Guide To Trust Deed Investing - Part Two

This is the second part of the blog to help educate both borrowers and investors regarding trust deed investing.  As always, please feel free to contact me with any questions...

Department of Corporations (DOC) - The Department of Corporations issues two licenses for the purposes of loan origination; a California Finance Lender License (CFL) and a Residential Mortgage Lender (RML) license. Without going into too much detail here, a CFL is a license to work with consumers and other CFLs and a RML is a license to work with institutions. Department of Real Estate (DRE) - This is how Source Capital Funding, Inc. is licensed. The DRE licenses individuals and corporations to originate and broker loans. They must pass an exam and keep up with continuing education to maintain their license. A DRE license is not required to apply for a CFL license. A DRE license is really geared toward the buying and selling of real estate, and less toward the financing and underwriting of real estate. It is important to look at the licensing credentials of the firm you are investigating. But as stated before, experience in underwriting and originating private money loans is paramount in your evaluation process. Source Capital Funding, Inc. Trust Deed Investing.pdf 4

The real estate market has enjoyed a spectacular rise in fortune over the last number of years. Overall, real estate prices have appreciated by 12.4% annually between 2001 and 2006, according to the S&P/Case/Shiller US home price index. In certain geographical areas returns have exceeded 20% per year for the last few years. In comparing these returns to stock prices, investments in real estate clearly outperformed stock price appreciation. Stocks gained only 4.3% per year as measured by the Standard & Poor's 500 over the same period of 2001 to 2006. The volatility in investments in stocks and commodities may show acceptable returns over the long term. However, this volatility forces investors to endure painful lows. Trust deed investments on the other hand remain stable investments with the one exception: at times, investors may receive their funds later than expected due to periodic loan defaults and as long as loan to value ratios are adequately determined, investors tend to receive increased payouts in the case of a default as a result of higher default interest rates and penalties.

The real estate value is of critical importance to private money lending as private money lending is essentially equity based lending. An independent appraisal is of value, however the appraisal will have to be reviewed very carefully to ensure that the value derived at is based upon current and, more importantly, future expected market value rather than historical value. The value allows for the calculation of two key ratios: the first being the loan to value ratio (LTV) which is the total loan including impounds divided by the property value. The lower this ratio the better for the investor, as it expresses the equity in the property. Another important ratio is the loan to cost ratio (LTC) which is the total loan including any impounds divided by the total cost of the project. This ratio may well be a lot higher than the loan to value ratio and indicates the amount of cash the borrower is contributing to the project or has invested in the real estate. Actual cash invested is always a strong motivator to protect the property.

The data on the borrower's credit status, which would include a credit report, financial statements, details of other assets and obligations will be collected and reviewed to ensure that proper knowledge is obtained on the credit worthiness of the borrower. The evaluation influences the final loan decision and provides a credit profile of the borrower, however, it's not the determining factor in approving the loan. In addition to the borrower's credit considerations lenders must assess clearly the experience of the borrower or their general contractor in completing the project on time and within the budget.

In addition to the subject property, additional sources of collateral may be available such as other properties which could be cross-collateralized, personal guarantees and, interests in partnership or LLC's.

It is of great importance to determine what priority the loan is going to have on the collateral based upon liens that have already been recorded against the property. The preference would be a first trust deed position, but there are instances when consideration could be given to a second trust deed as an investment.

In the case of second trust deed investments, details of the senior lien has to be obtained to determine the amount owed and the terms of the senior note including prepayment penalties, negative amortizations and Source Capital Funding, Inc. Trust Deed Investing.pdf 5

whether junior financing is permitted. The requirements to service the senior loan are important in the event of a default. In a second or junior trust deed investment, special attention needs to be placed on the LTV as viewed from the junior loan's perspective, i.e. all indebtedness and impounds divided by the value of the collateral.

As most of the private money loans are relatively short-term, it is of critical importance to determine the viability of the borrower's exit strategy. At the time that the loan matures, the interest impounds or any other impounds end. Any extension fees, interest payments and additional capital would have to be funded by the borrower, who may or may not be in a position to do so.

Determination of title and title insurance has to be completed and obtained. Insurances for such items as fire, earthquake, flood, construction and liability need to be investigated, as well as any possible environmental assessments and requirements. There are a number of other items to be examined and include borrower financials, tax returns, property reports, etc. Each private money lender has their own set of guidelines.

In the event that the borrower is unable to have the loan extended or make payments in accordance with the promissory note, a notice of default is registered and sent by the trustee to the borrower and all parties involved in the trust deed. A debt under the trust deed can be reinstated if payment of the overdue amount is made at any time after the notice of default is recorded, but no later than five business days prior to the date of sale in the subsequent recorded notice of sale. No less than three months after the notice of default is recorded, a notice of trustee's sale is given in the same manner as the notice of sale in a foreclosure. Reinstatement is possible up to five days before the sale date. At the sale itself, the beneficiary lender can credit-bid up to the amount of the debt owed. The more significant difference between a mortgage and a trust deed is that there is no right of redemption following the trustee's sale. The sale is absolutely final and the purchaser can take position immediately. Some borrowers may elect to file a petition for protection under bankruptcy code in order to forestall a foreclosure sale. Once the bankruptcy petition has been filed, an automatic stay prevents lenders from initiating any adverse proceedings. The cost of a foreclosure will be added to the loan and most private money loans will have additional interest and penalties that would become effective once the loan goes into default. It is important to recognize that as long as the loan to value, and therefore, the equity in the property was calculated correctly during the underwriting process, investors may be in a good position to not only collect their capital but all the interest and costs due to them, including the penalties and higher default interest.

Investors should be fully aware that investments in trust deeds generally yield higher (12% to 16%) annual returns than most other debt instruments. As a result, you need to expect that these investments include higher risk than other debt instruments. In particular: • Trust deed investments are not insured by any government agency and there can be no guarantee that capital and/or interest will be recovered from the borrower. • The value of the property is subject to change and to market forces. • The borrower's ability to repay the loan will depend upon the borrower's financial conditions and the success or failure of the project. Source Capital Funding, Inc. Trust Deed Investing.pdf 6

• Default of the borrower could interrupt monthly payments, and foreclosure could be stalled by the borrower seeking protection under the insolvency codes. • Investing in trust deeds is an illiquid investment. There is a limited, if any secondary market to trust deeds and generally investors are by law required to hold the investment for at least one year, and thereafter the liquidity is dependent upon market forces and the current state of the project and the borrower.