Trust Deed Investing Definition
Trust Deed Investing is essentially when private investors (any person or group of people who have money they are willing to loan) loan money collateralized by real estate. Trust Deed Investing is hardly new; banks and private individuals have been loaning money against hard assets like land and other real estate for centuries.
A traditional mortgage consists of a deed for the property and a recorded note indicating that the bank has loaned money against that property. Trust Deeds work the same way; the actual loan (or debt) is recorded using an instrument called a "Deed of Trust". The Deed of Trust is filed with the county where the loan is made and becomes part of the public record. Deeds of Trust appear on title searches.
The underlying property (e.g. land) acts as the collateral for the loan. Just like a mortgage, the lender(s) can foreclose on the borrower if the terms of the loan are not satisfied.
You may hear the term "Hard Money" associated with Trust Deed investing. It appears that the word "Hard" refers to the hard asset (land or other real estate); not "difficult" or other definitions of the same word.
Investor's funds are frequently pooled in order to gather sufficient capital to fund Trust Deeds. This is called fractionalizing and many hard money loans are fractionalized because individuals typically don't have hundreds of thousands or millions immediately disposable like banks.
The terms of the Trust Deed define the interest rate, duration, late fees, and other factors of the loan. Frequently prepaid interest or interest only is paid on a monthly basis.
Benefits
Investors in Trust Deeds enjoy generous rates of return over moderate durations. Rates are usually in the 12% to 16% range - but vary based on the type of loan, underlying asset, borrower, and duration. Durations also vary but are usually less than 2 years with the bulk in the 6-month to 1-year range. The collateral (the piece of property or other real estate) is what protects the investor's money. Just like a loan from a bank, if the borrower fails to pay the loan according to the terms, the lender can foreclose and take ownership of the collateral.
Good loans are never made for the full-appraised value of the underlying asset. Thus, the LTV (loan to value) ratio provides an additional assurance that the loan will be
paid back (or that the lenders money will be recovered in case of foreclosure). The LTV for loans varies depending on the loan, terms, and collateral.
Risks and How We Reduce Them
Given the rate of return, it is clear that the capital markets deem Trust Deed Investing as riskier than Bank CDs or Treasury Bills. However, it is clear that these loans are more lucrative with contained risks. The following section will detail some of the risks of Trust Deed Investing and how our experience and actions work to minimize them.
1. Foreclosure
The largest risk in making Hard Money Loans relates to foreclosure. There are two issues associated with foreclosure. First, during the foreclosure process as well as the period leading up to it, there is the loss of expected interest income. Second, at the end of the foreclosure process, the lender is either paid back or acquires the underlying property.
It is viewed that the acquisition of the underlying property through foreclosure can be very lucrative as the asset is 'purchased' for a fraction of its cost (see LTV above). Many lenders immediately put the asset back on the market for a fraction of its market value and achieve a large net rate of return over the duration of the loan.
Foreclosure means that the investors take possession of the asset which acted as collateral. If we take property back, we work together with our investors to preserve capital and try to recover interest and fees. One option would be putting the property on the market to be sold and using the proceeds to payoff the investors. However, this is unfamiliar territory, as we have never foreclosed on any of our borrowers.
2. Delayed Payment of Interest
Borrowers who delay interest payments are charged late fees that are returned to the investor. Although this increases the overall rate of return, the delay in receiving regular payments can be disconcerting.
3. Defective Title
If the borrower does not truly own the property in question - or does not own it free and clear, the foreclosure process can be unsuccessful or lengthy. To balance this risk, an accredited and licensed title company performs a title search and the associated Title Insurance policy (ALTA Title Policy) is purchased. This is almost a non-issue in today's lending market.
4. Disasters
A natural or other disaster could cause the value of the underlying asset to decrease. In cases like this, a borrower could walk away from their loan obligations and let the lender foreclose. We balance this risk by requiring appropriate insurance based on the requirements of the location (e.g. flood insurance on houses in a government designated flood zone). There is always the risk of uninsured disasters impacting the value of the underlying asset.
5. Current Taxes
In the case where property taxes are owed, the government will want to be compensated before a foreclosure can be completed or they will foreclose. A clean title indicates that there are no outstanding tax liens. However, new tax liabilities could be incurred after the loan is funded. Investors will get notice of past due taxes from the loan servicing company. If the borrower does not pay the taxes, and we foreclose, we will be responsible for paying the back taxes. We always require prepayment of taxes as a term of the loan to avoid this issue.
6. Incorrect Appraisal
The decision of how much to loan is based on the value of the underlying asset. A loan value based on an incorrect appraisal could mean insufficient equity is in place to compel the borrower to make payments. We balance this risk by performing personal appraisals, examining comps, and when appropriate, getting a formal appraisal from an independent 3 rd party.
7. Improper Recording of Trust Deed
The investor's ability to foreclose is based on clear public evidence of the loan. This is done through correct recording of the Trust Deed in the county where the underlying asset is located. As the loan is being made for the benefit of our investors and ourselves, we have the escrow company record the loan. We provide copies of the recorded trust deed to the investors associated with the loan (this is required by Nevada state law).
8. Position of Loan
In a foreclosure process, the lender in the 1 st position is compensated before subsequent lenders. If a loan is recorded in a position deeper than 2 nd , the ability to foreclose can be very challenging. We only fund loans in 1 st or 2 nd position.
If we are in 2 nd position, we may have to keep the 1 st current by making payments in order to avoid having the 1 st foreclose and wipe out our position. We are careful to watch that the 1 st is not so large so that the 2 nd will be exposed (have sufficient protective equity).
9. Hidden Liens (e.g. Mechanical Lien)
If there are liens (e.g. mechanical liens) that do not show in a title search or are added subsequently, these need to be satisfied ahead of the loan. In addition to the title insurance protecting against pre-existing title issues, we record our loan. Foreclosure removes liens that are subordinate to ours.
10. Construction Issues
In construction loans, the lender must be careful to only fund for work that has been performed. The lender must also be careful not to get the loan ahead of the value of the work that has been done (to protect the LTV). We balance this risk with monitoring the construction process, using voucher controls (where the borrower only gets funds upon proving that work has been performed or supplies have been purchased), requiring Course of Construction Insurance and getting appropriate inspections performed. We use an independent 3 rd party construction control agency on construction loans. This company is responsible for monitoring progress, approving steps against plan, and making disbursements
11. Limiting other risks
There are additional risks in making loans and in dealing with real estate. Some examples include decreasing asset value and that raw land generates no income. By limiting the duration of our loans (average around 1 year), having a good LTV ratios, performing appropriate research, establishing careful controls, requiring insurance, and providing the investor with clear information to determine if they want to invest, we work diligently to limit risks.
We strive to prevent risks from impacting investors' returns. However, ultimately, the investor makes the decision to invest - we will provide support and give you significant information to assist in the decision process.
FAQs and Additional Information:
How do investors get their interest?
The borrower pays an independent third party loan servicing company. The loan servicing company sends checks to the investors upon receipt of payment from the borrower. Barring issues, checks should arrive promptly to the investor; with the exact date and timing depending on the loan terms. Please note that interest is paid in arrears (like mortgages). This means that, with the exception of a partial month interest, the first payment will occur on the 2 nd month of the loan.
How do investors get their principal returned?
When the loan is paid off, the escrow company sends principal checks to the investors. Pay-off occurs when the loan expires, through sale of the property, or through re-financing.
Do investors have to pay taxes on interest income?
The loan servicing company sends investor tax forms (1099) to investors. Taxes should be handled on the investors tax returns based on applicable laws. We always recommend consulting with your CPA.
What 3 rd Party Companies are involved?
We use many 3 rd Party Companies including Escrow Agents, Loan Servicing, Appraisal, Title, and Foreclosure Companies. Note that we do not touch your money - your investment is paid to an escrow agency.
Are there laws covering Trust Deed Investing?
In Nevada , the Mortgage Lending Division (web site http://www.mld.nv.gov/ ) covers this area. The relevant law can be found at http://www.leg.state.nv.us/NRS/NRS-645B.html
How much do I need to invest?
We would only suggest that you invest at a level where you are comfortable. To offset the cost of the paperwork and overhead (loan servicing), we require loans to be a minimum of $10,000.
What kind of information do I get to make decisions with?
We provide a packet of information including:
· A description of the loan (interest rate, duration, position, other liens)
· Geographic information
· Pictures (when available)
· A copy of the title insurance policy
· A copy of the title search (preliminary title report)
· A copy of the formal appraisal (when performed)
· An investor's information sheet and receipt of documents and/or waiver (to be filled out and returned)
· A copy of the loan application / construction loan agreement (when applicable), and
· A mortgage investment disclosure form.
How do late fees and stepped up interest work?
Ultimately, this depends on the terms of the loan. The usual terms are that late fees are charged when a payment is 1 month late (after grace period); stepped up interest is charged on payments which are 2 months late (after grace period). Investor and lender may decide to make a deal to keep both whole.