Are you considering investing in trust deeds? It’s a solid investment if you’re adept at selecting the right deals and keenly aware of the risks involved.
Here’s how it works: As an investor, you essentially become the lender by extending a loan to a borrower.
This loan is secured with collateral, typically commercial real estate. Much like a bank, you lend money; the borrower pledges their real estate as security for the loan.
Each month, the borrower makes payments based on terms agreed upon in a document called the promissory note, which details the specifics of the loan.
Understanding trust deed investing
‘Trust deed’ is a term derived from a security investment instrument recorded on the property to secure a loan. If the borrower cannot fulfill the terms on the promissory note, you can initiate a foreclosure to regain the unpaid costs, such as any outstanding interest and the principal.
Trust deeds can be attractive investments because they provide consistent cash flow every month. Plus, they allow investors to invest in their community.
Trust deed investing also does not require investors to manage tenants, spend money on maintenance, or buy or sell property. It is a great option to dabble in real estate without all the overhead and responsibility.
Here are the common types of trust deed investments:
1. Individual trust deeds
In an individual trust deed, only one investor funds the entire loan on several properties or a single property.
2. Multi-lender loans or fractional loans
Fractionalized or multi-tender loans involve two or more investors funding a loan. These investors are often close friends or family members, although it’s not uncommon for multiple investors who don’t know each other to collaborate on funding one trust deed.
3. Mortgage funds
When you invest in a mortgage fund, you become a passive investor — which means you don’t have to manage potential defaults, loan payoffs, or the funding of new loans. This arrangement also ensures that your investment is diversified across all the loans within the fund.
However, this setup requires a fund manager to oversee all the details of the loans in the portfolio. You will likely need to pay upfront origination fees and an annual management fee. Most investors reinvest their dividends into the fund, which is typically structured to allow this reinvestment.
Should you invest in trust deeds?
When you’re new to trust deeds, it’s normal to wonder whether they are suitable investments.
Do you need this if your current portfolio already has a good mix of commercial property, stocks, and bonds? It depends.
Trust deed investing can be a good addition or alternative to many traditional investments for producing fixed, passive income.
Here are some of the reasons to invest your money in a trust deed and how doing so might benefit your portfolio’s overall stability:
1. High ROI
Trust deeds tend to do better than assets like stocks or bonds, making them favorable for those who want to create high-yield income streams.
During times when market volatility might affect your investment portfolio, trust deeds can provide stable and fixed returns with high ROI potential.
Investors typically see gains ranging from 7.5% to 13%, even when other assets are underperforming. This type of investment also ensures regular monthly payments because it is backed by real property.
2. Portfolio diversification
This strategy lets you buffer against market volatility, mainly when you invest in different real estate markets.
You can also further minimize risk through fractional or multi-lender loans — after all, collaborating with other investors to jointly finance various loans spreads risk. It opens up opportunities in multiple markets.
3. Security
As a trust deed investor, you won’t directly own the property but have a recorded lien that secures the debt owed. The property acts as collateral for the loan, and with a conservative loan-to-value ratio, the risk of losing money on trust deeds is typically low.
If a borrower fails to pay the loan, you can recover your investment through a foreclosure sale, or if there are no bidders at the auction, you might end up owning the property.
4. Stable and predictable
Trust deeds are fixed-yield investments that provide a stable and predictable source of income. Interest rates and monthly payments are fixed throughout the mortgage term to simplify your investment and financial planning.
That said, you need to be careful to avoid over-leveraging the property. You also have to ensure that it undergoes proper underwriting.
5. Tax perks
You can fund trust deed investments using your 401K, IRA, or personal pension scheme.
Whether targeting relatively low returns of 6.5% to 8.5% or aiming for higher yields of 10% to 12%, financing these investments through such retirement accounts can potentially give you tax advantages.
6. Forget about property management woes.
Trust deeds allow investors like you to profit from real estate without actively managing properties. You never have to deal with the complexities of handling tenants and property maintenance.
All you need to do is analyze the property and the loan details and provide funding. A trust deed broker will manage the rest. You simply wait for your electronic payments or monthly checks throughout the loan.
Is Trust Deed Investing Regulated?
Yes, trust deed investing is regulated at the state level. But don’t worry — regulations typically don’t burden individual trust deed investors with reporting or licensing requirements.
On the other hand, mortgage services, brokers, and lenders must comply with each state’s regulations in which they operate.
If required by local regulators, they may also need to register with the Nationwide Multistate Licensing System (NMLS). Once licensed, they must report their loan activities annually and quarterly through the NMLS.
In many Western U.S. states, such as Oregon, Nevada, Arizona, California, Utah, Montana, and Idaho, every mortgage broker must be licensed to create business-purpose loans funded by trust deed investors. Meanwhile, states like Florida have specific requirements: brokers must be licensed if loans are vested individually or in a trust, but not necessarily for loans granted in a corporation or LLC.
Potential challenges in trust deed investing
Every investment has risks, and trust deed investing is no exception. Here are some potential issues you might encounter with trust deed investments:
- Defaulting on payments
- Natural disasters
- Fraud
- Death / Non-Probate / Probate
- Bankruptcy
- Litigation
- Declining or flattening real estate market
You can minimize the drawbacks by working with a reputable, experienced mortgage brokerage or investment firm that understands your investment goals. These professionals can provide low-leverage and safer bridge loans while leaving the complex, high-leverage loans with mortgage funds and conduit lenders.
Mistakes to avoid when investing in a trust deed
Working with investors who have poor credit
Always check an investor’s credit history before committing. You want to avoid those with histories of bad credit, late payments, or bankruptcies.
You might think that only borrowers with poor credit turn to private lenders because banks reject them. This is not true. Many reliable real estate investors prefer private commercial lender for projects banks typically avoid, such as quick-turnaround renovations.
Overlooking the collateral’s importance
The property used as collateral is the most critical component you must thoroughly assess in trust deed investing.
Whether it’s a single-family home, a multi-family unit, or a commercial property, you must consider how marketable and liquid that asset is.
Single-family homes are generally considered safe and liquid assets because they can be easily rented or sold, and plenty of financing options are readily available.
Conversely, investing in raw land tends to be a bit riskier. The primary issue is the lack of immediate cash flow. As you know, undeveloped land doesn’t generate income on its own. This absence of revenue can make financing or selling the property difficult.
If you want to finance raw land, you must consider how comfortable you would be owning that land even if your plans to sell or develop it don’t materialize.
Take the time to ensure that any collateral you accept in a trust deed investment is something you would be confident managing and possibly holding onto for an extended period.
Ignoring the services of a loan servicing company
Choosing, underwriting, and funding a trust deed is only 50% of the investment. The rest involves managing or servicing the loan. This includes collecting payments, overseeing financial reporting, and communicating with the borrower.
Don’t underestimate this aspect. Hiring a professional loan servicing company can save hassle, especially if a borrower starts missing payments. These experts handle all aspects of loan administration, including initiating foreclosures when necessary.
Taking too much time to address a non-performing trust deed
Act fast if a borrower falls behind because waiting can complicate the foreclosure process significantly if the loan has matured or the borrower dodges communication.
Some investors make the mistake of delaying because they’re unfamiliar with the process or need to monitor their investments closely.
To avoid this, consider working with a third-party loan servicing company that can take timely actions on your behalf — from contacting delinquent borrowers to starting foreclosure processes. This proactive approach will go a long way in keeping your investments secure and your returns on track.
To explore more, contact our team of commercial real estate bridge loan lenders here at Private Capital Investors.
