BACKGROUND
These comments are written in February 2011 and pertain to California. Different States have different laws, although they are similar and tend to follow each other. Also understand that the laws have been changing at lightening speed since 2007. Legislators have been anxious to “protect” homeowners from predatory lending and every year they introduce a number of laws designed to do so. None of them have made it easier to make a loan and most include severe penalties for non compliance. The Dodd-Frank legislation has passed and is being implemented in stages and applies at the national level. The passage of this bill has convinced most Trust Deed Brokers to simply discontinue making loans to homeowners. Pacific Horizon Financial, Inc. (PHF) made that decision in 2003 because of the already apparent legislative trend and we also made the decision to make only 1st Trust Deeds (TD) because of their significant safety advantage compared to a junior loan. Don’t make a loan to a homeowner or a 2nd TD to anyone unless you are a seasoned Investor with deep pockets – and use very competent brokers and attorneys.
All that scary stuff said about lending to homeowners aside, the legislators have left the commercial arena pretty well unscathed. In that world, it’s kind of like the old days, you simply write a contract and if someone breaks it, you enforce it. It’s just not quite as simple as having a loan on a house. The underwriting is more difficult and you can’t pick on borrowers, they have attorneys and can fight back.
There are essentially two ways to invest in Trust Deeds: 1) own the entire Trust Deed by yourself; or 2) join with others to pool your money to purchase one or more TD’s. We will explore both ways.
OWN ALONE
Owning a TD by yourself is the simplest and most profitable option if you have enough money and the time, fortitude and knowledge necessary to administer it. The administration can be done by a competent Loan Servicer for a small fee. Fees range from just a few dollars to process checks up to 1.5% of the TD amount per annum for full service. Commercial loan sizes can be problematic for many Investors. We routinely find loans (TD’s) on Fixer houses (different rules than owner occupied/consumer loans) as low as $200,000 (southern California) with a 12% interest rate. A good strategy is to buy multiple TD’s if you have the money. This strategy requires effort since the loans are short term – usually less than six months and that makes it hard to keep your money working so your annualized yield is less due to down time, but it is simple and safe.
First TD’s on commercial income property seem to have a sweet spot of $1,000,000 to $2,000,000. This size is within SBA loan limits (which change over time) and the SBA option provides an excellent take out strategy. Anything less is usually too small or not in good enough condition. Owning a longer term variable rate 1st TD on a decent building with a decent borrower at 7% or 8% in today’s market makes perfect sense to me.
OWN WITH OTHERS
This is an excellent option for Investors that do not wish to be bothered with loan management, provided it is done correctly. In the late 90’s and early to mid 2000’s some brokers decided it was a good idea to put as many as 100 investors on a Trust Deed as Tenants in Common. They extolled the virtues of “…having your name on the Trust Deed” verses “…being tied up in an LLC with just a piece of paper.” As long as the good times rolled, there were no problems and loans just paid off. When 2007 came along, everyone learned why this was not a good idea. Have you ever tried to get 100 smart rich people and their attorneys to all agree on anything when there is adversity? Think of the defensive position the Borrower has if his attorney decides to sue each and every Investor individually! Tenant in Common ownership is not practical for a Trust Deed or any real estate equity investment. You may get away with it with family or a small group of like minded investors, but the cost of using an LLC, LP, Trust or Corp is well worth the protection it offers.
Many brokers rely on the 10 investor rule to sell Trust Deeds. This is simple (for the Broker and the Investors) and not as bad as having 100 partners, but still has issues. The documents may say majority rules, but not all Title Companies are onboard with this issue and may still insist on everyone’s signature to provide insurance. If there was a claim against the title insurance policy, you can bet every signature would be required. This can be very problematic when an Investor dies, gets divorced, files BK, or goes on an extended cruise. It may be 10 times better than 100 Investors from an odds position, but the odds are still not good enough.
There are also Fractionalized Loan Offerings that allow more than 10 investors and they provide better rules for operation and management. This is not a bad choice for Investors as long as you are comfortable with the sponsor and the terms of the prospectus.
PHF’s vehicle of choice is a Loan Pool for many reasons, some of which are:
- Diversity of loans in the pool
- Ability of the Pool to utilize a line of credit to fund new loans thereby keeping all Investor monies working all the time
- No conflicts with Title Companies, 1 entity not 100
- Investors do not get sued, they are protected by the LLC or LP
- Ability of management to deal with problems without resorting to cash calls which may be necessary on a singular loan in trouble
- Ability to provide cash flow even if one or more loans are not performing
Some Investors dismiss this option because they feel they do not have control of their investment. Consider it a bit like stock investing: you don’t choose a company that has poor management! A pool should be audited. It is the protection against fraud. A pool should be very transparent and have provisions that allow the Investors to change the Manager fairly easily. Trust Deed Investing is not effortless; someone has to do the work and keep up with the law, tax reporting, borrower acquisition, underwriting, collections, etc. A good pool accomplishes this very efficiently and provides investors with yields that are significantly better than money market instruments and much steadier than stocks.