Publication: Real Estate Finance Journal
Article: Making the Case for Trust Deeds in Today’s Volatile Real
Estate Market
Author: Michael Stewart
Date: 1-25-08
Photo Caption: Pacific Property Assets President Stephan Peasley
As the financial world is buffeted by fallout
from the sub-prime market and subsequent credit crunch, finding a safe place
to invest money and still make
double-digit returns is a priority of financial institutions and high-wealth
individuals.
If the rollercoaster of the stock market makes
you skeptical of investing on Wall Street, if you would like higher earnings
than banks typically pay, then trust
deed investing is an alternative worth investigating.
The smart investor should know - or at least
become familiar with - the basics of trust deed investing. Trust deed investing
is the loaning of money with real
estate as collateral. Loans are secured by real estate but are not insured
or guaranteed. Trust deeds can be an excellent investment because the interest
rate the
borrower pays to the lender/investor is generally higher than what the investor
receives from most stocks, bonds and mutual funds. Plus, the money you loan
is
secured by the borrower's equity in his or her real estate.
There are three common methods used by individuals
to make trust deed and mortgage investments: a) the investor who works alone,
similar to the
stock/bond ‘day trader’, b) the investor who works through a mortgage
(trust deed) pool fund, similar to a mutual fund and c) the investor who regularly
transacts
with an established, institutional borrower.
Trust deed or mortgage investments may seem
uncommon in comparison to the conventional financial instruments used by Wall
Street, but in reality, almost
everyone who has borrowed money for the purchase or re-finance of real estate
in the United States has participated in a trust deed or mortgage investment.
Real estate lenders require that borrowers
sign not only the promissory note (lender’s proof of the loan, together
with the terms of repayment) but also consent
to either a trust deed or mortgage arrangement. Both trust deeds and mortgages
are security instruments that secure the loan by giving to the lender the right
to
foreclose on the borrower’s property, should the borrower default on
the loan. However, two other fundamentals are likewise important.
One, the amount of equity in the borrower’s
property is very significant to loan security. Lenders equate larger equities
with greater security for the loan (the
lender’s investment). And in view of the recent wave of foreclosures
on low-equity houses, some lenders prefer to accept trust deeds on income-producing
properties only, such as multi-family apartment buildings (where foreclosures
are much less common).
Two, it is also essential that the borrower
is qualified to repay the loan. Well-qualified borrowers possess: a) excellent/good
credit history, b) sufficient income to
repay the debt and c) good equity in the borrower’s real estate. Although
underwriting standards can be flexible, lenders who maintain conservative guidelines
will
make safer, more profitable loans that produce regular monthly payments. However,
sometimes even well-qualified borrowers default on their loan, thus endangering
the lender’s Investment. What can a lender do?
The lenders choices are in large part dictated
by whether the lender used the traditional mortgage instrument or trust deed
arrangement as security for the loan.
Although the lender’s purpose with both agreements is protection of the
lender’s capital investment, the paths towards foreclosure on the collateral
(and ultimate recoup
of invested capital, as well as the anticipated return on investment) are different
and often produce very different financial results for the lender. As a general
rule,
mortgages follow a judicial foreclosure process, whereas foreclosure under
a trust deed is typically a non-judicial procedure.
The mortgage instrument is standard in 26 states,
with an additional 15 states allowing the lender the choice of either the mortgage
or trust deed arrangement. Almost
all states view a recorded mortgage as a lien that “attaches” to
the title on the real estate. (The exceptions would be those few states
that adhere to the title theory of
mortgages). The laws and procedures that define and govern the rights and obligations
of the “mortgagor” (borrower) and “mortgagee” (lender)
vary widely from state to
state. However, most mortgage arrangements share one common and crucial characteristic:
mortgages stipulate that the foreclosure process must be a judicial proceeding.
Courts of law can be agonizingly slow, expensive
and sometimes produce unexpected (and unwelcome) results. Judicial foreclosure
procedures vary from state to state,
but usually require between five to ten months. This means that the lender
receives no payments for this period (as well as the default period leading
up to the foreclosure suit)
and so receives no return on its capital investment. The lender’s collateral
(real estate) may also suffer serious damage during the protracted judicial
process, posing a serious
risk to the lender’s ability to recover its investment of principal.
The foreclosure problems inherent in mortgage instruments discourage some private
investors from either
originating or purchasing mortgages as investments. Fortunately for the private
investor/lender, trust deed investments typically lessen both the interruption
of payments as well
as reduce the risk to the investor’s capital investment.
Whereas mortgage instruments require two parties
(borrower/mortgagor and lender/mortgagee), deeds of trust feature three role-players:
the borrower/trustor, the
lender/beneficiary and the trustee, an independent third party that holds legal
title in behalf of the lender/beneficiary. The borrower/trustor signs both:
a) the promissory note
(evidence of the debt, due date and payments, late charges, penalties and other
obligations of the borrower) in favor of the lender/beneficiary and, b) the
deed of trust, which
conveys ‘bare legal title’ and a very limited right of power to
sell (limited to cases of loan default) to a third party “trustee” (usually
a title, escrow company or bank).
Should the borrower default on the loan, the
lender can instruct the third-party trustee to foreclose and sell the borrower’s
title to the property at a “trustee’s sale”. In this
manner, the lender may expect: a) return of the original principal investment,
b) an anticipated return on investment, as represented by back payments with
interest, late charges
and other fees and c) reimbursement of trustee and recording fees. The foreclosure
process is mandated by state statute and the entire process (from default of
the loan to the
actual foreclosure sale) can occur in less than four months. It is easy to
see why many banks and other lending institutions choose the promissory note/trust
deed as security
instruments, rather than the conventional mortgage. Use of prudent lending
practices, together with the recourse of non-judicial foreclosure, helps assure
the profitability and
security of the lender’s investment. The trust deed as a security device
is standard practice in Alaska, Arizona, California, Mississippi, Missouri,
Nevada, North Carolina, Virginia
and Washington D.C.
Although most persons participate as borrowers
in trust deed or mortgage arrangements, some individuals choose to become the
lender or ‘bank’ in a trust deed/mortgage
investment. These investors actively seek opportunities to make loans that
are reasonably secure and produce regular, fixed payments that reflect exceptional
yields. In a sense, this
type of private trust deed/mortgage investor is similar to the ‘day trader’ of
traditional stocks. If the day trader is knowledgeable about stock values and
trends, and has the capital
and patience to outlast market downswings, good investment returns are likely.
In comparison, the knowledgeable trust deed or mortgage investor can often
produce yields that easily surpass typical stocks, bonds or mutual funds, together
with the consistency of regular, fixed payments. And of course, if the borrower
defaults, the investor/lender can claim the real
estate as security for the investment/loan. However, despite the higher yields
and relative security of trust deed and mortgage investments, many investors
choose not to participate
directly in these types of investments. Here is why:
Being the ‘bank’ is not always
easy. Remember, the trust deed or mortgage investor is actually a lender and
assumes all the risks of a debt collector. Borrowers may skip
payments, interrupting the cash flow of an investment, or may stop payments
altogether. Although foreclosure under a deed of trust is typically much faster
and less expensive than a
mortgage foreclosure, the foreclosure process still requires an additional
investment of time and upfront trustee and recording fees. The foreclosure
process can sometimes become
timely and expensive. So, although the rewards of trust deed/mortgage investments
can be high, the risk for the individual investor can also be high. Fortunately,
there are two other
alternatives that allow the average investor to receive many of the benefits
of trust deed investments, as well as reduce the risks.
One possible option would be involvement in
a “mortgage (or trust deed) pool” with a professional trust deed
investment company. These institutional investors maintain a large
portfolio of trust deed and mortgage investments and invite participation from
small, private investors. This arrangement offers several important advantages
to the private investor.
Risk is diversified. The private investor participates
in a “pool” of mortgages (or trust deeds), which helps ensure both
regular cash flow as well as security of the investor’s original
capital involvement. Should one trust deed investment produce less-than-anticipated
results, the investor still receives returns from the other, performing investments.
In this sense,
investment in a pool of mortgages is similar to the traditional mutual fund
investment. Unfortunately, although mortgage pools do help the investor to
spread risk and obtain regular cash
flow, this arrangement presents an important disadvantage to the retiree who
wants to maximize income.
The biggest drawback of this arrangement is
a smaller return for the investor. Although the yields on these investments
are still very competitive with stocks, bonds and mutual funds,
the returns can be significantly less profitable than individual mortgage/trust
deed investments. Another downside is the private investor’s lack of
up-to-date information about such
important issues as payment collection and loan defaults on specific investments.
Fortunately, there is a third investment strategy that provides to the investor
both higher yields and close
control over mortgage and trust deed investments, as well as minimizing risk.
Transact with an established, institutional
borrower. Remember, the essential requisites for a profitable and secure trust
deed/mortgage investment are: a) borrower’s good credit
history, b) borrower’s sufficient income to repay the debt and c) good
equity in the borrower’s real estate. An institutional borrower that
satisfies these requirements presents very
profitable opportunities to the private investor. The institutional borrower
signs both a promissory note and trust deed in favor of the investor, who receives:
a) not only regular, fixed
payments that reflect an excellent yield, but also b) the relative security
of transacting with a company that has an excellent track record of payments
and c) has pledged substantial equities
in real estate as collateral. Very importantly, an institutional borrower can
offer regular investment opportunities to trust deed and mortgage investors.
Trust deed investments, like all investments,
represent a level of risk. However, the investor’s ability to reasonably
estimate and minimize the risk of a trust deed transaction is one of the
more attractive aspects of this type of investment. This is especially true
when the investor transacts with an institutional borrower. For example, familiarity
with the borrower’s qualifications
(credit, payment history, profitability) represents an important layer of risk
protection against interruption of payments and the resultant loss of return
on investment. The type of property
offered as security (single-family residential, multi-family apartment, commercial/industrial,
undeveloped land) and the equity equation of this property directly impact
the investor’s level of
confidence in the preservation of risk capital.
Ultimately, the trust deed investor doesn’t
want ownership of pledged real estate in a foreclosure scenario; an investor
wants regular payments that represent the expected rate of return
and the timely repayment of its principal investment. Pacific Property Assets,
LLC collects funds from investors via Private Placement Memorandums; all invested
funds are secured by title to
various apartment complexes in the company’s portfolio. Since 1999, Pacific
Property Assets, LLC has completely repaid 111 transaction offerings (all as
agreed) and issued more than 37,000
monthly interest checks to investors, each payment on time and as agreed.
In summary, although mortgage/trust deed investments
are not the typical, traditional investments found in Wall Street, these investments
can be significantly more profitable and comparably
secure. The high yields and regular, fixed payments of trust deed and mortgage
investments can greatly enhance the investor’s retirement portfolio.
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Michael Stewart is CEO of Pacific Property Assets, a privately
held investment firm that focuses on the strategic acquisition, renovation
and operation of
moderately priced, value-added apartment buildings in California and Arizona.
Its mission is to provide quality, long-term affordable housing, enabling investors
to benefit from the company’s growth via secured promissory notes, backed
by existing apartment buildings. An attorney and licensed Certified Public
Accountant CPA specializing in real estate investments, Stewart is articulate,
confident in his analysis and aware of current market trends. His property
investment
firm has tripled its revenues in the past two years. It has been ranked twice
in Inc. magazine’s prestigious “Inc 500” list and was one
of Ernst & Young’s
“Entrepreneurs of the Year” in 2006.
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