The Gorilla is Growing

One good reason to study politics/watch the news is to be able to make an educated guess as to how to grow and protect your nest egg. Of course, one could argue that it is almost impossible to predict the economy so you might as well flip a coin. It’s hardly worth the debate, but one constant is that the actions of government have a major effect and, of course, it is not always negative. It’s pretty clear that the impact of taxes and government requirements are the major concern.

What does this have to do with Trust Deeds?
A lot!!

• You have all heard of the new Dodd Frank regulations and the implementation of the Consumer Financial Protection Bureau (CFPB). The CFPB is another regulator for all financial businesses to contend with. Changing the rules is one thing, but adding a regulator is simply duplicative and leads to increased costs for financial institutions. A case in point is a local bank with a perfect lending record since its inception in 2007 suffered its 1st quarterly loss because it had to significantly beef up its compliance department. The effects of this will be that the bank will shun more borrowers – just because they are not squeaky clean – to please the regulators and these near perfect borrowers will seek alternative sources of funding. That’s us – and the many Hedge Funds that are coming to our marketplace. Rates for private money will go down – at least relative to Prime. So better borrowers for us, but at more competitive rates.

• The owner occupied single family loan business has been regulated so severely that it may head for the dinosaur burial grounds. Most Private Money Lenders are currently avoiding them. It is very dangerous to make them or to even service them, especially in California. Some of the big banks have stopped using correspondent sources for the loans in order to better control their underwriting and avoid future lawsuits. Counties and States have brought ridiculous suits against the big banks and have received substantial settlements or judgments. There are a few Private Money lenders that have elected to specialize in this business because there is no competition. Most have shunned it. The result is that many, many great loans will not be made by Private Money Lenders or banks. No more “…steel worker falls off girder, can’t work for 1 year, Private Money lender makes him bridge loan and saves his home…” stories. That guy will now lose his house. Now the Real Estate guy will buy that house at the foreclosure (which will probably take two years to complete due to the Dodd Frank laws) and make
the money. So, no more loans for the hurt, divorced, unemployed, or elderly homeowners; just foreclosure and the profit goes to the real estate investor.

• The upside to all this regulation could be that alternative lending gets legitimized. It is stunning to me that the Private Money Lending arena is still very much unknown. It is not stunning that we still have a bad rap – the normal business model of the broker gets paid up front and good luck to Mr. or Ms. Investor, is outmoded. If the Private Money community would adopt more policies from the banking arena as far as controls and protection of Investor money, then everyone would be much better off. If the general public had as much faith in private money as they do a McDonald’s Big Mac, then our industry would draw a significant amount of money from CD’s and make common sense loans to good people. Right now, the small “in the know” private money investors are “used to” a 10% short term market. There could be a much more stable, legitimate and sizable 6% private market in this 1% CD world.

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Is there a “New” Canary in the Coal Mine?

Since 1986, the price of a Big Mac has increased 171% from $1.60 to $4.33 today (that’s 6.3% per year). During this same time period, the consumer price index has increased at a much lower rate of 109%. More disconcerting is the effect of aggressive adjustment of monetary policy by the Federal Reserve, which began in 1999. This policy shift started with the Asian Crisis and Long Term Capital Management, followed by the Internet Bubble, the Housing Bubble and the Great Recession, and now we have the “New Normal” of zero federal funds rates and quantitative easing (QE1, QE2, QE3…). In the context of these Fed policies, the rate of price increases for the Big Mac is almost three times greater than the official Consumer Price index.

So what? It is pretty clear that the cost of food and many other items necessary for one’s comfort have increased. If you’re on a fixed income, it doesn’t really matter what the CPI is or whether the rules were changed. In 1986 you could buy a whole Big Mac with $1.60, now you canonlybuy37% of a Big Mac. If your budget is tight,you are in trouble.

What to do? A couple of years ago I wrote about what a killer deal it would be to buy a house with a 30 year fixed rate mortgage at these record setting sub 4% yields. Houses have gone up at least 15% in San Diego since then, and I think they have a long way to go. They don’t even have to get more valuable to “go up” a lot. If an average house remains worth four years pay for an average worker, then the simple act of destroying the value of the dollar can change the cost of the house dramatically – even if the value remains the same or goes down some. Think about it. If a Big Mac goes up on average 6% per year and you can lock in a sub 4% fixed rate for 30 years; oh my word, how grand this deal would look in 10 years. True, sub 4% is for owner occupants, so maybe you have kids or grand-kids that you could provide a down payment for and they could qualify for the loan. There is virtually no downside since the house is being used and the cost of the mortgage is very close to the cost of rent. The upside from the high leverage and the locked in low rate is stunning.
What does this have to do with Trust Deeds? Nothing. The point is simply that locking in low rate money for a long time, appears to be a strategy that will be immensely profitable and can be used by just about anyone right now.

What’s this about canaries?
Well the Big Mac is the canary that is now blowing (or not blowing) the whistle. Even though the government is understating inflation, the fact remains that Big Macs and bread and housing are going to get more expensive. The 2008 debacle has altered many lives, but because The Fund had staying power, we did not get wiped out. That aberrant slide is past. Land prices across most of coastal California are on fire and it is spreading east. Pretty soon, our loan on the 54 unit land in El Centro will be getting better and better. Additionally, we will be getting out of our 66th Street lots whole by building our way out (they had a special problem having to do with the City trying to make them a subdivision and pile on prohibitive costs).

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Market Conditions for San Diego County, California

Market Trend: The San Diego real estate market is strengthening dramatically. After stabilizing last year to approximately 2004 levels, it’s as if someone blew the whistle and there are buyers everywhere. Most neighborhoods are seeing reasonably priced listings garnering multiple offers, sometimes driving the price significantly over asking price. Frankly, it seems like the more below market the property is listed, the more attention it gets and the higher above market it sells. It’s simply an auction.

Inventory is low in many pockets of San Diego County right now. Hedge funds have entered the market and some have adopted the business plan of buy, fix, and rent for 5 years. They are not too picky on the pricing since they think the values will be much higher later and they have a lot of cash to get out. This has effectively destroyed the entry level fixer flipper market since the profit margins have been squeezed so much.

Some of our borrowers recognized this trend early on and have moved to higher priced locations. It takes more money, more renovation skill, and more time to cycle the product, but the reward for a job well done is higher. Pacific Horizon is currently underwriting a loan in Rancho Santa Fe and there are 4 pending listings and one recently sold listing within ½ mile of the subject property!! Eighteen months ago, you probably would not have found 1. We have been in the La Jolla marketplace since mid-2012 and the values and activity in La Jolla have been rapidly increasing. To be sure, these are not paint and carpet markets. It takes sensitivity to current buyer tastes, significant floor plan improvements, high quality trim, and tasteful exterior improvements.

Additionally, I expect to see a major increase in new construction this year! That is terrific in that it will get much of our construction force back to work and further spur our local economy. It would be good to see full restaurants all over town again. The numbers (profit) for new housing are very significant for builders who either held their land through the depression, or picked up land over a year ago. Land has really increased in value lately. It also seems that the planning and building departments are even tougher now then they were last cycle. Woe be the developer that is starting with unentitled land – it will be a long row to hoe!

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Unintended Consequences:

With as much legislation as there is becoming effective on the 1st of this year, much more throughout this year, and a boatload more on January 1, 2014, you can bet that there will be many unintended consequences. When something bad happens to a group of people, we rush to fix it by passing laws that are designed to fix the problem. Two significant examples of this are currently on the news daily: 1) the horrible killing of the 26 children and adults at Sandy Hook Elementary School and 2) Protection of everyone that was foreclosed on over the last 4 years from the predatory lenders and Wall Street bankers that created the problem. Let’s just focus on #2, predatory lending. The Dodd Frank legislation is enormous and the implementation of it is now rolling out. There are many good things in there for the protection of the general population, but there will be many unintended consequences that were not foreseen by the lawmakers. PHF and most all other Private Money Lenders, or Predatory Money Lenders if you wish, get many calls per month from homeowners in distress that we are no longer willing to help. The reason that we won’t help them is that Dodd Frank has stipulated the terms that we can lend to them on. To be brief, these terms are much closer to bank terms; that is, we have to underwrite much more like a bank would and charge much closer to what a bank would.

Just this morning I got a call from a 1st class 60 year old gentleman that I know and respect. He has retired from a very good career but now has a problem. Big Bank (I am not naming or knocking the bank because they are simply dealing with other provisions of Dodd Frank) has a $100,000 2nd TD on his house which is now all due and Big Bank is unwilling to rewrite the loan for him. He has ample income, has never missed a payment, and has great credit. Big Bank has every right to elect not to rewrite the loan, but now, because of the new laws, virtually no private lenders will do this deal. So if my 1st class 60 year old friend cannot come up with $100,000 very quickly, then Big Bank will be forced to foreclose and this gentleman is out on the street and foreclosed out of $600,000 in equity in the home! This, dear reader, is just the tip of the iceberg.

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The Surge

I can feel it.  No, it’s not a ramping up in troop force to stamp out the Taliban, it is a ramping up of construction workers to stamp out chronic unemployment in San Diego. Our housing prices are rising fast.  Even some of the staid old bankers are coming out of their cocoons.  In fact, one small bank is trying to steal one of our deals.  This bank has decided that since no other banks make construction loans, they should.  A novel concept.  What really is novel is that they recognize two important factors: 

1) that we are in a bull market for real estate.

2) that this last titanic cleansing took out a lot of good people. 

They have decided to seek out developers and contractors of good character and good capability and ignore, or at least evaluate, credit mishaps related to the great recession.  Of course they have not missed the fact that they are the only game in town for this product and they are charging what they think is a lot and what borrowers think is a gift.  I am not sure how they plan on dealing with the regulators, but that is their problem.  Assuming they have a plan, that is one smart bank.

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Trust Deeds: A Logical Alternative to Bonds

As 2012 draws to a close, the 10 year Treasury Bond is yielding 1.61%, and the Fed is promising to keep yields low until “as long as necessary”.  What happens when it is no longer necessary?   A peek at recent history gives us a clue.  If you purchased a $100,000 10 year treasury on July 24, 2012 (yield @ 1.4%) and sold it 50 days later, you would have lost $4,400 because the market rate on September 14, 2012 was 1.87%.

With yields at or near record lows, it is hard to imagine that they will be lower a few years hence when you may wish to liquidate.  Investors normally purchase treasuries for safety of principal, but if rates are at 5% when you want to liquidate, it may have been wiser to stuff the cash in the mattress.

Real Estate and Trust Deed Investments were negatively affected by the 2008 crash, but statistics generally show an upturn over the last year.  Should this upward momentum continue, then either Trust Deed Investments or Real Estate Equity Investments would benefit.

Trust Deeds are similar to Bonds.  The primary difference is that Trust Deeds are not as sensitive to interest rate changes as bonds.  Trust Deed yields are normally fixed and the term is normally short.  Current yields on well secured instruments range from 6% – 8% and terms range from 1-5 years.

Long a little known investment type, Trust Deeds are becoming much more respected and viable.  “Trust Deed” or “Private Money” lending has been partially filling the huge void created by the mass exodus of banks from the real estate market.   In effect, private lenders are simply replacing banks in the commercial real estate market and are being well rewarded for it.


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Equity Participation Program

As 2012 comes to a close, all the media can talk about is the “Fiscal Cliff”.   All I see is 8 successive months of increasing stats in the single family housing market; a gradual – but constant – increase in the jobs picture; land prices rising for the last year; a government that is pledging to keep interest rates low; and every single house that we make a fixer loan on flying off the shelf – for equal to or more money than we projected.

Because the current real estate market is still stressed but improving rapidly, PHF sees good reason for inclined Investors to take an Equity position in single-family homes and enjoy yields that usually come only with ownership.

Accordingly, PHF has established various “Equity Participation Programs”.  If an experienced cash Investor desires to passively participate as an Equity Investor, we can pair them with a Buyer/Borrower that does the work.  The cash Investor gets a set, preferred yield paid before the Buyer/Borrower gets his profit.  We accomplish this by collateralizing that obligation.

PHF could collect a significant fee from Borrowers for arranging this type of Equity Participation, but we put our money where our mouth is and take no upfront fees on our Equity Participation Programs.  The cash Investor gets paid all of his or her agreed upon yield before the Buyer/Borrower gets a dime or PHF takes any fee on the Equity!

The yields on these programs will vary between 20 -30% APR depending on:

  • the amount of collateral we have to secure the obligation
  • the experience of the Borrower
  • the track record of the Borrower with us
  • the cash in of the Borrower, if any (after all the idea is to provide the Borrowers’ down payment in exchange for a high yield)

Basically, we tailor the yield to the risk but make no pairing that we do not think will pay off for everyone.    If you think an Equity Participation has a position in your portfolio, then talk it over with Paul, Tracy, or me at your convenience.

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The Power of 8% in 2012

Or: How to get a free Toyota!

During the go‐go years of 2000 to 2007, the deceptive advertising of the prime mortgage industry was very bothersome. They used to have ads that touted the mortgage rate at something like 1.9% in large print and then the microscopic print said “..for the 1st two months and then we really sock it to you”. The problem is that it worked. That said, let’s logically examine how you can get a “free” Toyota.

Let’s put things in perspective. Back in that time, “the Banks” paid depositors up to 5% for CD’s. Now they pay about 1%, or 20% of what they used to pay. Toyota Motor Company is currently advertising 0% financing on new Toyotas for 5 years. That makes sense for them since the can borrow at very low rates and they can certainly pack the cost of financing into the price of the car. We all love “free”; free shipping, 2 for 1, no interest, et cetera; but usually, nothing is free, there is no free lunch.

Let’s look at the lending side of “the Banks”. They don’t make loans anymore unless you are a super good customer and are making them so much money they can’t afford to lose you, or the government guarantees the loan. Effectively, they don’t make loans.

Because Banks don’t make loans, there now exists a significant need for capital at reasonable rates. Yes, Bank financing for triple grade “A” borrowers with grade “A” properties is available for less than 6% if you have 3 CPA’s and 7 months to get a loan, but that leaves a lot of good people wanting. For the 1st time in 30 years or more, decent borrowers with good income properties are willing to pay prime plus 5% to get capital. Prime is now 3.25%, so that translates to about 8% which doesn’t sound like too much to borrowers these days, and it is a whopping yield for lenders.

Banking is not terribly difficult to understand. A bank pays depositors a low rate, loans it out at a high rate and keeps the difference. The world is evolving quickly and middlemen are being replaced all the time by computers, the internet and the access to information by the public. Since banks are not paying you anything, why not eliminate them? Yes, you lose the FDIC insurance, but you can mitigate that risk by making quality loans. It is not very difficult to assess the value of local collateral. You do it every time you purchase a house, you just have never called that “underwriting.”

Assuming you have a pile of money sitting in a CD or money market at 1%, and you can safely get 8% on a 1st TD on a local income property, you increase your yield by 700%. Given Toyotas 0% financing program for 5 years it takes the following amounts moved from the bank to a 5 year 1st TD to get a “free”:


Toyota Corolla         $ 57,000

Toyota Avalon         $ 100,000

Toyota Sequoia       $ 186,000


Now isn’t that better than a free toaster?

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What is the Best Way to Participate in Trust Deed Investing?

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.

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.

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.

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