Risks of Trust Deed Investing

Since real property secured loans can vary greatly from loan to loan, there is no absolute method to determine the level of risk for each loan.  However, by evaluating each of the characteristics of a loan, the relative risk can often be determined. 

Characteristics that must be considered when evaluating risk include:

  1. the fair market value of the property securing the loan,

  2. the income stream and expenses applicable to the property,

  3. the location of the property,

  4. the type of property,

  5. the condition of the property,

  6. the balance and terms of any loans that are senior to the loan being evaluated,

  7. the size and duration of the loan being evaluated,

  8. the creditworthiness of the borrower, including not only the borrower's ability to make interest payments and to repay the loan at maturity, but also the borrower’s experience and track record.

Many of these characteristics have their own criteria that must be evaluated. It is also important to understand that each characteristic may be more or less important to any given loan.  Therefore, the party evaluating the loan must be experienced, in order to understand which characteristics are most important for a particular loan, and to understand the criteria that must be examined and evaluated for each characteristic.

Priority of Trust Deeds

Deeds of Trust are almost always recorded.  This allows anyone looking to buy the property or a lender looking to use it as collateral for another loan, to readily determine the current loans secured by the property.  This is an essential element of real estate lending, as the priority of recordation determines the priority of repayment of loans.  Thus, a first trust deed will have priority of repayment over all other loans.  Further, should a borrower default and a foreclosure process be started, then the "junior" lien-holders (second, third, etc.) must either cure the default related to the first trust deed, or risk losing their investment when the first trust deed beneficiary completes the foreclosure proceedings.  A foreclosure is the legal proceeding which a lender uses to take ownership of the collateral (the real property) securing its loan.

Many lenders will not consider loans unless they are secured by a first or second trust deed.  While priority of a loan is very important, in itself "loan priority" should not be the determining factor as to the quality of the loan. 

For example; assume a borrower wants to borrow $100,000 on an apartment building valued at $1,000,000, which already has a first trust deed of $300,000 and a second trust deed of $150,000 secured against it.  The new $100,000 loan would be third in priority and would bring the total loans secured by the property to $550,000.  This would create a loan-to-value ratio ("LTV") of 55%.  Theoretically, there is $450,000 of the owner's money ("protective equity" or "net equity") protecting the third trust deed lender ($1,000,000 minus $300,000 minus $150,000 minus $100,000).  Now assume that same borrower decides to "refinance" his property and obtain a new second trust deed for $400,000.  Proceeds from that loan would pay off the existing $150,000 second trust deed, leaving the new lender as a new second trust deed holder.  However, that lender only has $300,000 of protective equity ($1,000,000 minus $300,000 minus $400,000).  In this instance, the third trust deed of $100,000 in the first scenario would have greater "protective equity" than the second trust deed of $400,000 in the second scenario, and thus represents a better risk (assuming this was the only parameter being examined).

It should be noted that when lending in a junior position, the ability of the junior lender to cure any default of a senior loan is a very important component to consider.

Determining Interest Rates

While interest rates vary widely on trust deeds, loans made by non-institutional lenders usually earn interest between 10% and 14% per annum.

Borrowers are prepared to pay these higher rates for various reasons, such as:

  1. Needing money quickly

  2. Not wanting to pay off existing loans that have good loan terms

  3. Needing money for only a short time ("bridge financing")

  4. Having credit issues not acceptable to an Institutional Lender

  5. Having property issues not acceptable to an Institutional Lender

  6. Needing liquidity in their financial statement

Lending Criteria for Non-Institutional Lenders

  1. Types of loans made include:

  2. 1.Apartment and commercial loans

  3. 2.Land acquisition and/or development loans

  4. 3.Construction and renovation loans

  5. 4.Non-owner occupied residential loans.  California, and most other states, have laws making it is very restrictive to make loans that are secured by a homeowner's principal residence and therefore many Non-Institutional Lenders do not consider such loans. 

  6. Personal Guarantees - Personal guarantees represent a significant component of the lending criteria.  Therefore, not only is the real property securing the loan a source for payment of the monthly interest and the return of principal, but so are all of the other assets of the guarantor(s).

  7. The fair market value (FMV) of the property is extremely important.  The first step in establishing the FMV is to compare the subject property to similar properties recently sold.  Then, the asking price for similar properties currently for sale are considered.  Often times, borrowers provide third party appraisals evidencing the appraiser’s assessment of the property value, which are used in the independent evaluation of the property.

  8. In the case of income producing properties, the Net Operating Income (“NOI”) must be calculated.  The NOI is the net annual income remaining after all annual expenses are paid, excepting principal and interest on trust deeds.  By knowing the NOI the Capitalization Rate (“Cap Rate”) can be determined.

  9. The Cap Rate is simply the annual rate of return on investment assuming the property has no loans. Thus, a property valued at $1,000,000 with a $60,000 per year NOI, would have a 6% Cap Rate.  If the NOI were $70,000 per year the Cap Rate would be 7%.  Capitalization rates usually have a fairly narrow range for any given geographical area and property type.  Therefore, two similar 20 year old apartment buildings in the same area of San Diego, can be expected to have similar Cap Rates.

  10. The strength of the borrower is often the most important parameter considered in making a loan.  Strength does not solely encompass financial aspects.  Credit worthiness and the financial statement are very important, but so too is the borrower's past performance in managing real estate investments; their track record.

  11. Generally, most loans will be secured by first or second trust deeds. While priority is a main consideration in evaluating a prospective loan, it is not as important as the "protective equity".  Protective equity is the amount of net equity in the property that remains after considering the repayment of all loans. 

  12. Loan to value (“LTV”) ratios are also evaluated. In times of tight money, rarely does the total amount of all loans secured by a property exceed 75% of the fair market value of that property. Many factors are considered when determining an acceptable LTV ratio. Each loan is considered on its own merits and thus the final LTV can frequently differ from loan to loan even when secured by the same type of property.

  13. Hard money loans normally have maturity dates of 6 months – 3 years.

  14. In a “down trending” real estate market, income producing property will generally suffer less of a percentage loss in value than raw land.  Since raw land has no income, its fair market value is related almost exclusively to its “underlying” use, and consequently its value tends to be more volatile.

Individual versus Group Investing

When considering investing in trust deeds, investors must determine whether they intend to invest as an individual or as a "group" investor.  Investing alone  permits the investor to have complete control over the entire process, from evaluating all the initial criteria in selecting the loan, to making all decisions regarding actions necessary if the loan does not perform as expected.  

On the other hand, loans secured by trust deeds generally require significant amounts of capital and most investors are not prepared to make such a large commitment in a single loan, unless they are very experienced in trust deed investing.

Group investing can be "public" or "private".  Normally, public investments are considered to have more liquidity but lower rates of return than private investments holding the same types of loans.  Public investing is usually done through mutual funds or Real Estate Investment Trusts (REIT).  Private investing is normally associated with "tenants-in-common" arrangements, limited partnerships or limited liability companies. 

The term "tenants-in-common" refers to the direct ownership of a fractional interest in a promissory note with one or more other investors.  This means that each investor actually owns an undivided interest in the note and trust deed.  Sometimes all owners will make decisions together, but generally there is a servicing agent appointed to collect and distribute payments and to initiate collection proceedings on behalf of all of the owners in the event of a default.  While this form of investment allows each investor to retain some control over decisions, it can also cause problems when owners are in disagreement as to how to proceed.

Limited partnerships and limited liability companies will remove the investor from the decision making process, but will also eliminate the ability for the investor to make decisions regarding the loans.  However, since many investors either do have the time or expertise to invest in trust deeds on their own, they actually prefer investing through limited partnerships or limited liability companies.

There are a number of advantages to investing in a limited partnership (LP) or limited liability company (LLC).

  1. Lower Capital Requirements - Investors are able to invest a much smaller amount of capital than what is generally required to fund a single loan.

  2. Experience and Historical Performance - The General Partner or Manager should have years of experience in real estate matters and trust deed investments. This should provide them with the knowledge and expertise necessary to evaluate both the quality of the property that will be securing a loan, as well as the quality of the borrower and guarantor committing to make the payments. Further, professional management should possess the skills required to minimize the impact of any defaulting loans in their portfolio.

  3. Spreading the Risk - Since the LP/LLC invests in many loans at the same time, there is less likelihood of a catastrophic loss of income or capital when compared to investing in a single loan. 

  4. Diversification - Having a variety of loans, secured by various types of real property, located in different geographical areas generally results in much greater diversification of risk.  If one segment of the market, such as apartments, begins to show signs of weakness, this does not necessarily mean that the commercial market is softening.  Likewise, just because San Diego's first time home buyer begins to be priced out of the market does not mean that New Orlean's first time home buyer will be too.   

  5. No Management Hassles - Investment as a limited partner or member is management free.  The General Partner or Manager of the LP/LLC is responsible for all activities of the LP/LLC.

  6. Semi-Liquid - While an investment in the LP/LLC is frequently illiquid, some LP/LLC's offer investors the ability to request a full or partial return of capital.  To the extent that the LP/LLC agreement permits it and capital is available, such a request would normally be honored.  In contrast, investing directly in a loan to one borrower almost always means that an investor must wait for the loan to pay off before receiving any return of capital.

  7. Personal Guarantees - Depending upon the loan criteria used by the Manager or General Partner, frequently loans secured by real estate are also guaranteed by one or more individuals.  This is often found when the borrower is a corporation, limited partnership or limited liability company.  Therefore, not only is the real property securing the loan a source for payment of the monthly interest and the return of principal, but so are all of the other assets of the guarantor(s).

All group investment vehicles, whether public or private, will not necessarily invest in the same types of loans.  One may invest only in loans made to individual homeowners, while another may invest strictly in loans on commercial property.  One may invest solely in loans secured by first trust deeds, while another may specialize in loans secured by second or third trust deeds.  It is incumbent upon an investor to understand the types of loans that are being made by the "group investment vehicle".   It is critical than an investor understands the general level of risk of the loans making up the portfolio and compares that risk to their own "risk tolerance level".

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