TRUST DEED INVESTING
Thirteen Trust Deed Investing Tips
We are going to start with some slightly more advanced stuff, Thirteen Trust Deed Investing Tips, rather than with the basics. Only at the very bottom of this guide do we cover the basics of trust deed investing, like what is a trust deed, how much interest you can earn, what are the risks of trust deed investing, and what is a trust deed fund. The reason we have reversed the order is because most of our readers already understand the basics of trust deed investing.
Please don't get turned off to trust deeds simply because we have an adult conversation about a few scary situations. If you make small first mortgages, at affordable interest rates, to borrowers with decent credit and the clear ability to repay, I predict that you are going to really-really like trust deed investing.
THIRTEEN TRUST DEED INVESTING TIPS
1. Small Loans Are Much Less Risky
You have $25,000 to invest. Your hard money broker offers you two different loans, both yielding 8%. One is a $1 million loan on a shopping center. The other is a $100,000 loan on a converted house that is being rented out as a little real estate office. When investing in trust deeds with my own money, I will choose the smaller loan just about every time.
Why? Small loans have small payments.
When making high-interest-rate loans, you have to be sure that the higher monthly payments don't slowly grind the borrower into the dust. The wise trust deed investor wants his borrower to succeed.
You've got to remember that banks are charging just 5.5% on commercial permanent loans. That shopping center could probably easily debt service a $1 million loan at 5.5%. However, a $1 million loan at 9.9% (the gross interest rate before loan servicing fees*) might produce a negative cash flow of $2,800 per month for the borrower.
Now let's look at that converted house. If the little office building cash flowed at 5.5%, a 9.9% loan produces a negative cash flow of only $275 per month. Now which negative cash flow is easier for the borrower to carry - $2,800 per month or $275 per month?
* Isn't that an awfully high loan servicing fee? (See further below.)
2. When You Are Investing in Trust Deeds, Make Sure the Interest Rate is Affordable
A 16% loan is better than a 9% loan, right? You get to make more interest. Yummy. That 16% loan sure is a good one.
No-no-no! Have you ever considered the fact that the monthy payments on a 10% interest-only loan are twice those of a 5% interest-only loan. And a 16% loan? Fuhgetaboutit! You are virtually guaranteeing yourself a foreclosure.
In Tip #4 we will explain why foreclosoures result in losses for the trust deed investor at least 80% of the time. For the purposes of this section, please accept this statement as unfortuately true. Since a foreclosure is likely to produce a loss for the trust deed investor, the smart trust deed investor wants his borrower to succeed. So is a 16% trust deed better than a 9% trust deed? Heck no!
Folks, please don't get turned off to trust deeds because of all of this scary stuff. Trust deed investing can be marvelous. The smart trust deed investor can avoid most foreclosures by simply making sure his loan payments are affordable. Even if you invest in lower-yielding trust deeds, you can still reasonably expect to earn 5% to 8% more than C.D.s. That's a great return for a fixed income investment.
The secret to successful trust deed investing is actually pretty simple. Don't get greedy.
3. Make Sure the Borrower Can Afford Your Payments
It's not quite enough to invest in trust deeds with affordable interest rates. The borrower still has to be able to afford the monthly payments. Think back to that nice $100,000 loan on that little real estate office that we discussed in the very first tip. The interest rate on that loan was only 9.9%, which is pretty affordable for a private money loan.
But what if the borrower was an old widow, living solely on social security? The $275 per month negative cash flow may be too much for her to carry. While she may be able to carry the negative cash flow for a few months, we want to avoid investing in trust deeds where the monthly payments are so high that they financially grind the borrower into the dust.
Okay, we only want to lend to borrowers who can reasonably afford the payments. Got it. That's easy. Let's look at the borrower's paycheck stubs and tax returns and verify that he can make the payments.
Unfortunately its not that simple. Wall Street lenders (Silver Hill Funding, Velocity Mortgage, PeerStreet, and many others) have moved into hard money lending, and if a borrower can show on paper that he can afford the payments, Wall Street will make him a loan at interest rates 2% to 3% below hard money rates - even if the borrower has bad credit. How can they do this? They are securitizing these loans and getting this paper rated by the rating agencies.
The good news is that the market is not perfect. Borrowers don't always know about these Wall Street lenders, so your hard money broker should still be able to find some loans where the borrower can prove on paper that he can afford the payments. Increasingly often, however, hard money brokers are being forced to look at deals where the borrower cannot document on paper the fact that he can afford the monthly payments. Many of these loans can still be quite good.
A good example of such a reasonable hard money loan is a loan to a restaurant owner who is showing only a paltry income on his tax returns, and yet he has tens of thousands of dollars in the bank and very little credit card debt. Another example could be the owner of an unflagged hotel, where many of the guests pay in cash. Another example is the owner of a small trailer park, where the park owns a number of the coaches. A great many times the tenants pay their rent in cash, and - shhhh - maybe not all of the incoming rent gets reported on the park owner's tax returns.
4. Trust Deed Investors Lose Money on Foreclosures 80% of the Time - Part 1
It's true. Foreclosures are losers. Ouch. Why? Three reasons: (1) If there is lots of equity in the property, the borrower will almost always file a Chapter 11 Bankruptcy to buy himself some time to sell the property. It never works. (2) Most foreclosures take place during recessions, when real estate values are depressed. (3) Because potential buyers think the lender is over a barrel, it is sometimes difficult for a lender to get full fair market value for a foreclosed property. (We explore points two and three further below.)
An example will make the first point clear. A trust deed investor makes a $600,000 hard money first mortgage on a $1 million office building. That's reasonably conservative, right? The borrower falls behind in his payments. The trust deed investor files a Notice of Default. About four months later, just as the Trustee is about to hold his Trustee's Sale, the borrower predictably files a Chapter 11 Reorganization Bankruptcy. A stay of the foreclosure sale automatically springs (fancy legal words for, "Hey, trustee, stop trying to foreclose!"), so the trust deed investor can go no further with his foreclosure until he gets permission from the judge.
The borrower is invariably late in filing his Plan of Reorganization, his bankruptcy attorney pleads for extension after extension, months drag on, and the trust deed investor's loan balance grows and grows as interest accrues (usually at a juicy interest rate). Finally - finally - the debtor's Plan of Reoganization arrives, and the plan is nothing more than to sell the property.
Finally, the debtor get serious about selling the property. The debtor is going to sell the property, and everyone is going to paid off in full. Hooray! Sorry, Charlie, in 37 years in the hard money business and through several hundred Chapter 11 bankrupties, I cannot remember ever seeing a debtor successfully sell his property while in Chapter 11 Bankruptcy. I'm sure it happens occasionally, but I have never seen it.
Why is it so hard for a debtor to sell his property while in a Chapter 11? Sooner of later the prospective buyer will see a title report (aka: title commitment). Prominently displayed on the title report will be the fact that the borrower is in bankruptcy. "Ha! The borrower is in bankruptcy. He is over a barrel. Why should I bail him out? I'll just say that I was unsatisfied with one of the property inspections, and then I'll buy the property for a lower price from the lender after he forecloses." That never ends up working either because the bleeding heart-bankruptcy judge will drag out the Chapter 11 for a full 14 months or more, and by then the prospective buyer has moved on and bought something else.
In the meantime, the unpaid interest accrues and accrues. Only when there this no more equity left in the property and the lender is guaranteed to take a loss, will the Bankruptcy judge finally grant the trust deed investor's Motion For Relief of the Automatic Stay.
You might be thinking to yourself, "Gee, I never knew that trust deed investing could be so risky." Folks, if you invest in a diversified portfolio of small first trust deeds, where the interest rates and the payments are affordable to the borrower - trust deeds can be a delighful, laid-back kind of investment. Imagine yourself on the beach as time washes up interest payment after interest payment. (Careful here: Before you lay out your beach chair and umbrella, please be sure to read the the serious warnings at the end of this article.)
You should be noticing a common thread to all of these scary scenarios. Some greedy trust deed investor invested in a loan where the borrower couldn't afford to make the payments. He then financially gets beat over the head with his beach chair. Don't do that.
5. Trust Deed Investors Lose Money on Foreclosures 80% of the Time - Part 2
Most painful trust deed losses take place during recessions. During regular recessions, real estate typically falls by 20% to 25%. During great recessions - like the S&L Crisis, the Dot Com Crisis, and the Great Recession - real estate seems to fall exactly 45%. (Remember that number - 45%.) Don't panic and try to sell the property during a recession. You will only end up taking a painful and unnecessary haircut. In the case of great recessions, you'll end up taking an outright scalping.
Instead, simply rent the property out and wait for three and a half years. By then real estate will probably be approaching new highs again, and you'll likely end up making a handsome profit, instead of taking a painful haircut.
Not convinced? I could make a good argument that one of the best investments on earth is real estate purchased at the very bottom of a recession. Historically, real estate pops around 30% to 35% in just the next three and half years, as it bounces off its nadir (low point) and recovers to new highs. Therefore, rather than sell (your foreclosure) at the bottom of a recession, hold at the bottom of a recession.
6. Trust Deed Investors Lose Money on Foreclosures 80% of the Time - Part 3
It is unfortunately very hard for a trust deed investor to get fair market value for a foreclosed property. In real life, (almost) no one will pay a lender more than 50% to 60% of the fair market value for a property, once potential buyers discover the fact that the property is a foreclosure.
Why is this? Buyers think the lender is over a barrel. Over a barrel? Six accredited trust deed investors own a $300,000 retail building free and clear, and they are somehow over a barrel? Well, that how the world perceives them. Why?
The Office of the Comptroller of the Currency ("OCC") doesn't want banks owning real estate. Their depoits are not insured by the public so that the banks can become landlords. "Get rid of your REO's quickly!" Those are the orders to the banks from on high. Banks get punished financially by the OCC if they don't get rid of their REO's quickly. Therefore a bank really is over a barrel when it forecloses on a property. It really must sell that property quickly. Discounts off the fair market value of 50% are not uncommon.
And everyone knows this. This is why almost no one will ever offer more than 60% of fair market value for a bank foreclosure.
But wait, if you are one of those six private trust deed investors that owns that nice retail building free and clear... heck, you're not under any pressure. The OCC can't order you to dump your property for just 50% or 60% of what it's worth. The OCC can kiss your seat!
Yeah, but the buying public doesn't know this. In their minds, you and your fellow trust deed investors are "a bank", and hence you are over a barrel. How did these potential buyers even find out that the property was a foeclosure? Your disloyal listing real estate broker couldn't wait to spread the word to his cronies that the property was a foreclosure. Potential buyers started to salivate and rub their hands together in greed. "I offer 46% of fair market value." "We offer 46.2% of fair market value!" "I'll go 46.8% of fair market value." But no one will offer you anything close to fair market value.
Okay, so what should a wise trust deed investor do if he forecloses? Don't immediately list the property for sale. Fix it up a little and then rent it out. Once you are offering a leased investment, the world will beat a path to your door!
7. Avoid Second Trust Deeds - Even If There is Lots of Equity. Second Trust Deed Can Quickly Become Alligators.
An alligator is a property with a negative cash flow, and alligators will quickly eat you alive. Picture this... Sicily, 1948. Ha-ha! Seriously though, picture this... You make a $50,000 second mortgage behind a $500,000 first mortgage on a house worth $1 million. The borrower then becomes an opioid addict and stops making payments.
You get notice from the bank that the first mortgage is seven months in arrears, and you are facing another eight months to foreclose and to get relief from the borrower's inevitable Chapter 11 bankruptcy. Fifteen months worth of first mortgage payments equals another $50,000 - not counting another $20,000 in foreclosure and legal costs. And what about the cost of the repairs and the renovations that will inevitably be necessary?
You are going to have to shell out all of this new money - approaching $100,000 if you include likely repairs - just to protect your original $50,000. And there is no guarantee when the bankruptcy judge will finally grant your Petition For Relief From the Automatic Stay. The borrower might be able to postpone the sale for another full year.
Alligators are a dangerous thing. When there is no definite end in sight, and when you are shelling out big money every month, six months feels like six years. Alligators can drive investors mad. They tend to lose all sense of economic reason. Do you know what happens in real life, at least seventy percent of the time? The second trust deed investor ends up walking away from his original $50,000 investment, even though there is tons of equity in the property.
Moral of the story: Avoid second trust deeds unless you are richer than Crassus.
8. Foreclosed Property Will Never Sell or Lease Until It is Renovated.
You foreclose on a property. You are reluctant to throw good money after bad. (Some of the most foolish words ever uttered.) "Let's just sell the property as is and get whatever we can get." You list the property for sale with a real estate broker "as is", and then the property just sits and sits and sits. The roof starts to leak, mold grows, and vandals - after seeing no activity on the property for months - break in and steal the appliances and the copper pipes. Vandalism insurance only cover your losses if the property is at least 20% occupied.
Heed these words of warning: Foreclosed property never sells or leases until it is renovated. The wise trust deed investor, on the morning of the foreclosure sale, immediately sends in his locksmith and his renovation contractor. You don't have to turn the place into the Taj Mahal, but you do have to immediately renovate it. Observable facts of nature: Apples fall out of trees. Water flows downhill. Foreclosed property never sells or leases until it is renovated. Been there, learned this (again and again). It just an observable fact of nature.
9. Invest More Aggressively During Recoveries and Vice Versa
Four and a half years from now (2/17/18), this once-in-a-lifetime economic recovery will be getting long in the tooth. At that time, you will want to start paying more to get superior quality first trust deeds. The way you "pay more" is to accept a lower yield. For example, your hard money broker may be offering two different loans. Loan number one is yielding 10% and is 75% loan-to-value. Loan number two is is yielding 7%, but it is only 60% loan-to-value. Four and a half years from now, you need to start choosing deals like loan number two.
Recessions always follow recoveries. You therefore want to be invested exclusively in superior quality first trust deeds by the time the next recession starts. The good news is that the next recession will probably be just a regular one, the type where real estate only falls by 20% to 25%. We can be fairly sure of this because the Great Recession already cut most of the fat (buggywhip manufacturers holding on by a shoestring) out of the U.S. economy.
On the flip side, you can be much more aggressive during recoveries. When real estate is appreciating at 1% per month, a loan made at 75% loan-to-value will be less than 63% loan-to-value within one year. Therefore, if the subject property is attractive and less than 40 years-years-old, go ahead and be aggressive on your loan-to-value ratio right now, if this is what it takes to win the deal.
For the first time in 15 years, I believe that we are about to enter a big-time bull market in real estate - perhaps almost a mania. It has to do with the trillions of dollars injected into the economy by the Fed during the Great Recession. When Americans start borrowing and spending like normal again, inflation has the potential to go ballistic.
10. Good First Trust Deeds Are Very Hard To Find These Days, So You May Need To Move Fast
This section is going to sound like a Ronco television commercial. "But wait, if you order in the next five minutes, we'll throw in..." Ha-ha! In truth, however, this section is perhaps the second or third most important among all of my 25 tips. If you dilly-dally every time you see a good trust deed offering, the remaining 24 tips are moot. You'll never get into a deal.
It is no longer easy to find good first trust deeds in which to invest. Because banks are paying just 1% and trust deeds are yielding 7% to 9% (and even higher on riskier deals), tens of thousands of accredited investors nationwide are pouring billions of dollars into first trust deeds. Hundreds of brand new hard money shops have opened up over the past two years, so the competition for good loans is immense. This is by far the most competitive market for hard money loans that I have ever seen in my 37 years in business.
If your hard money broker offers you a good new loan, you need to call him instantly. You are in a race with the other investors on his list. After you have dilly-dallied a few times, only to find that you called too late, you will learn this lesson.
Cold, Hard Fact: There is far-far more investor demand for good-quality first trust deeds than there are good loans available.
11. (Almost) No One Ever Bids at Foreclosure Sales.
You have probably seen the reality show, Fix or Flop, about the guy who flips houses. Juicy gossip: The couple is divorced now, and that former beautiful wife of his is now (before?) dating the poor hero's general contractor.
Anyway, our hero in Fix or Flop would go to foreclosure sales, and there would actually be competitive bidding at the foreclosure sale. Yeah, but competitive bidding doesn't happen very often in real life. When you bid at a foreclosure sale, you have to bid all-cash. There are not thousands of people in the world with the financial horses to bid $500,00 or more, all-cash, at a foreclosure sale.
In Tip #7 we talked about a trust deed investor who had made a $50,000 second mortgage, behind a $500,000 first mortgage, on a $1 million house. In real life, that second mortgage investor would probably choose NOT to advance another $100,000 in new money, just to protect his $50,000 investment. The good news is that someone might bid $550,000 for this $1 million house at the foreclosure sale. If it happened, the second mortgage investor would be rescued.
Unfortunately, in real life (almost) no one ever bids at foreclosure sales. Okay, if we are talking about dirt cheap, foreclosed houses that are desperately in need in of a major renovation, then, yeah, the fix and flip community may be there bidding 46.8 percent of fair market value. "No, I'll pay 46.9% of fair market value!"
Ourtside of these dirt cheap houses, there may be vultures and lookey-lou's at a foreclosure sale, but the odds are 20 to 1 that the no one will bid. The all-cash requirement is one big hurdle. The second big hurdle is that most bankruptcy judges are bleeding hearts. The bankruptcy judge is unlikely to grant the first mortgage lender's Motion For Relief From the Automatic Stay in a Chapter 11 bankruptcy, until the accrued interest on the first mortgage loan has eaten up almost all of the junkie's equity in his house.
12. Will Your Hard Money Broker Survive the Next Bad Recession?
Do you remember that footnote in Tip #1 where we posed the question, "Isn't that loan servicing fee pretty high? Let's address that issue now. Here's a wake-up call for you. There were around 400 hard money mortgage companies in America when the Great Recession began. By the end, maybe a dozen of them survived. (Actually the real number may even be lower than that.)
When a hard money broker files for bankruptcy, really bad things happen to the trust deed investors. The court appoints an expensive trustee ($$$), who immediately hires a receiver ($$$), who brings in a CPA firm as an auditor ($$$) and an attorney ($$$) to represent the investors. Then they hire property managers ($$$) for the properties. Guess who gets to pay for all of these expensive jackels. You guessed it. The trust deed investors.
To make matters worse, there is no capitalist around to say to the jackels, "Hey, that little report couldn't possibly have taken you eight billable hours to complete!" "What's this $26,000 invoice for copies at 42 cents per copy?" The jackels feed and feed, with no one to rein in their spending. I wouldn't fall off my chair in surprise if some of the trust deed investors with some of these bankrupt hard money brokerage firms recovered less than 40% of the face value of their accounts.
How did Blackburne & Sons survive the Great Recession (and the S&L Crisis and the Dot Com Crisis)? We have always charged very low points (loan fees), but we almost always charge a loan servicing fee of 1.9% annually. What did most of our competitors charge for loan servicing? Most of them charged 0.50%.
When the Great Recession hit and new loan originations tumbled by 85%, Blackburne & Sons was able to fall back on its loan servicing revenue (after cutting our staff to the bone). Our competitors had just a tiny fraction of our loan servicing revenue. They had lived for years off their big loan fees on their newly-originated loans. When that source of income virtually disappeared - poof - so did they - poof.
About a decade ago, there was a hilarious animated movie entitled, Chicken Run. The movie was about a bunch of chickens who escape from a massive chicken-raising facility. (The movie was modeled after the 1963 war movie, The Great Escape.). There is a line from that movie that still tickles my wife and me ten years later. When the chickens discovered their likely fate, a cute little chick pipes up, "I don't wanna be a chicken pot pie!" So if you don't want to be a chicken pot pie or jackel food, make sure you invest with a hard money broker with the cash flow to survive a recession.
I could make a good argument that 90% of the newbie hard money shops opening up these days closely resemble Ponzi schemes, all but pre-destined to collapse in the next recession. It may sound counter-intuitive, but you want your hard money broker to charge a large loan servicing fee.
13. Loans on Adult Entertainment Properties Can be Excellent
Okay, so Wall Street is snapping up a huge chunk of the subprime commercial loan market. As private investors, we are desperate to find high-yielding loans that will pay agreed.
Here is a sad but true reality: Our hard money mortgage company, Blackburne & Sons, has made about 15 loans on churches over our 37 years in business. Every single chuch loan defaulted, and we were forced to foreclose. Our average loss was over 45%.
Over the same time period, we also made between 15 and 20 loans on adult entertainment properties. By adult entertainment properties, I mean gentlemen's clubs (nudie bars), adult bookstores, lingerie shops, and the like. We once even made a loan on the World's Largest Female Mudwrestling Palace. Girls Mudwresting? Ha-ha!
But here's the deal. Every single of these loans performed admirably - most without a single late charge. Unfortunately, most of them paid off early because the clubs made so much money that the borrowers doubled-up and tripled-up on their payments.
If you get can past the moral issues, loans on adult entertainment properties are often great trust deed investments.
14. Loans on Cannabis Facilities
Under Federal law, the sale or use of marijuana is illegal, even if it has been specifically legalized in the state in question. Nothing that I will say in this section negates that. If you invest in a trust deed loan on a cannabis growing or retailing facility, you are arguably providing material assistance to a drug dealer. If the Feds ever decided to crack down, you could, in theory, be facing jail time. These realities having being expressed, would you really be shocked to learn that such loans paid more like nudie bars than churches?
How likely is a Federal government crackdown? The risk is not zero, but a good argument can be made that the risk is low.
What is a Trust Deed?
A high school buddy of yours come to you two weeks before the Prom. "Steve, the Prom is coming up, and I am broke. I need to rent a tuxedo, I need to hire a high-end Uber for the drive, and I need to buy Liz a nice cosage. Can I please-please borrow $250?"
Now your buddy, Tony, is a warm, kind, and likeable guy, but he's a little bit of flake. You want to help him out because he is absolutely nutso-in-love with the lovely Liz; but you need your $250 back to buy books for college next year. So you reply, "Okay, Tony, I'll loan you $250, but you have to put your 1952 Mickey Mantle rookie Topps baseball card up as collateral. And I want our agreement in writing. If you don't pay me back within 30 days, I am going to put the card up for auction. We might get $3,000 or $4,000 for the card, and I'll give you anything over my $250, plus interest and selling costs."
This agreement with Tony, where he pledges this valuable card as collateral for a loan, is known as a security agreement. All sorts of things can be pledged as collateral for a loan, including equipment, inventory, accounts receivable, real estate, and even intellectual property. When I bought the domain name, CommercialMortgage.com, for $100,000, I pledged the domain name to the bank for a 12-month loan. Does that sound like an insane amount money? The seller originally wanted a whopping $1 million for this domain name, and I had to beat him down over seven years to get him back down to earth.
Security agreements for real estate are called mortgages, and in some states, they are known as trust deeds. The basic deal is the same. If you don't pay back the loan, the lender gets to sell the real estate pledged as collateral.
My hard money mortgage company, Blackburne & Sons, makes and sells first mortgages nationwide, and the security agreement used in many states for real estate is the mortgage. Therefore, let's explain a mortgage first, before we get into trust deeds. The mortgage has two parties, the borrower (Mortgagor) and the lender (Mortgagee). The Mortgagor is the borrower. A good way to remember this is that the Own-Nor is giving a mortgage to the lender. The lender is the Mortgagee, the party re-CEE-ving the mortgage.
Now the thing to remember about a mortgage is that you have to use the courts to foreclose a mortgage, and courts can be glacially slow. The borrower has two months to answer a summon and complaint for foreclosure, and at the last moment some newly-hired attorney often asks for extra time "to research the case." A second extension of time is common. Then the case goes to court - usually a Motion for Summary Judgement - where the lender proves up the delinquency. When the judge finally grants a Judgment of Foreclosure, the lender is far from home free. It can take many weeks (sometimes several months) before the Sheriff finally conducts a Sheriff's Sale (foreclosure auction), often 50 or more sales in a single day. During all of this time, no one is protecting the property.
Mortgage states suck. Should you cut your loan-to-value ratios back by 5% or 10% in mortgage states to allow for the delay? One could make a good argument. But what if you get a chance to make a 75% LTV purchase money first mortgage on a small apartment building, where the buyer is putting 25% down? See? Investing in first mortgages is as much of an art as it is a science.
We are now ready to discuss Trust Deeds. Because courts are glacially slow, the Trust Deed was developed. The Trust Deed has three parties - the Trustor, the Trustee, and the Beneficiary. The thing to remember about a Trust Deed is that a lender can foreclose a Deed of Trust without involving the courts at all. A Deed of Trust is exactly the same thing as a Trust Deed.
The Trustor is the Own-Nor of the property, the person giving up bare legal title in the form of a Deed of Trust. The Trustee is the party re-CEE-ving bare legal title to the property. The Beneficiary is the party receiving the Benefit of the Deed of Trust, the right to foreclose if the Trustor (Own-Nor) doesn't pay.
To understand bare legal title, you need to understand that real estate is a bundle of rights. Think of a bundle of rights as arrows in a quiver. One right - one arrow in our metaphor - is the right to occupy the property. Another right (arrow) is the right to exclude others. "Get the fudge off MY property." Another right (arrow) is the right to collect rent. Another right (arrow) is the right of quiet enjoyment. "Hey, Bucko, I am trying to suntan here. Stop blasting your crazy music and stop roasting cow paddies. I am downwind, for Heaven's sake!"
One more right (arrow in that quiver) is the right to bare legal title. Bare legal title is the right to tell the world that I am owner of the property. "Hey, Bucko and Mrs. Bucko, I own this property free and clear of anybody." The Trustor (the Own-Nor) gives away this right when he assigns bare legal title to a Trustee (the party re-CEE-ving it).
We're almost ready to discuss a Trust Deed foreclosure, but first we have to discuss the Trustee. What or who is a Trustee? "Tony, you and I both know and trust Philip. We are going to give Phllip the Mickey Mantle baseball card. If I sadly have to tell him that you have defaulted on my loan, Philip will contact an auction house and have a public auction for the card." A Trustee is a party trusted by both parties to hold bare legal title to the property until the loan is paid in full. He is also the party who will arrange a Trustee's Sale, if the borrower doesn't pay. Trustees are usually attorneys or title companies.
Okay, a property owner signs a Note (the promise to pay) and a Deed of Trust (the form of Security Agreement for real estate in trust deed states) in return for a $200,000 loan on his small office building. He defaults on the loan. The Beneficiary (the lender) sends a notice to the Trustee. The Trustee files a Notice of Default in the county records against the the property. Ninety days later (some states may vary), if the delinquent payments are not cured (brought current), the Trustee will publish an announcement of his Trustee's Sale. About a month later, on the steps of the local courthouse, the Trustee will conduct his foreclosure sale.
Now we finally get to the big-time benefit of Trust Deeds, as compared to mortgages. The Trust Deed foreclosure process can take less than five months, and it does not involve the courts at all. Remember, when you have to use the courts to foreclose, it really slow down the process. Can a first mortgage investor be more aggressive in a Trust Deed state? Yes, but if you have hallucinations of making a big profit off of a foreclosure sale, you are forgetting about bankruptcy court.
How Much Interest Can You Earn By Investing in Trust Deeds?
You can invest in 16% trust deeds. I've seen them offered. Yummy. A higher interest rate is better, right?
Heck, no! There is almost no reasonable way that a 16% first trust deed can work out happily for the investor. First of all, the monthly payments will almost always grind the borrower financially into the dust. Do you remember above when I wrote that the monthly interest-only payments on a 10% loan are twice those of a 5% interest-only loan? Twice! And can you even imagine the monthly payments on a 16% loan? No one on earth - with the possible exception of the owner a gentleman's club - can afford to make the monthly payments on a 16% loan. The borrower is almost guaranteed to default.
"But what if there is plenty of equity in the property?" It won't help. If there is lots of equity in the property, you can absolutely sure that the borrower will file a Chapter 11 Bankruptcy.
"But then the borrower will simply sell the property while in bankruptcy and pay me off, right?" Nope. I'm sure it sometimes happens, but I cannot remember a single time in 37 years where a borrower successfully sold his property while in a Chapter 11 Bankruptcy. Why? Because sooner or later the prospective buyer will see a title report and realize that the borrower is in bankruptcy. Then the buyer gets greedy and figures, "Why should I pay retail for the property, when I can just wait for the lender to foreclose and then buy it wholesale?"
The sale then falls out, and the bankruptcy court grants extension after extension to the debtor. Sale after sale falls out. Over time , the potential wholesale buyers move on to other properties. By the time the bankruptcy court finally grants leave to the lender to foreclose, all of the equity in the property has been eaten up with interest, foreclosure costs, and legal fees. I have often thought to myself in frustration, "This bankruptcy judge is not going to let us foreclose until our investors are guaranteed to take a loss."
If your goal is to get rich quick by making high-interest-rate trust deeds, go home. You could do that 25 years ago, when real estate was appreciating by one percent per month and trust deeds were just a niche investment, known to just a handful of savvy investors. Modernly, borrowers have hundreds and hundreds of hard money shops from whom to borrow. If a borrower is willing to pay even 13% today, there is something very, very wrong with the deal.
"Okay, what about 11% and 12% first trust deeds? Those rates are more reasonable, right?" Yes, but I can confidently predict that if you invest in five Trust Deeds at 11% or 12%, at least one of them will go bad. The loss that you take on that one bad deal will eat up a lot of the interest that you earned on the other four trust deeds. Now our hard money shop, Blackburne & Sons, does offer 11% and 12% loans, but we describe them in our Mortgage Investment Bulletins as speculations, rather than investments.
Blackburne & Sons has a small profit sharing plan, and as Trustee of the Plan, I invest some of the Plan money in first trust deeds. Here is my rule for trust deed investing, "We will never invest in any first trust deed yielding more than 9%." After decades of originating and servicing hard money loans, I developed a law of trust deed investing, more precisely a hypothesis, that I call Blackburne's Law:
A portfolio of 8% and 9% first trust deeds will outperform a portfolio of 11% and 12% first trust deeds over a seven year holding period.
So if your patron saint is St. Ebenezer Scrooge, and you love-love-love to maximize your money, you will invest in 8% deals, as opposed to 12% deals. Why? Because the borrowers can afford the payments!
What are the Risks of Trust Deed Investing?
Before we get into a long list of trust deed investing risks, let me tell you a story. Blackburne & Sons specializes in subprime commercial permanent loans. These are loans that are based materially on the equity in the property. Three times in our 37-year history commercial real estate values have fallen by 45%. This means that a loan written at 68% loan-to-value before the crash is now upside down. The borrower has no more equity in the equity in the property.
Blackburne & Sons had about 250 loans outstanding when each of these real estate depressions hit, and indeed around 50 loans each time went bad. The investors in these loans suffered losses, a few painful losses, and a few losses being on the order of 35% to 40% of their original investment. Ouch! Almost invariably the loans that went bad had double-digit interest rates. Hmmm. Is there a lesson here?
But you know what? The borrowers on the remaining 80% of our loans continued to make their payments, even when they were upside down on these properties! Huh. Who would have figured? And remember, a great many stocks and bonds fell by 45% during these same great recessions.
So here's my point. Even during the worst of times, a diversified portfolio of small first trust deeds, all with reasonable interest rates, can just keep plugging along, much like the Little Train That Could. Therefore please do not freak out as I go down my list of the Ten Biggest Risks of Trust Deed Investing.
- The property gets stripped of copper pipes, copper wiring, and appliances during the foreclosure process or during the time the property was sitting vacant.
Investing in first trust deed involves significant risk. A substantial and prolonged decline in real estate values is possible. Foreclosed property almost always needs to be renovated, so be sure to maintain some liquidity. Be sure to read the Risk Factors section of the Offering Circular or Private Placement Memorandum carefully before investing.
Not everyone is suitable to invest in first trust deeds. To be suitable you must be an accredited investor, with a net worth, outside of your home, furnishings, and automobile, of at least $1 million.
Our first trust deed investments are offered by Blackburne & Sons Realty Capital Corporation, the sister company of C-Loans, Inc. Both companies are owned by George Blackburne, III, an attorney licensed in California and Indiana. The company was founded in 1980. The main office is located at 555 University Avenue, Suite 150, Sacramento, CA 95825. The office can be reached at 800-606-3232, attention Angela Vannucci, Executive Vice President. If you have money to invest immediately, you are invited and encouraged to call or email Angela directly.
C-Loans, Inc., California Real Estate Broker, License Number 01330173
Blackburne & Sons Realty Capital Corporation, California Real Estate Broker, License Number 829677
NMLS # 103430
Updated March 3, 2018