset-backed investments offering regular income, capital protection, and an uncomplicated risk profile.
Given that equities remain volatile and commercial property still faces headwinds, it’s hardly surprising that more investors are turning to the often-overlooked mortgage funds sector.
Far from being rocket science, mortgage funds allow investors like you to pool capital, which is then lent, typically secured against real estate to commercial borrowers like developers.
You will earn interest on those loans knowing that when it comes to the repayment waterfall [redemptions] you rank ahead of equities.
With flexibility across pooled and contributory structures, mortgage funds can also offer greater liquidity than traditional property trusts.
For example, some pooled funds offer redemptions every 90 days or monthly.
Transparency and disciplined lending
But while that can be a game-changer for income-focused investors, Ben O’Hara, executive director at GPS Investment Fund is quick to warn investors to look for mortgage fund providers offering both transparency and disciplined lending practices.
He believes these two factors will become increasingly crucial as more capital flows into the private credit sector.
The greater the pool of money flowing into private credit, the more attractive O’Hara expects it to become to investors.
Now worth more than $50 billion in Australia, O’Hara expects it to reach $90 billion within the next 7 years.
Funds risk overextending
According to O’Hara, there’s a real risk right now of funds overextending, chasing deals they shouldn’t be doing just to maintain usage rates.
“It’s easy to lend money. Getting it back is the skill,” he said.
What should serve as a red flag for would-be investors in this sector are the recent antics at the Regal Partners-backed Merricks Capital Partners Fund.
Investors in Merrick's $1.2 billion flagship fund were recently advised that redemptions would be delayed because there was no ‘unallocated cash’ to distribute to them.
While they will continue to receive distributions, redemptions are unlikely to start being processed until December 2025 and then in six-monthly increments.
Goldilocks zone
Meanwhile, O’Hara is concerned that returns, currently sitting in the Goldilocks zone - where they’re just right to satisfy investors – may get pushed higher, forcing the sector into riskier lending or misaligned pricing.
O’Hara suggests investors keep a radar out for telltale signs that sector risks are rising.
The key risk factors he’s talking about include leverage, borrower quality, and loan-to-value ratios (LVRs).
He also reminded investors to ask prospective mortgage funds where their money is going – how they’re investing it - who will be borrowing from the fund, and how risks are being mitigated.
In some situations, O’Hara says fund specialisation in a particular asset type or region can be an advantage.
“Some may see that as a lack of diversification,” said O’Hara.
“But deep knowledge of local markets, from build costs to buyer demand, helps make faster, more informed lending decisions.”
Clear reporting
While disclosure obligations vary between retail and wholesale funds, O’Hara believes investors should always expect clear reporting, regardless of its structure.
He expects increasingly sophisticated investors to demand greater transparency into exactly where their money is going and on what terms.
O’Hara also reminded investors that capacity constraints across the residential construction industry have implications not just for housing affordability but also for development finance.
For example, delays, cost escalations and supply bottlenecks all increase risk, making rigorous borrower assessment and project selection more important than ever.
“Mortgage funds may have once been niche, but as they move into the mainstream, investors are demanding more discipline, and clarity around how capital is used,” he said.
“For those seeking stable, income-generating alternatives to traditional fixed income or property, mortgage funds are increasingly being viewed as a compelling part of a diversified portfolio.”
