Trust deed investing is about smart investment diversification and opportunity. Trust deeds offer investors the opportunity to invest in selective real estate properties and enjoy, generally, greater rates of return than those realized from other traditional investment options. Moreover, trust deed investments are available to meet a variety of investor goals, including fractionalized and individual trust deed investments, as well as mortgage funds.
TRUST DEED INVESTING BASICS
What is a Trust Deed Investment?
Trust deed investments are specialized high-yield loans secured by real estate that are provided from the private sector. They are not real estate investment trusts (REITs). They are also not mortgage-backed securities – the repackaged loan bundles that have been under significant scrutiny for the past few years.
Trust Deed Investing Summary:
Trust deed investing is loaning money that is secured by real estate as collateral. In the simplest terms, it is a privately funded mortgage. The trust deed investor loans money to the borrower, and the loan is secured by the real estate (collateral) of the property.
What is a Trust Deed?
The “deed of trust” or “trust deed” is the document used to secure the loan against the property. It acts like a mortgage and is used as security for repayment of the loan. In a trust deed investment, there are three parties – the beneficiary (the lender), the trustor (borrower), and the trustee (who is often the county public trustee or in some states, a private trust company). The trustee is a third party selected by the lender. The trustee has the legal power to act on the lender’s behalf and hold title until the note has been paid. If the borrower defaults, the lender can take possession of the property.
Trust Deed Returns:
A trust deed generally secures a note with a set interest rate. Loan programs vary from traditional amortized loans, interest-only loans and balloon loans. Based on the particular loan type, the investor may receive regular periodic payments or payment in full at maturity.
Real Property as Collateral:
In many ways, trust deeds offer less risk than many other investments. If a borrower defaults on a loan, the property secured by the trust deed can be sold as a foreclosure in order to recoup the outstanding balance.
Property Valuation:
The accurate value of the property securing a trust deed investment is of critical importance. Trust deed investors are careful to consider the value of the property securing the loan compared to the amount of the loan (referred to as “Loan to Value” ratio or “LTV”). For example, a trust deed investor may choose to limit lending to a maximum of 80% of the value of the collateral property. This would ensure a minimum equity of 60% in the property to act as safety padding in the event of default.
Trust Deed Investment Vehicles/Programs:
There a several different ways to invest in trust deeds to meet the investor’s needs and goals. These include individual trust deed investing, fractionalized trust deeds and fund investing.
Individual Trust Deed Investing (type 1):
This type of trust deed investing refers to an investor that fully funds a loan on one particular property. As the note is paid, the investor receives the return at the interest rate in the note.
Fractionalized Trust Deed Investing (type 2):
This type of investing refers to a group of investors, each funding a percentage of the total loan amount. For example, if a borrower required a $1 million loan, the note may be fractionalized into 10 different investors, each contributing $100,000. Thus, each investor would own 10% of the transaction. All 10 investors would be vested on the recorded security document and they would share in the profits based on percentage of initial contribution.
Fund Investing (type 3):
This is also referred to as “mortgage pool”. This method allows investors to combine their investment funds together to invest in multiple transactions, similar to mutual funds that invest in a variety of stocks.
NSB Investors 19 Fund does not do Fund Investing or “mortgage pools.”
WHY INVEST IN TRUST DEEDS?
The Lure of Trust Deeds:
Investors who pursue trust deed investments are attracted to them because they offer a way to diversify their investment portfolio, generate regular income, minimize risk, and typically produce higher return rates than traditional investments in stocks and bonds.
Consistent Higher Returns:
When compared to fixed-rate bond investments, which are subject to fluctuations due to changes in interest rates and the economy, deed trust investments offer more consistent returns. In essence, trust deed investing is similar to investing in a bond with a fixed yield and pay-off at maturity. Example: If you, as an investor, loan $100,000 to a borrower at 10% interest and require interest-only payments, you would receive $10,000 in interest income per year. Absent any default, the loan would pay off at or before maturity, and the original principal would be returned.
Demand for Private Loans:
Today’s economy has generated a consistent demand for specialized loans, which energizes higher yields for investors. Real estate developers and investors have limited access to traditional lending sources, especially with the recent credit crisis. As a consequence, loans offered by private trust deed investors demand higher interest rates, as well as lower loan-to-value ratios to protect the investment. This results in higher returns with less risk.
The Advantage of Deed of Trust Security:
Trust deeds can yield higher returns than stocks, with less risk. This is because trust deed investments are secured by tangible real property – houses, buildings, acreage, etc. Moreover, borrowers have a great deal to lose from defaulting on a secured loan. The risk of losing the property provides strong incentive to keep current on payments.
Diversification of Investment Portfolio:
There are a number of reasons investors embrace trust deeds. The first is diversification. Because trust deeds are fixed-income, real property investments, they are attractive to investors seeking ways to divide investments between equities, such as stocks, and fixed-income investments, like bonds. Trust deeds provide the opportunity to invest in the real estate market, which when done well, usually delivers considerable returns. Smart investors look for different sectors of the economy in which to invest, such as agriculture, technology, or real estate.
What Investors Should Understand:
While anyone can invest in a deed of trust, investors are encouraged to seek expert advice in this rather complicated investment arena, especially with respect to real estate valuation, project management, law, and financing. Partnering with competent professionals not only makes investing less time consuming, it greatly reduces risk. Below are a few considerations that any prospective investor should explore before investing in trust deeds.
Property Value:
One of the most important factors in trust deed investing is the value of the property securing the loan. In conventional financing, banks and other institutional lenders have relied heavily on borrower credit history to determine whether the lender should loan to the borrower. Private-money, or asset-based lending, is different. The main underwriting component of a private-money loan is the actual property itself. One must make certain that the amount of the loan is well below the value of the property. Generally, trust deed investors look for a loan-to-value (LTV) ratio of 80% or less. For a property valued at $100,000, a loan with 80% LTV would be $80,000. The lower the LTV the better, because the leftover equity in the property (the other 40%) can protect the investment in the event of default.
Determining Loan-to-value Ratio:
The first step in determining LTV is to determine the value of the property, something that can be a lot trickier than it sounds. At NSB Investors 19 Fund, we take a three-step approach to property valuation:
Broker Price Opinion (BPO):
When we examine a potential loan our first step is to conduct a BPO, which provides us with relative values of comparable properties in the neighborhood. A proper BPO is not an automated valuation, but is conducted by a professional who visits the property, knows the neighborhood, and can evaluate the property against comparable sales.
Appraisal:
The second step to proper evaluation involves a real estate appraisal prepared by a licensed appraiser. At NSB Investors 19 Fund, we don’t just want to know the current value and the estimated after-repaired value, but also want the appraisal to indicate the values if the property had to be liquidated quickly. This “liquidation” valuation gives additional security that if the loan defaults, the property can still be sold for a profit.
Renovation Scope:
Valuation for renovation and construction projects can be more difficult to perform because you’re valuing the cost of the work to be done and estimating the value of the property after the project is complete. You must have knowledge of the type of construction project involved, including the range of costs to complete the project. Without adequate information, a trust deed investor could loan on a property to find out later that the borrower had vastly underestimated the cost of renovation and is unable to complete the project. At NSB Investors 19 Fund, we closely scrutinize construction costs, require firm bids, and, in most cases, conduct our own on-site inspections prior to and after funding the loan.
Borrowers:
While borrower credit score may not be as critical a factor in private loan underwriting, borrower credit character is certainly important. Successful trust deed investors examine the credit character of each borrower to assess risk.
Occupancy Types:
Another consideration for trust deed investors is whether the borrower will occupy the home, or whether the borrower is acquiring the real estate for investment purposes. Lending to owner-occupant borrowers requires numerous regulatory compliance issues with respect to the loans. However, real estate investors are in the business of acquiring and selling real estate. Consequently, they require private-money loans that allow them to complete transactions efficiently and successfully. NSB Investors 19 Fund only loans to non-owner occupied borrowers who are experienced and successful rehabbers.
Lien Position:
When a trust deed is recorded with the county clerk and recorder, it is placed in a lien position. If it is the first lien recorded, it will be in first position. A trust deed recorded after the first trust deed on the same property takes second position, and so on … The recording position of the trust deed is important because the trust deed in the highest priority position will receive payment from a foreclosure sale before any lower priority positions. Thus, second lien trust deeds may carry more risk of loss than first lien trust deeds and may pay a higher interest rate. NSB Investors 19 Fund only loans on first or second position lien loans.
Loan Maturity:
The maturity date for a loan is also a significant consideration for a trust deed investor. If the loan is for 15 or 20 years, the investor must be willing to have those funds out for the full term of the loan. This may not leave a lot of room for emergencies. The investor must be comfortable with vast market fluctuations that may occur during the term of a 15 to 20 year loan. NSB Investors 19 Fund only focuses on short-term loans, usually 12-24 months. Short-term loans have several advantages, the main one being the liquidity of the investor. The shorter term also insulates trust deed investors from changes in the real estate market. During a short period of time, any declines in property are manageable and help with the security of the investment.
Documentation & Protection:
It goes without saying that property documentation is key for protecting the security of a trust deed investment. Not only must the loan and security documents be accurate and complete, the trust deed investor must ensure the title of the property is clear of any prior liens or defects that could impair the investor’s interest in the property.
At NSB Investors 19 Fund, all trust deed investments are insured by title insurance and all projects are insured to protect against hazards.
Personal Guarantee:
If you ever lend money to a borrower that is an entity, such as an LLC or Corporation, you should always obtain a personal guarantee. This means that the owners of the entity make themselves personally responsible for repayment of the loan. If the business is unable to pay, the guarantors will still be responsible for repaying you personally.
Ongoing Management Needs:
Trust deed investors must be aware of ongoing management issues after a loan is placed. For many trust deed investments, the borrower uses funds for renovations or construction. This requires ongoing management of the project to ensure the work is being completed, the contractors are paid, and the title remains clear of contactor liens. Some trust deed investors will manage the servicing of their own investment loans, while others will utilize companies to manage the loan for them. Regardless of the method, the trust deed investor (or the management company) must have mechanisms in place to properly service the loans, including required IRS reporting procedures, and systems to deal with defaults and foreclosures.
Investing Options:
Trust deed investing can involve different investment vehicles, as well as different funding sources.
Individual Trust Deed Investing:
This type of trust deed investing refers to an investor that fully funds a loan on one particular property. As the note is paid, the investor receives the return at the interest rate in the note. One benefit of this type of vehicle is that the investor can receive the full amount of return on the note. Individual trust deed investing may also appeal to an investor who wants to invest in a shorter-term project, such as funding a note with a six-month maturity. One of the risks associated with individual trust deed investing is the lack of diversification. Since the investor’s entire investment is secured by a single property, the investment holds more potential risk as opposed to an investment spread over several properties. Another challenge to whole deed investing is the limitation on investment funds. When dealing with whole trust deed investments, a single investor must have sufficient capital to fund the entire loan amount in order to purchase a whole trust deed. Individual investors may have insufficient funds to act as the sole funding source for a larger loan.
Funding with Retirement Accounts:
Investors can invest through their corporate entities, trusts, and various retirement accounts with significant tax-saving advantages. This allows investors to take advantage of the higher returns of trust deed investments through their tax-sheltered retirement accounts.
Want to Learn More?
Wise investment decisions are only made when all the available information is at your fingertips. Regardless of how you wish to fund an investment, whether you are using cash or a retirement accounts, NSB Investors 19 Fund is available to ensure your unique goals and needs are fully met. We invite you to contact us to learn more about our services and investments.
WHAT IS TRUST DEED INVESTING?
Hard & Private Money, Trust Deed, Cannabis Real Estate Financing
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