Protecting your Trust Deed Investments!
Your money will be 100% secured by the subject Real Estate property.
Trust Deed Investor’s position:
Trust deed investors position will be the 1st lien on Title, therefor you will be paid before any other lien recorded on title. So if the property will foreclose, your money is safe.
When a hard money lender qualifies a borrower equity is a major factor. We require a minimum of 30% down payment in most cases. This down payment adds better cushion for your money. So if this loan turns bad then we have enough equity to put the property on the market at a discount and get our money back plus attorney fees.
Borrowers Exit Strategy:
While qualifying borrowers we want to make sure they know the plan for this project. We want to know if the borrowers are looking to purchase and flip the property or purchase to hold. We have to qualify them from the beginning stages for both. All we are doing is gathering information about how we are going to get paid. If a borrower is purchasing to hold the property, we need to understand how he will qualify for a conventional loan or any type of loan he is thinking of getting after 12 months. Then qualifying him by looking at credit history, income docs, etc. We need to make sure he will be able to qualify.
Normally hard money lenders like to get their money really fast. In some cases trust deed investors want to keep their money for few years but most don’t. Our terms are 6 months, 12 months or 24 months.
If borrowers default the loan:
Sometimes you will have borrowers that in true hardship and after putting 30% of their money in the property, remodeling the property and paying the high fees and interest can’t make payments anymore. Our next step will be to contact the borrower and try to modify the loan, maybe reducing the interest rate by 1% or 2% will help him and us. If this modification doesn’t work, we will contact our attorneys and start the process for foreclosure.
Foreclosure process can take up to 6 months. In the process you will not get any checks from the borrower and you will have to pay the attorney fees of up to $5000. Once the house is foreclosed, now it’s ready to sell. We will sell the property at a discount and recoup your investment and all the fees you had to pay for the foreclosure process.
What is the role of the loan servicer?
The loan servicer collects interest payments from the borrower and disburses them to the lender. The servicer also initiates the foreclosure process at the request of the lender in case of default by the borrower.
How do I know if a particular TD is safe?
There are four broad areas of due diligence required for a trust deed investment: (i) property/value assessment; (ii) borrower; (iii) legal items; and (iv) other items, including the broker/intermediary, if applicable. A trust deed is safe if all four areas check out properly.
Who will be making the decision where to invest your money?
What Can Go Wrong
What can go wrong investing in real estate loans?
Trust deed investing results in one of two outcomes: (1) the borrower performs, or makes all interest and principal payments stipulated in the loan agreement; or (2) the borrower defaults. In the case of a default, the lender has a clear pathway, called foreclosure, to taking over the property that is the security for the loan. Once the foreclosure is done, the investor can sell the property to recover the investment. I had an illustrator create the cartoon below to show the two possible paths.
As with any investment, there are risks and in case of a default by the borrower, there are several things that could create challenges. Some examples include the following:
• a sharp drop in real estate values; • a mistake in estimating the property’s true value; • bankruptcy by the borrower; • litigation affecting title to the property; and • mortgage fraud or other defects on title.
These five situations are discussed in their own respective FAQs.
What happens if real estate values drop sharply during the course of a trust deed investment?
The equity risk of the real estate investment is borne by the borrower. If real estate values drop, the borrower takes the first loss on their investment, and is still obligated to make interest payments and ultimately pay off the loan. In the event that the borrower defaults on the loan (stops making interest payments or fails to pay off the loan at maturity), then the lender generally has two choices. The lender may either (1) foreclose and sell the property, hoping that the proceeds are still high enough to pay off the loan even in light of the drop in values; or (2) encourage the owner to sell the property without pursuing a foreclosure.
If the proceeds from such a sale are not enough to satisfy the loan in full, then the transaction is referred to as a “short sale.” It is “short” in that the lender is agreeing to the sale even though the lender will come up “short” of the amount of money they should receive under the loan terms. In either case if the property is sold for less than the value of the loan and interest owed, the trust deed investor (lender) would take a loss on the investment.
The lender can protect himself against a sharp fall in property values and a subsequent default by ensuring that the loan-to-value (LTV) is conservative—60% or less is a good rule of thumb. The higher the value of the property relative to the loan amount the greater the margin of safety. The lower the LTV, the more the property value would need to fall before the lender would take a loss.
What happens to trust deed investments when interest rates rise?
Trust deed investments are generally short-term loans of 12-36 months. Because they have a short maturity, the value of a trust deed investment will not change much even if interest rates rise.
In contrast, fixed income investments with a longer maturity, such as municipal or corporate bonds, drop in value when interest rates rise. For reference, see here.
For example, a bond with 15 years left until maturity might fall as much as 15% in value if the interest rate rose by just 1%. For those who are interested in the math, see http://en.wikipedia.org/wiki/Bond_duration.
What happens if the value of the underlying property is estimated incorrectly?
Suppose you make a $200,000 loan investment on a property whose value you estimate to be $300,000. The margin of safety is $100,000. In case of default and foreclosure, the $100,000 should be enough to pay a brokerage fee (5% of $300,000, or $15,000) plus any legal fees incurred during the foreclosure (perhaps $5,000 or so).
Now suppose that the real property value at the time of the loan was only $250,000. The margin of safety was only half what it was intended to be. In this case, there is still enough equity in the property to exit without taking a loss.
Now combine a mistake in estimating the property value with a drop in real estate values, or deterioration in the condition of the property (such as a leaky roof that results in extensive water damage, or theft of appliances). At this point the trust deed investors may not be able to recover their entire investment.
What happens if the borrower files for bankruptcy?
In short, this will cause a delay in being able to foreclose on the property. In California, the foreclosure process takes about four months from the time of filing the notice of default to the time of the foreclosure sale. If the borrower files for bankruptcy, that could add weeks or months to the timeline. In general, if there is equity in the property, the bankruptcy process will take longer. Also, a bankruptcy judge has the ability to re-write key terms of the loan. For example, the judge could reduce the interest rate on the loan.
What are some examples of title issues or litigation that could cause problems?
There are any number of legal issues that might arise clouding title to a property, compromising the lender’s claim to the collateral securing the loan.
An example of what could happen is that the lender finds out, after it’s too late, that a property line cuts through the building securing the loan.
Another issue could be that an adjacent property owner sues, and places a lis pendens on the title, claiming that the subject property violates building codes and subsequently diminishes the value of their property. The property securing your loan may have previously been involved in a case of mortgage fraud, resulting in a lis pendens being placed on the property until the case is resolved.
It is also possible that the borrower, unbeknownst to you, takes out two loans on the same day using the property as collateral, one of the lenders will invariably end up in a junior position.
These are just a few examples of what could happen. Property titles are susceptible to legal disputes. And as a trust deed investor it is important to conduct due diligence on the property in order to avoid becoming involved with a property with the potential for becoming the center of a dispute. Of course in the event that legal issues do arise, it is important to be able to navigate these issues as expediently a possible less legal fees destroy investment returns.
What is a lis pendens? How does litigation surrounding a property affect a trust deed investor?
The term “lis pendens” means “legal action is pending”. For example, suppose someone sues the owner of a property, alleging that the owner owes money and the property was pledged as collateral for a loan. The plaintiff’s lawyer may file a lis pendens on the property in question, to prevent the owner from selling the property and hiding the proceeds. A lis pendens is a very serious action because it clouds title to the property in question and could take many months to resolve. In other words, other parties will stay away from entering into any transactions involving a property so long as the lis pendens remains. Therefore, recording a spurious lis pendens exposes the party recording the lis pendens to liability.
For a trust deed investor, a lis pendens is one of the more dangerous developments that can take place. If the legal case has merit, then the lender may have trouble exiting the transaction in a timely way, even assuming the lender has done nothing wrong.
What is mortgage fraud?
Mortgage fraud occurs when a borrower has stolen money from a lender without giving the lender the security promised, or has otherwise conspired to defraud the lender.
In one type of mortgage fraud, the borrower obtains a false appraisal and borrows more money than the property is worth, with no intention of paying the money back. Another scheme involves bringing in an unsuspecting party to become the owner of the property and using his or her good credit to borrow money.
The best way to ensure no mortgage fraud enters into a trust deed investments is to assess the credibility of all the parties involved in a transaction, and to make sure that all of the pieces of the transaction make sense for each party involved.
What if a fire destroys the building that is security for a trust deed investment?
The lender should be named as an “additionally insured party” on the fire insurance at the time of the investment. This way, in case of a fire, the lender should receive their original investment back even if the borrower defaults.
What if an earthquake destroys the building that is security for the trust deed?
Southern California is very active seismically and there is a possibility that an earthquake severely damages or even destroys a building. If the borrower carries earthquake insurance the lender should be named as an “additionally insured party”. In the event that the building is not insured and is destroyed in an earthquake, and the borrower defaults, the trust deed investment will lose a significant portion of its value since the property value would be reduced to land value, minus the cost to demolish and haul away the remains of the building. It should be noted that even in a strong earthquake, total destruction of the building beyond repair is quite unlikely.
Investing in a portfolio of trust deeds on various properties, or in diversified fund that holds a portfolio of loans, should mitigate the risk of loss due to a severe earthquake.