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What is Trust deed investing?
Trust deed investing is simply investing in loans secured by real estate. Most trust deed investments are relatively short term loans (maturity under five years, with many loans two years or less) made to professional real estate investors. In the current economic climate professional real estate investors are buying properties at foreclosure sales for bargain basement prices, fixing-up these properties, and reselling them for a profit.
Banks are reluctant to lend to this market not because the loans are particularly risky, but because banks have a great deal of bad real estate loans on their balance sheets as a consequence of the loose lending practices of recent years. Presently, banks are unwilling to make real estate loans unless they fit a very strict set of criteria. They often do not want to lend to opportunistic real estate investors because the property which is security for the loan is not “move-in ready” at the time of loan funding—it usually needs some work. For this reason, real estate investors have limited financing options available to them, and lenders to this market are able to command relatively high interest rates.
Who are the borrowers and how can they afford to pay double digit interest rates?
The borrowers are savvy real estate 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.
These borrowers can often afford to pay lenders low double digit rates of return, even though the loan is well-secured, because the borrowers are typically aiming to make an annualized return of 20%-50% on their trust deed investments. Paying the lender a much lower return (relative to their projected returns) allows them to enhance the returns they earn on their cash investment.
Why are banks reluctant to lend to this market?
As of the end of the second quarter 2011, nearly 20% of the $2.6 trillion in mortgages on banks’ balance sheets were delinquent. The secondary market for non-conforming mortgage backed securities is a fraction of what it used to be. For these reasons banks have tightened their lending standards and are reluctant to lend to anyone with less than picture perfect credit. It is precisely the banks’ reluctance to participate in this market that has created the attractive investment opportunity in short term real estate loans. The fact that banks are not lending to this market has created a supply/demand imbalance that doesn’t have anything to do with the quality of the borrowers, but instead with the condition of banks’ balance sheets.
What makes trust deed investing attractive?
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. The risk of losing money in a trust deed investment is mitigated by a built in “margin of safety.”
What is the margin of safety in a trust deed investment?
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, the lender can foreclose on the property and sell it to recoup the investment, plus any past due interest. If the loan is sufficiently conservative, i.e. the property value 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 of 65%.
What are the disadvantages and risks associated with trust deed investing?
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 blue chip company. 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.
With Trust Deed investing there is little chance for capital appreciation. For the most part the only returns that the investor will be entitled to will come from interest income generated from the loan.
Directly investing in trust deeds requires that the investor identify borrowers, assess deals on their merit, and conduct due diligence on the borrower and the property. This all requires a particular knowledge set that the investor must be acquire.
Trust deed investing is not without risk. A small flaw in the documentation or due diligence of a trust deed investment could mean that an otherwise very safe investment becomes very risky. For example, litigation or title problems could cause problems if the borrower or some other party can make a credible claim that your trust deed instruments are not valid, or that they have some interest in the underlying property that is equally or more valid, the trust deed investor might need to battle to protect the investment.
Trust deed investing is not for the faint of heart. Amateurs need to take particular care, and seek guidance from trusted experienced investors. That being 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.
What returns can trust deed investors expect?
As of 2011, investors can receive returns of 9-12% on trust deeds with a solid margin of safety (loan-to-value of, say 65% or less). Even higher returns are possible for professional trust deed investors, because they invest frequently and have close relations with mortgage brokers and mortgage banks that create trust deed opportunities. Such professional investors can frequently negotiate to receive one or more points in addition to interest as part of their investment, increasing the overall yield.
Why do trust deeds yield more than bonds?
Individual trust deed investments are relatively small when compared to government or corporate bond issuance. For this reason it would be difficult for large institutional investors to put a lot of money to work into trust deeds. Therefore, the trust deed market is left to smaller investors who also have the expertise to distinguish good trust deed investments from bad ones. It turns out that the universe of such investors is fairly small compared to the universe of borrowers who are seeking private money loans.
The combination of limited supply and high demand results in a high price—in other words, a high yield for trust deed investors.
Additionally, many investors place a high value on liquidity — being able to sell investments quickly and convert them into cash. 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. This lack of liquidity contributes to the higher yield of trust deed investments.
Trust deed investing seems too good to be true. What is the catch?
The risk adjusted returns of trust deed investments are very attractive. That being said, there is no such thing as a free lunch. First of all these investments are not liquid and therefore cannot be converted into cash quickly. Secondly, there is real risk involved, the most obvious of which being that the borrower defaults and the lender cannot sell the home for more than the amount of the loan. To a great extent this risk can be mitigated by properly valuing the property and structuring the deal with a high enough margin of safety.
There is also the possibility of unanticipated legal disputes involving the property, the navigation of which could easily destroy investment returns. It is necessary to have advisors with relevant experience should a situation such as this arise. Furthermore, while there are safeguards in place to protect against fraud, real estate transactions are susceptible to unscrupulous individuals looking to take advantage of unsophisticated lenders. Realizing the superior risk adjusted returns offered by trust deed investing is not for the faint of heart and requires a certain level of sophistication.
That being said, investing in trust deeds can be done in a safe manner. The investor needs to be armed with the proper knowledge and to take care in crafting each investment including conducting the proper financial analysis and thorough due diligence.
During the recent financial crisis, real estate loans caused billions of dollars in losses. How are new investments in real estate loans any safer?
During the financial crisis, real estate values dropped about 40% from peak to trough. Given that many real estate loans were set at 75% or more of market value, there was no way to avoid lenders taking losses. In the latest financial crisis, lenders’ losses were exacerbated by a number of factors including the following: (1) many residential loans were made at 80%, 85% or even 90% of market value, so that the original margin of safety for the lenders was very slim; (2) many loans were made to borrowers with poor credit; (3) in the case of commercial real estate loans, some loans were for development of high rise buildings and subdivisions that only made sense under very optimistic assumptions.
Today’s real estate loan investments are not immune from losses. However, the risk is lower to the extent that: (1) another 40% drop in values from today’s much lower values is unlikely; (2) experienced bridge lenders limit their loan amount to 60% or 65% of current market value; (3) most bridge lenders require a personal guarantee and require that the borrower have good credit and a good balance sheet.
Why don’t major Wall Street firms offer trust deed investments?
In short, Wall Street firms cannot make enough money from trust deed investments to make it worth their while. The size of each investment and the work involved in creating each investment properly combine to make this business “non-scalable” from their perspective. It is the absence of huge amounts of capital in this market that explains the strong risk-adjusted returns available to those willing and able to participate in the market. However, Wall Street banks are major players in the securitized loan industry, which does relate to trust deed investing.
How does the securitized loan market relate to and impact the market for trust deed investments?
In the universe of real estate loans, many 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 the lender with the intention that the loan will be sold off within a period of weeks to an investor who 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.
What will happen if Wall Street increases its issuance of Commercial Mortgage Backed Securities (CMBS)?
During the financial crisis, the volume of CMBS loans plummeted from the record levels achieved before the crash. As the CMBS market recovers, it will absorb more loans that might have otherwise gone to private lenders. However, for opportunistic situations that require quick funding, and for unstabilized properties that don’t have steady cash flow, there is always a role for competent private lenders and trust deed investors.
What makes your money protected?
1. Your name/Company name will be on the Deed as the lender
2. Your lien position is always 1st. This is very important to be in first position because if borrower will default on the loan, you will be the first person to get paid.
3. Our company require C-ALTA insurance from the Title company. Read below about C-ALTA title insurance.
4. Our company require Fire insurance and Homeowner insurance to be paid in escrow as well. This add more protection in the case the house will go on fire or will be damaged in any way.
5. Our company require at the time of purchase or refinance that borrower will have at least 30% of his own money in the property. This way if borrowers will default on the loan and we will have to go to foreclosure, then we will have enough money to cover attorney fees, interest payments and all other fees involved in the foreclosure process.
What is C-ALTA title insurance:
The C-ALTA loan policy insures the lender against loss or damage up the policy limit, plus costs and attorneys. Fees incurred under the policy that are caused by (1) title being vested in a person other than the one shown in the policy, (2) title defects, (3) liens and encumbrances, (4) lack of a right of access to the land, (5) marketability of title, (6) prior mechanics’ liens, and 9&0 street improvement assessment liens. In addition, the policy insures the priority and validity of the lender’s lien on the property, except to the extent that the insured encumbrance is invalid or unenforceable due to usury, the effect of any consumer credit protection, or truth in-lending laws. By Arixa Capital