Trust deed investments is a financial tool that has been used for a very long time. In very simple terms, a trust deed loan is very similar to a mortgage, but with the difference that besides the borrower and the lender, there is another party involved which is the investor or a group of investors. That’s basically trust deed investments in one paragraph, but let’s dive deeper into this type of investment.
In this article we will walk you through:
- What are trust deed investments
- What is trust deed investing
- Why banks don’t like to lend to this market
- What are the pros of trust deed investing
- What are the cons of trust deed investments
- Expected returns on trust deed investing
- How to protect your money with trust deed loans
What are trust deed investments
Today the real estate market is much more sophisticated and complex than what it was used to be. you have many more options both as a borrower and as an investor. With this type of financial tool, a trust deed loan can be very beneficial for borrowers looking to bridge loans for their real estate projects.
What is a trust deed?
Trust deeds or more commonly known as a deed of trust is basically just a document that is being used in real estate projects and deals in the US. What this document is is an agreement between a borrower who has taken out a loan from a direct lender and that lender. Usually these loans are taken to purchase a property.
The trust deed is an agreement where both parties agree that the property in question will be held in trust by a third party who is neutral to both sides and also independent until the loan is paid off in full.
Trust deeds are not allowed in all states of the US, and are less common than they were in the past, but 20 states still allow the use of a deed of trust instead of a mortgage where financing is needed for real estate projects. The states that currenyly allow trust deed investments are:
How a trust deed investment work
When a borrower wants to buy a home, or invest in a property, he contacts a lender to lend him the money to be able to complete the deal. With trust deed investments the lender asks in return a promissory note that is attached to a trust deed. This deed essentially transfers the legal title of the property to a third party, which is impartial and independent from both sides, usually a bank or an escrow company.
This third party will now hold the deed as collateral and security of the loan, however the borrower still holds the right to obtain full ownership and full responsibility for the property.
This state continues for the life time of the loan. The trustee will hold the title until the borrower will repay the entire loan to the lender and is this point the title for the property will be returned to the borrower.
If for some reason the borrower defaults on the loan, the trustee takes full control of the property.
Trust deeds are used where one side borrows money for another side to secure a real estate property, and the title of that property is transferred to a third party such as an escrow until the borrower pays off the loan in full.
What is the difference between a trust deed and a mortgage
Trust deeds and mortgages are similar in the way that in both ways a borrower takes money in order to purchase a house, or some other real estate property. With a mortgage there are only two sides to the transaction:
- A borrower
While with Trust deeds there are three sides involved with every deal. You still have a borrower, and a lender, but now you also have a trustee, which is a third party who holds the title of the property until the borrower pays off the loan in full. In case of a default, the trustee will retain all rights to the property. So with trust deed investments you have:
- A borrower
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.
Investors who are looking for high yield on their money, sometimes turn to trust deed investments, they lend money to a real estate contractor who is looking to develop a property or simply purchase a property with the intent of upgrading it and selling it for a profit.
The investor’s name is going to be on the deed of trust and the investor will also collect interest on the money he gave. When the project is over, and the borrower pays back the money to the investor in full, the name on the deed is removed. It is very common that a hard money lender acts as a broker between the two sides.
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.
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.
Banks in nature are very conservative, and are always looking for the easiest and safest deals to make. This created the eco system for many financial tools smart investors can use to either lend money, or borrow to advance their real estate projects.
Most common type of borrower
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.
While trust deed investing is definitely not for everyone, for the savvy real estate investor who knows what they’re doing this is a great way to advance their deal and move quickly, without having to wait months for traditional lenders to supply funding.
Pros of trust deed investments and investing
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%.
The pros of trust deed investment from the borrower side is obvious, fast and simple access to funds to be able to close real estate deals faster. The savvy real estate contractor or investor can know in advance how much the loan will cost him, and how much profit he will make after the sale ( after returning the loan in full )
|Fast and simple source of funding.|
|More relaxed qualifications|
Cons 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 too 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.
|Trust deed investments are not liquid|
|Little chance of capital appreciation – interest rate income is mostly what you will earn|
|Harsh due diligence process|
|Some risk if you make a mistake with the trust deed and it’s not valid|
|Not for amateurs|
The cons of a trust deed loan from the borrower side are also clear. You pay high interest rate compared to traditional lending companies. And you risk the lost of the property in the chance you default on your loan.
What returns can trust deed investors expect?
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.
What protects your money?
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 the 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
By understanding all that goes into trust deed investment, both the borrowers and investors can benefit from this financial tool. Real estate projects and deals can happen faster, and savvy investors can earn more on their money by funding borrowers who they trust and know.