FAQ | Trust Deed Investing
FAQ | Trust Deed Investing
Get answers to common questions about investing in trust deeds (also called deeds of trust or TDs)
By Jan Brzeski
Managing Director and Chief Investment Officer, Arixa Capital
Updated October 10, 2022
The Basics of Trust Deed Investing
-
Trust deed investing is simply investing in loans secured by real estate.
Most trust deed investments are relatively short-term loans made to professional real estate developers or investors. Here, short-term means loans with maturities under five years, often with maturities of one to three years.
Here’s how it works:
Some professional real estate developers specialize in flipping properties — that is, buying them, fixing them up, and reselling them for a profit. These developers often need loans to pay for the properties and renovation costs.
Banks are reluctant to lend to these developers for several reasons (explained below), so the developers look for alternative lending options. Trust deed investors fill this gap in the market by offering the short-term loans the developers need. In return for making these loans, trust deed investors can earn attractive returns with relatively low risk.
-
Banks are reluctant to make short-term loans to real estate developers primarily because doing so isn’t a good fit for their business model. Here’s why.
Banks prefer to make real estate loans that fit a very strict set of criteria.
Banks want to lend on properties that are move-in ready at the time of loan funding. The properties that developers are working on usually need some work.
Following the financial crisis that began in late 2007, banks tightened their lending standards to an extraordinary degree. They became very reluctant to lend to anyone with non-traditional or inconsistent sources of income, and house flippers fall into that category.
There’s a major mismatch in the timelines banks and house flippers follow.
Banks prefer to make real estate loans that will be outstanding and earn interest revenue for 15 to 30 years. People who flip houses plan to pay back their loans in under a year.
Banks need to generate interest for many years because they must spend a lot of time underwriting borrowers in order to comply with complex regulations. Banks can’t make the profits they’re seeking on loans that will be repaid quickly.
People who flip homes face intense competition when buying properties. One way they can increase the chances they’ll win the deal is to offer the seller a quick close. That means house flippers have very short loan funding deadlines, often one or two weeks. Banks can’t meet these short deadlines because of internal bureaucracy and the regulatory environment.
As a result, there’s more demand for short-term real estate loans than there is supply. The limited supply has nothing to do with the quality of the borrowers or loans, and it creates the investment opportunity for trust deed investors.
-
A deed of trust is just another name for a trust deed, and TD is sometimes used as an abbreviation for trust deed.
-
If structured properly, trust deed investments offer an attractive current yield with relatively low risk. Trust deed investors usually earn high single-digit annual returns, paid monthly. In some cases, returns above 10% are possible.
These returns are very favorable relative to other investment options with similar risk profiles, such as bonds. And, you can mitigate the risk of losing money in a trust deed investment by building in an adequate margin of safety.
-
The margin of safety is the difference between the loan amount and the value of the underlying property. The core concept of trust deed investing is that if the borrower does not perform (that is, pay back the loan on time, as agreed), the lender can foreclose on the property and sell it to recoup the investment, plus any past due interest.
If the value of the property securing the loan is high relative to the loan amount, then the investment should not lose money even if the borrower defaults on the loan. A well structured trust deed investment might have a loan-to-value (LTV) of 65%, meaning the loan is equal to about 65% of the property’s value.
For example, a trust deed investor might lend $650,000 on a property with a value of $1,000,000. If the borrower doesn’t perform, the lender (the trust deed investor) can foreclose on the property and, in the vast majority of cases, sell it for more than the loan amount.
-
As of 2022, investors in a first trust deed fund can expect to earn 6% to 9% annual returns depending on that fund’s particular strategy and risk profile.
Professional first trust deed investors who source and originate their own loans can charge borrowers an annual interest rate of 7% to 9% plus 1 to 2 points for a 12-month loan at 75% to 80% loan-to-cost (LTC). Annualized, that is an 8% to 11% return, but that assumes the investor is able to source and originate a new loan immediately after the first loan pays off.
We explain points, LTC, and first trust deeds versus second trust deeds in more detail later in this FAQ.
-
Individual trust deed investments are relatively small when compared to government or corporate bond issuance. That makes it difficult for large institutional investors to put a lot of money to work into trust deeds, leaving the market to smaller investors.
Successful trust deed investing also requires the expertise to distinguish good trust deed investments from bad ones. There simply aren’t a lot of small investors with the required expertise compared to the number of borrowers who are seeking private money loans.
In short, demand is high and supply is limited. In any market, that combination raises prices. For trust deed investors, that combination leads to a higher yield than what’s available from bonds.
Additionally, many investors place a high value on liquidity (being able to sell investments quickly and convert them into cash) and are willing to give up some returns in order to get that liquidity.
Corporate and government bonds are some of the most liquid investments in the world. Trust deed investments, on the other hand, cannot be converted into cash quickly, and this contributes to the higher yield of trust deed investments.
-
Here, we provide an overview of the risks of trust deed investing. In a later section, we provide more detail on risks and mitigation strategies.
All investment strategies come with risk, and trust deed investing is no different. If you’re new to the process, it’s best to seek guidance from trusted, experienced investors. That said, there are tens of millions of valid trust deeds owned by banks as well as hundreds of thousands owned by private investors. Creating a valid trust deed and accompanying note is not rocket science.
Here are the key risks to consider
Trust deed investments are not liquid. In other words, you cannot decide you want your money back one day and quickly convert your investment into cash, as you could with a municipal bond or shares in a company trading on one of the major stock indices. You need to be willing to stick with your investment until the borrower pays off the loan, or, in case of default, until you have foreclosed and sold the underlying property.
Trust deed investing offers little to no capital appreciation. The majority of the returns a trust deed investor earns come from the interest income the loan generates.
Directly investing in trust deeds requires you to identify borrowers, assess deals on their merit, and conduct due diligence on the borrower and the property. Doing all those tasks well requires knowledge that takes time to acquire. The good news is that, if you don’t want to acquire that knowledge, you don’t have to invest in trust deeds directly. We explain other ways to invest in trust deeds below.
Even a small flaw in the documentation or due diligence of a trust deed investment could cause an otherwise very safe investment to become very risky. For example, litigation or title problems could arise if the borrower or some other party can make a credible claim that your trust deed instruments are not valid. Or, this other party could claim that they have some interest in the underlying property that is equally or more valid than your trust deed instruments. In a case like this, you may need to enter legal proceedings to protect the investment.
-
You can mitigate some, but not all, of the risks that come with investing in trust deeds.
• Liquidity risk: you can mitigate, to some degree, the fact that trust deed investments are not liquid by investing in a private real estate debt fund rather than investing directly in trust deeds. Some funds can offer redemption flexibility to investors, meaning you could get your money back in a few weeks in some instances. Even if you invest in a private debt fund, your investment will still not be as liquid as an investment in stocks or bonds.
• Borrower default risk: the borrower may default, and the lender may not be able to sell the home for more than the amount of the loan. You can mitigate this risk to a large degree by properly valuing the property and structuring the deal with a sufficiently high margin of safety.
• Legal risk: unanticipated legal disputes may arise, and dealing with these disputes may require time and legal fees. Those could easily destroy your investment returns. You can help mitigate this risk by having advisors with relevant experience to guide you. Be sure to put in place safeguards to protect against fraud, but know that unscrupulous individuals can take advantage of unsophisticated real estate lenders. Realizing the superior risk-adjusted returns offered by trust deed investing requires a certain level of sophistication.
Investing in trust deeds can be done in a safe manner. Investors need to be armed with the proper knowledge and to carefully craft each investment by conducting proper financial analysis and thorough due diligence. See below for more details on risk mitigation strategies for trust deed investing.
-
During the global financial crisis, real estate values dropped about 40% from peak to trough. Many real estate loans were set at 75% or more of market value, so when market values plummeted that much, there was no way for lenders to avoid taking losses.
A number of other factors made lenders’ losses worse:
• Many residential loans were made at 80%, 85%, or even 90% of market value, so the original margin of safety for the lenders was very slim.
• Many residential loans were made to borrowers with poor credit.
• Some commercial real estate loans were for development of high-rise buildings and subdivisions that only made sense under very optimistic assumptions that didn’t materialize.
Today’s real estate loan investments are not immune from losses. However, the risk is lower because:
Experienced lenders limit their loan amount to 60% or 65% of current market value, giving them a better margin of safety.
Most lenders require a personal guarantee and require that the borrower have good credit and a good balance sheet.
-
Wall Street firms cannot make enough money from trust deed investments to make it worth their while. Properly identifying and underwriting each investment takes a fair amount of work, and each investment is small compared to what major Wall Street firms usually manage.
As a result, Wall Street firms don’t see investing in trust deeds as a good fit for their business model, and that reduces the supply of money in the trust deed investing market. That means people who are willing and able to invest in trust deeds can enjoy strong risk-adjusted returns.
However, Wall Street banks are major players in the securitized loan industry, which does relate to trust deed investing.
-
Real estate loans can take one of a few different forms.
Many real estate loans are funded by a bank or other financial institution and held on the bank’s balance sheet as an asset.
Other loans are funded by a lender that plans to sell the loan off within a period of weeks to an investor. The investor will package the loan with others and then sell a security in the capital markets whose underlying assets include the loan.
Yet another variation for commercial real estate loans are Commercial Mortgage Backed Securities (CMBS). In this case, a Wall Street firm makes the loan using its own funds and then sells off the loan as part of a security when enough loans have been funded to create a diversified pool of loans.
-
In 2008, the volume of CMBS issuances plummeted from the record levels achieved before the crash. As of 2021, CMBS issuances remain lower than they were in 2005, but issuances may grow over time. As that occurs, the CMBS market will absorb more loans that might have otherwise gone to private lenders. However, for opportunistic situations that require quick funding, and for properties that don’t have steady cash flow, there is always a role for competent private lenders and trust deed investors.
How to Invest in Trust Deeds
-
There are four main options for an individual to invest in trust deeds:
Personally source individual loans and lend money directly to real estate investors.
Purchase loans backed by real estate from brokers.
Identify people who are directly investing in trust deeds as a group and invest along with them.
Invest in a fund that invests in trust deeds.
Read on to learn more about the pros and cons of each option.
-
The answer depends on how you want to invest in trust deeds.
To be an active trust deed investor, the largest investment you’ll have to make is time spent upfront learning how to distinguish solid investments from risky ones. Once those skills are learned, trust deed investment is not necessarily very time consuming. It takes much more time than buying a bond or mutual fund, but it need not be a full-time job.
The tasks involved include sourcing prospective deals, evaluating the deals on their economic merits, and conducting due diligence on the property and borrower. Most trust deed investors integrate these tasks with other related work such as managing real estate that they own. Experienced trust deed investors might spend ten hours over the course of a week to identify and consummate an individual investment.
To invest passively in trust deeds, which you can do through a fund, you’ll also need to spend time up-front, but you’ll spend it evaluating fund managers. We offer guidance on how to evaluate a fund manager below, in answer to the question, “How can I evaluate someone offering trust deed investments?”
-
Unless you are a professional real estate investor with a significant amount of time available to manage your investments, the answer is probably “no.”
Personally sourcing deals, evaluating them, negotiating terms, and managing the legal issues requires substantial resources, including knowledge and experience that it takes time to acquire. Consider, for example these tasks:
Reviewing all key documents, such as the loan documents.
Spotting potential issues with the title.
Underwriting the borrower.
Knowing when to hire outside legal counsel.
Some very experienced real estate investors do put together deals on their own because they can confidently handle these tasks, along with all the other important responsibilities that come with lending money directly to real estate developers. These investors also have the financial resources to pay for legal fees and other transaction costs that can become excessive, especially in the case of small trust deed investments.
While trust deed investments do have the potential to generate excellent risk-adjusted returns, investors without these resources face significant risk.
-
The best way to take advantage of the opportunities available in trust deed investing right now is to invest with the help of a trustworthy expert. One way to do this is through a fund structure, where a professional investment manager is responsible for sourcing and evaluating trust deeds.
If your ultimate goal is to gain the knowledge necessary so that you can invest in trust deeds yourself, find somebody to personally show you the ropes. Look for someone who is actively investing in real estate loans and would be willing to show you their process. Once you become comfortable with the basics, ask this person to mentor you as you apply the process and evaluate deals on your own.
-
Most trust deed investors do rely on brokers to present them with opportunities, and brokers can be a great way to source trust deed investments.
However, it’s important to understand what the broker’s job is and is not.
Brokers work on a commission basis and are incentivized to broker as many loans as possible. Yes, there are good brokers who look out for the interests of their clients, but it is not the broker’s job to evaluate deals or perform key due diligence tasks. That’s the investor’s job, and it’s one that requires a specialized knowledge set.
Brokers can be excellent allies and a good source of information, but they cannot do the job of the investor, too.
-
Most brokers and investment firms require minimum investments in trust deeds, but the exact amount will depend on who is offering the investment. Some investment firms allow investments as small as $10,000 while others require $100,000 or more. The minimum amount will similarly vary by broker.
Successful trust deed investing requires thorough research on each investment, so it often makes more sense to invest a larger amount in a smaller number of investments rather than spread funds across a large number of very small investments where the research behind each investment was more superficial.
-
The answer depends on your circumstances and preferences.
If you prefer to actively manage your investments and you have deep knowledge of real estate investing, you may earn higher returns investing in individual trust deeds than investing in a fund.
Each loan requires a great deal of analysis and due diligence on both the borrower and the property. Furthermore, when a loan pays off, the money sits in cash until it can be redeployed. Investing in individual trust deeds requires constant sourcing of deals so that when one loan pays off, the money can be reinvested quickly in another.
If you prefer to invest more passively or you don’t have deep real estate investment experience, investing in a professionally managed fund can save you time and effort. A good fund manager will have the infrastructure and expertise to analyze, underwrite, and perform other due diligence on the individual loans. An established fund manager will also be in a better position to source deals and ensure that money is continuously reinvested.
In either case, researching the key person who is creating the investment is very important. In the case of an individual investment, that is the broker arranging the loan. In the case of a fund, it is the fund manager.
-
When investing in a fund, investors are delegating all day-to-day decisions to the fund manager. Evaluating the competence, character, and trustworthiness of the fund manager is critical. If the fund manager is lacking at all in any area, the investment is a no-go.
Investing in trust deeds can be done in a responsible low-risk manner; however, an incompetent fund manager can make mistakes that result in money being lost. In the worst case, a dishonest fund manager could steal the money that is supposed to be invested.
We offer guidance on how to evaluate a fund manager below, in answer to the question, “How can I evaluate someone offering trust deed investments?”
-
Efficiency is the percentage of a fund’s assets that is invested, on average, during a period. Suppose that a $10 million fund has $8 million invested for six months and $9 million invested for the next six months, with the balance in cash. On average for the year, $8.5 million out of $10 million was working, with $1.5 million idle. The corresponding efficiency is 85%.
-
Efficiency affects performance, and a highly efficient fund can outperform one that charges higher interest rates to borrowers while probably making lower-risk investments to boot. A fund manager’s efficiency depends on the robust supply of investments that the manager can tap into.
Let’s illustrate by continuing with the example we started in the answer to the last question and suppose all investments earned 10% interest. The fund’s returns would be 10% x 85% = 8.5% per year.
Suppose another fund earns 12% on its investments but has a lower efficiency. This fund only keeps 70% of its assets invested on average. Its annual returns would be 12% x 70% = 8.4%.
In this example, that .1% translates into an extra $10,000 return for the more efficient fund.
-
There are some risks to purchasing a participation in a loan with other investors. Here are the most common risks:
Key decisions, such as whether or not to begin the foreclosure process when a loan goes into default, typically require the consent of a majority. That could translate to delays, disagreements, or even stalemates that cost investors time and money.
In some cases, more cash may need to be invested into a property after the initial loan is made. For example, the property might need additional repairs or renovations to sell at full market value. Different investors have different appetites and resources to invest further funds, which could create challenges to doing what’s necessary to optimize returns.
-
One is not necessarily better than the other, but they are different. Understanding those differences empowers you to make the right decision for you.
Investing directly in real estate equity and investing in trust deeds are simply two different types of investments, each with advantages and disadvantages.
With any investment there are two possible sources of return: income and capital appreciation. A direct investment in real estate can generate income and also appreciate in value. Trust deed investments only generate income.
Direct real estate investment also presents a great deal of risk because the properties can generate negative income or lose value.
Well-structured trust deed investments, on the other hand, have a margin of safety not present in real estate ownership, due to a low loan-to-value (LTV) ratio. In other words, the loan is for part of the value of the property, not all of it.
In the event of a default, the lender may need to cover costs associated with foreclosure, repairing the property (if necessary), and selling it. With a low LTV, the lender can typically sell the property for significantly more than the loan amount, giving them an excellent chance of recouping their investment and earning a profit despite all these costs.
There are other important differences between the investment types:
Income from direct real estate ownership has favorable tax treatment, while trust deed interest income is treated as ordinary income.
Real estate investors can use leverage to enhance their returns.
Real estate investments lend themselves to a buy-and-hold approach, whereas trust deed investments have a natural maturity, at which time the investor must find a new investment in order to continue earning a return.
-
Neither is better, but they are different, primarily with respect to valuation and due diligence.
Valuation
Commercial properties such as multi-unit apartment buildings or shopping centers are valued based on the cash flow they produce each year. Single family residential properties are valued based upon comparable property sales in the neighborhood, not on their income potential.
Due diligence
Commercial property trust deeds require extra due diligence that the average investor may not be familiar with carrying out. For example, when investing in a trust deed secured by a shopping center or an industrial building, it is critical to have an environmental assessment of the property prior to funding. The presence of any environmental problems is a major red flag and could expose the trust deed investor to significant liability.
Whether you’re considering commercial or residential trust deeds, the key is to make sure that the loan-to-value (LTV) is conservative: 65% or less is a good rule of thumb. Having an LTV that is far below 100% ensures a margin of safety for the trust deed investor. We explain this in more detail above under “What is the margin of safety for a trust deed investment?”
-
Yes. The first step is to work with a self-directed IRA custodian company. These firms specialize in administering IRAs that are invested in alternative asset classes such as real estate, trust deeds, and commodities.
Two established firms based in California that provide these services are Pensco Trust and Entrust. Costs for administration are in the range of 0.3% to 0.5% of assets under management, per year.
-
Income from trust deed investments is treated as ordinary income, meaning it’s taxed at a relatively higher rate than some other types of investment income. Income received into an IRA or other qualified retirement account can be re-invested tax-free. The taxes are due when the funds are withdrawn from the account. Investing in trust deeds through an IRA neutralizes this disadvantage that trust deed investments have when compared to some other types of investments.
Interested in investing in a trust deed fund?
Talk with one of our experts who can guide you through every step of the process.
How can I reduce the risk of investing in real estate loans?
-
To mitigate the risk of trust deed investing, it’s important to first understand what can go wrong.
Trust deed investing results in one of two outcomes:
The borrower performs; that is, the borrower makes all interest and principal payments stipulated in the loan agreement.
The borrower defaults.
In the case of a default, the lender has a clear path, called foreclosure, to taking over the property that is the security for the loan. Once the foreclosure is done, the investor can sell the property to recover the investment.
As with any investment, there are risks, and if the borrower defaults, there are several things that could create challenges. Some examples include the following:
A sharp drop in real estate values in a short time period.
A mistake in estimating the property’s true value.
Bankruptcy by the borrower.
Litigation affecting title to the property.
Mortgage fraud or other defects on title.
We discuss each of these five situations below and share ways to mitigate these risks.
-
Sharp drops in real estate values (that is, drops of more than X% within Y months) are rare. However, these drops can happen, and when they do, borrowers bear the majority of the risk.
If real estate values drop, the borrower takes the first loss on their investment and is still obligated to make interest payments and ultimately pay off the loan.
If the borrower defaults on the loan — that is, the borrower stops making interest payments or fails to pay off the loan at maturity — then the lender generally has two choices:
Foreclose and sell the property, hoping that the proceeds are still high enough to pay off the loan even in light of the drop in values.
Encourage the owner to sell the property without pursuing a foreclosure.
If the lender pursues option two and the sale proceeds are not enough to satisfy the loan in full, then the transaction is referred to as a short sale. It is “short” because the lender is agreeing to the sale even though the lender will come up short of the amount of money they should receive under the loan terms.
In either case, if the property is sold for less than the value of the loan and interest owed, the trust deed investor (lender) would take a loss on the investment.
Lenders can protect themselves against a sharp fall in property values and a subsequent default by ensuring that the loan-to-value (LTV) is conservative: 65% or less is a good rule of thumb.
With a conservative LTV, the value of the property is high relative to the loan amount, and the higher the value of the property relative to the loan amount, the greater the margin of safety. The lower the LTV, the more the property value would need to fall before the lender would take a loss.
-
Trust deed investments are generally short-term loans of 12 to 36 months. Because they have a short maturity, the value of a trust deed investment will not change much even if interest rates rise.
In contrast, fixed income investments with a longer maturity, such as municipal or corporate bonds, drop in value when interest rates rise.
Consider a bond with 15 years left until maturity. If the interest rates rose by just 1%, the bond’s value could fall as much as 15%. For those who are interested in the math, see Wikipedia’s article on bond duration.
-
The best way to answer this question is with an example.
Suppose you make a $200,000 loan investment on a property whose value you estimate to be $300,000. The margin of safety is $100,000. Let’s assume the borrower defaults, and you go into foreclosure. You then sell the property for $300,000. The $100,000 should be enough to pay a real estate brokerage fee (5% of $300,000 or $15,000) plus any legal fees incurred during the foreclosure (perhaps $5,000 or so).
Now suppose that the real property value at the time of the loan was only $250,000, not $300,000 as you estimated. The margin of safety is now only $50,000, or half what it was intended to be. In this case, if there is a default and foreclosure, and you sell the property for $250,000, the $50,000 would still cover a brokerage fee (5% of $250,000, or $12,500) and legal fees (perhaps $5,000). In other words, you still have enough equity in the property to exit without taking a loss.
But, what if there’s an error in estimating the property value and another issue? These issues can include a broad drop in all real estate values or deterioration in the condition of the property (such as a leaky roof that results in extensive water damage, or theft of appliances). The costs of these issues can add up quickly.
If there is a default and foreclosure, and you sell the property for less than you estimated, plus you’ve had to spend unanticipated amounts on repairs, you may not be able to recover your entire investment.
-
A borrower’s bankruptcy will delay the foreclosure process.
In California, the foreclosure process takes about four months from the time of filing the notice of default to the time of the foreclosure sale. If the borrower files for bankruptcy, that could add weeks or months to the timeline. In general, if the borrower has equity in the property, the bankruptcy process will take longer.
Also, a bankruptcy judge has the ability to rewrite key terms of the loan. For example, the judge could reduce the interest rate on the loan.
-
There are any number of legal issues that might arise clouding title to a property, compromising the lender’s claim to the collateral securing the loan.
As a trust deed investor, it is important to conduct due diligence on the property in order to avoid becoming involved with a property that could become the center of a dispute. If legal issues do arise, it is important to address them as quickly and efficiently as possible; otherwise, legal fees could eat into or even destroy investment returns. Here are a few examples of potential problems:
The lender finds out, after the loan closes, that a property line cuts through the building securing the loan, meaning the building is likely worth less than originally estimated.
An adjacent property owner sues and places a lis pendens on the title, claiming that the subject property violates building codes and subsequently diminishes the value of their property. (More on lis pendens in the answer to the next question.)
The property securing your loan may have previously been involved in a case of mortgage fraud, resulting in a lis pendens being placed on the property until the case is resolved.
The borrower, unbeknownst to you, takes out two loans on the same day using the property as collateral. One of the lenders will invariably end up in a junior position.
-
The term “lis pendens” means “legal action is pending.”
For example, suppose someone sues the owner of a property, alleging that the owner owes money and the property was pledged as collateral for a loan. The plaintiff’s lawyer may file a lis pendens on the property in question to prevent the owner from selling the property and hiding the proceeds.
A lis pendens is a very serious action because it clouds title to the property in question and could take many months to resolve. Other parties will stay away from entering into any transactions involving a property so long as the lis pendens remains.
For a trust deed investor, a lis pendens is one of the more dangerous developments that can take place. If the legal case has merit, then the lender may have trouble exiting the transaction in a timely way, even assuming the lender has done nothing wrong.
There are penalties for filing a spurious lis pendens, but these penalties may not deter everyone. So, it’s important for a trust deed investor to fully vet a property to help avoid title issues.
-
Mortgage fraud occurs when a borrower has stolen money from a lender without giving the lender the security promised, or has otherwise conspired to defraud the lender.
In one type of mortgage fraud, the borrower obtains a false appraisal and borrows more money than the property is worth, with no intention of paying the money back. Another scheme involves bringing in an unsuspecting party to become the owner of the property and using his or her good credit to borrow money.
Any type of mortgage fraud creates risk for trust deed investors; they may lose some or all of their money.
The best way to ensure no mortgage fraud enters into a trust deed investment is to assess the credibility of all the parties involved in a transaction, and to make sure that all of the pieces of the transaction make sense for each party involved.
-
The lender should be named as an additionally insured party on the fire insurance at the time of the investment. This way, in case of a fire, the lender should receive their original investment back even if the borrower defaults.
-
If a building is destroyed in an earthquake and not adequately insured, and then the borrower defaults, the trust deed investment will lose a significant portion of its value. The property value would be reduced to land value, minus the cost to demolish and haul away the remains of the building.
The good news is that, even in a strong earthquake, total destruction of the building beyond repair is quite unlikely.
If you invest in trust deeds in areas where earthquakes are possible, such as Southern California, check if the borrower carries earthquake insurance. This is usually a special coverage that isn’t included in a standard homeowners policy. If the borrower carries this coverage, the lender should be named as an additionally insured party.
Investing in a portfolio of trust deeds on various properties, or in a diversified fund that holds a portfolio of loans, should mitigate the risk of loss due to a severe earthquake.
-
The answer relates to the likely costs of problems that could arise. An example illustrates how this can work.
In some parts of the U.S., such as certain midwestern cities, homes in distressed neighborhoods can sell for well under $100,000. If you make a loan of $20,000 secured by a property that is selling for $40,000, that is a 50% loan-to-cost (LTC), which should normally be fairly safe.
Although 50% LTC is good in general, in this particular case the margin of safety in dollars is only $20,000. If the loan goes into default, the cost to process a foreclosure might be $12,000 or more. Once the foreclosure is done, the lender’s new cash investment in the property is now $32,000 (the original $20,000 loan plus the $12,000 foreclosure costs). Your chances of recouping that money and making a profit are now lower. In other words, the margin of safety may no longer be enough to ensure a profitable exit.
Now suppose you discover work that needs to be done on the home that will cost $10,000. The total cost to foreclose and fix the property, plus the loan amount, equals $42,000, which is more than the value of the property.
In addition, when it comes to selling the home to recoup the investment, normal costs are 5% of the selling price, which are split between buyer’s broker and seller’s broker. In this case, with a $40,000 value, that would only be $2,000 ($1,000 each), and few good brokers would bother with all the work of selling a house for a $1,000 commission.
For all of these reasons, very small loans hold unique risks. With a loan amount of $100,000 on a home worth $200,000, most of these issues go away.
Bridge lenders, hard money lenders, and other participants in the trust deed market
-
A hard money lender is a non-bank lender that makes loans that don’t fit the criteria that banks use to evaluate loans. As we mentioned earlier in this FAQ (under “Why are banks reluctant to lend to this market?”), borrowers seeking loans that don’t tick every box on a bank’s standard list may look for a hard money lender to fund their project.
Hard money lenders fund loans that banks won’t, and they can move more quickly than banks. In return, hard money lenders charge higher interest rates than banks, often in the double digits. Hard money lenders also charge a fee to the borrower at the time a loan funds. This is called an origination fee and is expressed in points. Each point corresponds to 1% of the loan amount.
Hard money lenders are frequently successful real estate investors who have extra cash. They prefer to lend money rather than leave the cash in a bank account or money market fund earning a low interest rate.
There are two main types of borrowers who are willing to pay the double digit interest rates charged by hard money lenders:
Savvy investors who are planning to make a very large return and/or strike a very favorable deal and are willing to pay for a quick and simple source of capital.
Homeowners with poor credit who don’t qualify for any other type of loan.
Trust deed investors should only invest in loans made to the first type of borrower.
-
The terms bridge lender and hard money lender are sometimes used interchangeably. Both types of lenders focus on making short-term real estate loans.
Sometimes the term hard money loan signifies a loan where the borrower’s credit is not good, whereas with bridge loans, the borrower’s credit is typically good but the property is not in a condition to qualify for a traditional bank loan.
Hard money loans always have interest rates that are higher than those from traditional banks, whereas bridge loans can sometimes carry interest rates close to those on traditional bank loans.
-
Most trust deed investors work through a broker who brings together the borrower and the trust deed investor. In some cases, the broker allows multiple investors to purchase participations in a single trust deed. This is particularly common on larger, commercial real estate trust deeds.
In many cases, the investors rely on the broker to a large extent to perform the key tasks that ensure the trust deed is a safe investment. For example, the broker frequently checks the borrower’s credit, offers an opinion on the value of the real estate that is security for the loan, and signs off on the acceptability of the title report and loan documents.
When investors rely on the broker to perform these key tasks, they need to understand that an error by the broker could easily result in a loss of some or all of their investment. In other words, the investor should retain their own real estate legal counsel on each investment — especially to check for title and loan document issues — and/or choose very carefully which broker or brokers to work with.
-
The loan servicer collects interest payments from the borrower and disburses them to the lender. The servicer also initiates the foreclosure process at the request of the lender in case of default by the borrower. One of the largest servicers for trust deed investments in California is called FCI Lender Services.
-
When choosing an advisor or broker in the trust deed arena, make use of a wide variety of techniques to check out the person’s reputation.
The best technique is to find someone you know and trust who has worked directly with the broker.
Here are other ways to assess the provider of trust deeds:
Use online professional networks such as LinkedIn to find mutual connections.
Ask your friends and professional contacts for references to reputable people involved in the trust deed market.
If you have access to lawyers and certified public accountants (CPAs), ask them for a recommendation.
No matter how you identify a potential provider of trust deeds, always ask for references from people whom you know and trust, and whom you believe to have good judgment in the area of investing. These people will tend to recommend capable professionals who know what they are doing.
-
There are four broad areas of due diligence required for a trust deed investment:
Property/value assessment.
Borrower.
Legal items.
Other factors, including the broker/intermediary, if applicable.
A trust deed is safe if all four areas check out properly. We’ll address each of these in the next section of this FAQ.
Underwriting investments backed by real estate loans
-
Yes, if you are investing directly into a trust deed, you should see the property first. By inspecting the property and nearby comparable properties that have recently sold, you can better assess the value of the property you’re considering investing in. As a result, you can improve the chances that the loan will have a sufficiently coservative loan-to-value (LTV) and that you’ll, in turn, have a sufficient margin of safety.
Also, suppose the property suffered damage right before you were going to close the loan. For example, say a fire destroyed the property the day before you planned to finalize your investment. The borrower might inform you, but the only way to know for sure that your investment still makes sense is to see the property itself.
If you are investing passively in a fund that holds trust deed investments, the fund manager is responsible for inspecting each property. When you are evaluating trust deed investing funds, ask about the inspection process so you get a clear picture of what the fund manager looks for. We take a deeper look at key aspects of a good inspection in the answer to the next question.
-
First, do not skip the important step of inspecting the property prior to funding a trust deed investment. By seeing the property, you will learn things that you could not find out any other way.
If the loan goes into default for some reason later, you will be much calmer if you can visualize the property and the neighborhood, and this will allow you to make better decisions. Seeing the property after a default is important too, but it is no substitute for a pre-investment inspection.
When inspecting the property, you should focus on two topics:
How much is the property worth? Look for the same kinds of things a home buyer would look for
Is the neighborhood appealing?
How does the home show? Does it have curb appeal?
Are the flaws easily fixable, such as with a fresh coat of paint and new carpets? Or are the flaws difficult or expensive to fix, like foundation issues?
Be especially cautious about hillside properties and look for any signs of structural problems, which can be very expensive to fix.
How easily could I sell the property if I took it back through foreclosure and I needed to get rid of it?
Beware of neighborhoods with many homes in foreclosure. These comparable homes will affect the value of the property you’re considering investing in and could make it necessary to sell that property at a low price, meaning you could lose money.
Look for pride of ownership in neighboring properties. Even inexpensive homes can be kept up with care, and buyers at all price points will be more likely to want to purchase a home in a well maintained neighborhood, meaning there will be higher demand for the property once it’s renovated.
-
Let’s assume the property is a single family home. The key technique is to look at recent sales of similar properties nearby. Sales more than six months old are not reliable, because the market might have changed.
Look at the absolute price at which the properties sold, as well as the price per square foot. Assuming you can find homes of similar size and quality that sold nearby recently, the amount of your loan should be much lower than the typical selling price of the other homes, both in absolute dollars and in dollars per square foot of living space.
For example, if I am lending $200,000 on a 2,000 square foot house, which equates to $100 per square foot, then I want similar homes to be selling for $300,000 or more, or $150 per square foot or more. This way, even if real estate prices fall during the loan term, I still have a large margin of safety to help reduce my risk.
-
Loan-to-cost (LTC) is the total amount of the loan divided by the cost of the property to the borrower.
For example, if a borrower buys a property for $300,000 and the trust deed investor is providing a new loan for $200,000 on that property, then the LTC is 66.7% ($200,000/$300,000).
The LTC shows how much of a financial stake the borrower has in the project. When the borrower has skin in the game, they have an incentive to make the project successful, which increases the chances you, the investor, will also succeed.
Even if a borrower has identified a great deal on a property that, when renovated, has an excellent chance of selling for a high price, we will still not lend 100% of their cost.
If something went wrong on a project with 100% LTC — for example, the renovation and repairs took longer and cost more than expected — the borrower would have no cash investment and nothing concrete to lose. That would reduce the borrower’s incentive to keep the project on schedule and on budget.
-
Loan-to-value (LTV) is the total amount of the loan divided by the value of the property.
If a property is worth $400,000 and the loan amount is $240,000, then the LTV equals $240,000/$400,000 or 60%.
The LTV is important because the margin of safety is directly related to the LTV. A low LTV means a higher margin of safety for the lender. An LTV of 60% or lower is generally a good signal, although for a very small loan even a low LTV may not equate to a safe loan (see the FAQ on “Why can very small trust deeds be more dangerous?” above).
-
Homes purchased at foreclosure sales are often purchased for less than their fair market value.
Loan-to-cost (LTC) is a measure of how much equity a borrower has in a property and therefore is an indication of their financial motivation to repay a loan.
Loan-to-value, on the other hand, is a more relevant measure of a lender’s margin of safety. Both ratios are important considerations when structuring a trust deed investment.
As an increasing number of investors bid on homes at foreclosure sales, prices are being pushed up closer to fair market value, narrowing the gap between LTV and LTC.
-
First, know the relevant laws regarding owner-occupied homes. Some states, including California, have laws that make it difficult and time-consuming to foreclose on owner-occupied properties. If you’re investing in a trust deed secured by an owner-occupied property, and the borrower defaults, you could experience extreme delays and obstacles to foreclosing and ultimately recouping your investment.
In fact, we recommend never lending on an owner-occupied home in California.
Assuming you are lending to an investor on a non-owner occupied property, you need to evaluate both the creditworthiness and the character of the borrower.
To evaluate creditworthiness:
Review a credit report and the borrower’s personal financial statements and tax returns.
Focus on the liquidity of the borrower. If something unexpected goes wrong, will the borrower have the cash available to solve the problem and get the project done?
Assessing the borrower’s character is a complex process that’s hard to address in an FAQ. If you intend to make direct trust deed investments, you need good judgment and a good nose for sniffing out anything that doesn’t seem right. If you don’t have this skill, you are probably better off investing passively in a fund managed by a reputable, expert investor.
-
The quality of the borrower’s credit is very important in any trust deed investment because it’s a key sign of how likely the borrower is to repay the loan. A borrower with a high credit score is, all other things being equal, much less likely to default. The credit report, and the FICO scores in it, are one tool for determining a borrower’s credit.
Just as important as a credit report is a personal financial statement. The next FAQ addresses this tool.
-
A personal financial statement is a snapshot of an individual’s assets, liabilities, and net worth.
Assets include cash, securities, real estate, and automobiles.
Liabilities include mortgages on any real estate owned, other outstanding loans, and credit card debt.
Net worth equals assets minus liabilities.
Lenders require borrowers to submit a personal financial statement before deciding whether to make a loan because the statement provides a lot of relevant information about the borrower.
For example, you can see if the borrower drives fancy new cars even though they have a small net worth. You can check if the borrower has borrowed against all their assets.
A good borrower is one who is responsible with their money and not pushing the envelope in every way. Ample liquid assets are always a good sign to a lender that a borrower is more likely to repay the loan.
-
The term points refers to the origination fee charged by a private or hard money lender at the time a loan is funded. Each point corresponds to 1% of the loan amount.
For example, a fee of three points on a $400,000 loan would be $12,000.
Hard money lenders typically charge between one point and three points for loans to high-quality borrowers. For riskier loans, a larger origination fee is common, up to five points or even higher.
-
A prepayment penalty is a fee that borrowers pay if they pay off a loan before it is due.
Hard money lenders frequently charge a prepayment penalty as a way of enhancing their returns. A prepayment penalty may be as little as one month’s interest or as high as several months’ interest.
When a borrower pays a loan off before it’s due, the lender then needs to spend time and energy to re-deploy the money from that loan. That is, the lender needs to find another loan to make and do so earlier than they’d originally expected. Otherwise, the lender will not be earning a return on the money. The prepayment penalty compensates the lender for the time spent finding another loan.
-
When a borrower pays the loan off, the investment succeeds. However, now the investor has cash in the bank that is earning a very low return. To maximize the return on their money, most trust deed investors look for another trust deed to invest in as soon as one pays off.
If you invest directly in individual trust deeds, you’ll be responsible for finding that next investment quickly to keep your money working for you.
If you invest in a managed trust deed investment fund, the fund manager is responsible for keeping the money invested and earning a return.
Directly investing in trust deeds may earn you a higher return than investing in a managed fund. However, to accurately compare your returns from a direct investment to investing in a fund, you need to account for the time between investments that your money is not earning a strong return. When you run that comparison, you may find the returns from direct investment are not much different from investing in a fund.
-
As stated previously, it is very important to see the property personally before investing in trust deeds, or to delegate this task to someone competent and completely trustworthy.
As a rule of thumb, only invest out-of-state if the loan and origination fee are large enough to justify the time and expense of a site inspection.
Remember that real estate laws differ in every state, so it is critical to confer with and be represented by local counsel on each investment or make sure that a trusted person is doing so.
First trust deeds
-
A first trust deed (or first deed of trust) is a first lien on the property securing the loan. If there’s a default or foreclosure sale, the first trust deed has the superior position above any other trust deed holders.
For example, say you invest in a first trust deed and someone else invests in a second trust deed on the same property. The borrower stops making payments, and you (the first trust deed holder) foreclose on the property. You can proceed through that process and ultimately sell the property to recoup some or even all of your investment.
This process wipes out the second trust deed, meaning the second trust deed holder’s investment is now worth zero.
-
A second trust deed is second in line in case of a default.
As noted above, If the first trust deed holder forecloses on the property, the second trust deed holder’s investment is wiped out. On the other hand, if a second trust deed holder forecloses on a property, the first trust deed is not affected. Instead, the second trust deed holder becomes the new owner of the property, subject to the existing first trust deed, which remains in place.
-
A junior loan is any loan other than the first trust deed, including a second trust deed.
Junior loans are riskier than senior loans because they have lower priority in case of a default by the borrower.
If the senior loan on a property goes into default, the junior lender stands to lose his or her entire investment. To protect the value of the junior lien, the investor in the junior loan must cure the default in the first — that is, the junior lender must make payments on the senior loan.
To be worth the extra risk, junior loans need to generate much higher returns than senior loans.
Trust deed loan defaults and foreclosures
-
If the borrower fails to make an interest or principal payment or fails to live up to some other provision of the loan agreement, a default occurs. At this point, the lender instructs the loan servicer (an independent company that deals with the borrower) to file a notice of default.
This is the first step in a series of events that culminates in a foreclosure sale. In California, it takes about four months after the notice of default is filed to hold a foreclosure sale.
At any time after the notice of default and before the foreclosure sale, the lender and borrower could make arrangements that would eliminate the need for the foreclosure sale. For example, the borrower could cure the default by making all the payments due. Or, the lender could give the borrower more time to pay back the loan.
When a foreclosure sale does take place, there are two main outcomes.
The lender ends up owning the property.
Someone else makes an all-cash bid to purchase the property, and the lender accepts that bid instead of taking back the property.
-
The foreclosure process varies from state to state. In California it takes about four months from the initial default by the borrower until the foreclosure sale. In other states, it may take more or less time.
No matter where a foreclosure takes place, you can make the process more efficient by working with an experienced trustee and real estate lawyer.
The trustee provides proper notices at each stage of the foreclosure process to ensure that the process is deemed valid by the courts. The real estate attorney helps negotiate any special circumstances, such as a bankruptcy by the borrower.
Trust deed investors need to be prepared for a default on any given loan. The foreclosure process takes time and money, but by outsourcing the key processes to competent, trustworthy professionals, the investor can manage foreclosures reasonably easily.
-
The amount of time varies by state.
In California, it takes about four months to foreclose, if the lender takes action immediately at the time of the default. The property is then fixed up, if necessary, and listed for sale. The selling process itself should take 45 to 60 days if the property is priced properly.
Therefore, the entire process of exiting a defaulted trust deed investment is about six months. In other states the timeline and process vary and can be longer. A bankruptcy by the borrower adds time to the process, possibly 30 to 90 days.
On the other hand, expert handling of the default could shorten the exit time substantially. For example, if the lender and the borrower work together, instead of a foreclosure, the home can be sold without a foreclosure, cutting the process down to about 60 days instead of six months.
-
There is always a price at which every property will sell.
A homeowner might struggle with selling their house because the asking price is too high. A trust deed investor who has foreclosed on a house has a strong incentive to sell the property quickly and will price the house to sell.
Interested in investing in a trust deed fund?
Talk with one of our experts who can guide you through every step of the process.
©Arixa Capital Advisors, LLC. 2022 All Rights Reserved. Arixa Capital Advisors, LLC is licensed with the California Department of Financial Protection and Innovation. In California, all loans are made or arranged by Arixa Capital Advisors, LLC pursuant to a California Finance Lenders Law license No. 60DBO-98673 (NMLS ID No. 2318142). Arixa Capital Corporation is licensed with the California Department of Real Estate under license no. 02001940 (NMLS ID No. 1458115). Arixa AZ, LLC originates loans in Arizona and is licensed with the Arizona Department of Insurance and Financial Institutions under license no. BK-1029177 (NMLS ID No. 2187382). Please visit www.nmlsconsumeraccess.org for more licensing information. All Arixa companies make loans only for business or commercial purposes and not for personal, family, or household purposes. Loan product availability may be limited in certain states. This is not a commitment to lend. All loans are subject to borrower underwriting and credit approval, at Arixa’s sole and absolute discretion. Rates, fees and related terms are subject to change at any time without notice, and may vary among borrowers, depending on a variety of matters. Other restrictions may apply.