How does investing in Trust Deeds Work?

By Willard Michlin
September 25, 2020

Before we can talk about Investing in Trust Deeds the reader has to know the meaning of some of the key words.

Is a Hard Money Loan Like a Bank Loan Made on the Residence you Live in?

It works the same as when you buy a home. The bank makes a First Trust Deed loan on 80% of the sale price or appraisal value -WHICHEVER IS LESS.

Sometimes the seller, if it is on a purchase, carries a 2nd trust deed of 10% of the sale price.

The buyer puts down 10% plus all the inspection fees, loan fees and escrow charges.

Example: House is sold for $1 Million. Bank loans $800,000. Seller carries $100,000. Down payment is $100,000, inspection fees $500.00, loan fee $15,000, escrow $4,000.00 = $119,500.00

Buying a Home for investment

The banks do not always like to make loans to real estate investors, for a multitude of reasons.

1. The bank resells its newly funded owner occupied SFR (Single Family Residence) loans to a government agency. (Freddie Mac or Fannie Mae) and get the bank’s cash back. So, it can make more loans. When the bank makes loans, it makes money on the loan fees-it makes a lot of money on loan fees! The bank sometimes also gets a premium when it sells its loans. (They resell the loan for more than 100% of the face value amount.) This is because the investor may be happy with a lower interest rate than the bank charged the borrower.
2. When a bank makes a real estate loan that is not an owner occupied SFR, it can’t sell it through the normal Freddie Mac or Fannie Mae channels. These loans are sold in blocks of $100 Million and must be sold to Pension Plans, Insurance Companies, Government retirement funds, Labor Union retirement funds, and large Religious Gift trusts.
3. Individuals, even rich individuals can’t play the banks game. The game of how banks get very rich. Rich individuals however can and do create their own money lending game to get rich. I am going to talk about how you and me can do this.

Why do borrowers go to the private money markets?

Many real estate owners, even owner-occupied borrowers, for a multitude of reasons prefer to borrow money from private investors rather than go through the bank borrowing process. Some of the reasons are:

1. They want the money quickly and banks are slow. (This is the primary reason.
2. They do not need the money for a long time. Maybe one or two years.
3. They do not want to pay a penalty for early payoff. Most non-owner-occupied bank loans have a penalty for early payoff. This can be as much as six months interest on the loan amount. If you have a 6% interest loan for $800,000, the penalty could be as high as $24,000. (This is tied into the 2nd reason, above)
4. They may have some negative credit issues.
5. When a private investor agrees to fund a loan, it gets completed at the terms agreed. When dealing with institutions, you are never sure of approval or the interest rate, until a week before closing. Banks have backed out at the last minute on many occasions, and they change the interest rate, at the last minute.

How do private investors fund trust deed loans?

There is a very large private investor network that are always making trust deed loans. Some investors have enough cash personally to be the sole investor in a single loan. This is the preferred method, if possible. These investors double check everything they are given, to assure themselves that their money is secure. These investors have lots of money because they have experience and knowledge.

Small investors will pool their money together and invest in a single loan. The fewer investors in a loan, the better. Having fewer people funding a single loan makes it easier to get an agreement within the group. These small groups investing in a single loan work best if there is some relationship between the members. For example. 1. The investors know each other, 2. one of the investors knows everyone and is knowledgeable and agrees to handle any issues. The brokers, who originate these loans always say they will handle any problems but if the real estate market is having its problems, then the loan broker is having his problems.
Other less knowledgeable put their money in trust deed investment pools, usually created and controlled by a loan broker. These pools own a multitude of private loans, with the idea that the risk is spread around on many properties.

The author (Willard Michlin) does not like these pools of loans. The reason is that brokers have too much power to pick the loans and their decisions may be based on their own greed rather than the security of the pool members. The loan brokers make loan fees for doing these Hard Money Loans*. The higher the risk the higher the fees the broker charges, but the harder to find investors willing to take the higher risks. In the pools, the broker doesn’t need to sell anyone on the loan, he just uses the pool to fund them.

What is the difference between a First Trust Deed and a Second Trust Deed?

The first loan placed on a property is the first trust deed loan. The only claims in front of a first position loan are A. Property Taxes, B. Easements and C. Street improvement bonds put on by the builder when he built the housing tract. You do not see this very often, but they are around. These loans are usually for 10 years so they would have been paid off, even if they existed in older neighborhoods. The loan amount of these bonds is not big enough to worry about them, especially considering the high property values in California. They may make a difference in less expensive real estate areas.

Second Trust deed loans are in a subordinate (secondary) position to the first loan. If the payments are not paid on the first loan, the second needs to make those payments and then start the foreclosure process on the second trust deed loan.

If you do not pay the first trust deed’s loan payments, they will start the foreclosure process ahead of you and if you do not bring them current before their sale, you get wiped out at the first foreclosure auction. If you foreclose before the first, then you get title to the property before you must bring the first current. Bringing a loan current requires ALL the back payments, plus late fees and foreclosure costs, to be paid. Being a second can be risky if 1. You do not have the necessary funds to bring the first current, B. The loan amount of the first trust deed and your second trust deed is over 80% of the property value. Your equity disappears fast when interest is being paid or being accrued on a first trust deed and the second trust deed for between 6 months to 1 year. The other issue when you are missing payments is that the condition of the house is probably deteriorating and the property value might be going down. If there was a cushion between the value of the property and the loan balances, the property owner would be motivated to sell the property quick to recover some of his money. This is not always true though. Property owners sometimes freeze and do nothing when they still have options. This is how real estate flippers make money on foreclosures.

How to minimize risk?

Only make first trust deed loans. Then you never have the risk of having to make payments on a loan in a priority position to yourself.

If you are going to make a second trust deed, only loan up to 65% of the real market value of the property. You are assured that the property owner can sell the property easily and pay off your loan.

Remember that the higher loan to value* you lend, the higher the interest rate you can charge. The more equity behind you, the lower the interest rate the borrower expects to pay. There are exceptions but life is a negotiation. I just funded a $500,000 3rd trust deed loan behind a $1.2 Million first Trust deed and a $500,000 second trust deed. The property value is $6 Million. The owner still has over 60% equity. The first, second and third lenders are all a group of my friends. In a very unusual case like this I control all the loans and am responsible to protect everyone’s money. The first or second would never foreclose on the third because all the lenders are connected.

Construction Loans

If you want to have safety, stay away from construction loans or remodeling loans, unless you are very knowledgeable about real estate. I have talked to investors that are grabbing 12.5% on a construction loan and are not being told how risky they really are. Contractors are notorious for running out of money in the middle of projects and stealing funds from other projects. During economic downturns, banks foreclose on construction projects in droves. The return is not worth the risk. When you foreclose on construction projects you probably will be asked to contribute large amounts of money into the project to finish it. I had a consulting client who I suggested he invest in California Trust deeds which I approved. Instead he invested in Construction Projects in Texas. I had to negotiate the return of his money from the brokers under threat of litigation and criminal charges. The promised reserves were not in the escrow as promised. I recently agreed to do a second trust deed construction loan and ask for 100% interest on my money. The borrower agreed but my wife still killed the deal. That is how risky construction loans can be when you are not a building contractor or developer.

Summary

Hope this article makes this more understandable. If you still have any questions contact me via email or phone.

You can write to Willard at Willard@EvaluateABusiness.com and he will always answer your questions. He can also be contacted at his Seal Beach, California office by calling 805-428-2063