My goal is to help educate those interested in not only investing in trust deeds, but those that might not be aware that there are other legitimate sources for financing than a bank. Sometimes referred to as "hard money", there are a number of good and bad sources for financing real estate. Please feel free to conatct me with any questions. Part Two to follow...
Definition of a Trust Deed Investment
Real estate lending is essentially the making of a loan to a borrower. The loan is comprised of two basic components: a promise to repay the debt, known as the promissory note and a recorded document that is evidence of the debt, known as the deed of trust, also referred to as a trust deed or a mortgage depending on the state in which the document is recorded. Once the trust deed or mortgage is recorded, the promise to repay the loan is secured by a "lien" placed on the property. In short, the promissory note promises to repay the loan and the trust deed is the security instrument recorded with a county recorder's office creating the lien on the borrower's real estate.
Trust Deeds vs. Mortgages
The advantage of a trust deed over a mortgage is a shorter foreclosure. With the judicial foreclosure proceedings required with a mortgage, it may take as long as a year to acquire clear title to a defaulted property. This is due to the filings, court delays and redemption periods. Under the non-judicial foreclosure trust deed's power of sale clause, this effort is reduced to as few as 120 days. Although the borrowers (trustors) still own their property, they have agreed to pass claim against this ownership over to the lenders or their nominees (trustees) to hold during the term of the loan. The trustee is often a title company, attorney, or an independent corporation that is set up to act as trustee. When the loan is fully repaid, this trust ownership is reconveyed (released) to the borrower, clearing the records of this encumbrance. If there is a default, this trust ownership will be perfected by the trustees through the foreclosure process and to full ownership of the real estate. Thus, under a deed of trust, borrowers retained an equitable title to the collateral while the lenders secure a form of legal title. Although only the borrowers sign the note, both borrowers and the trustees sign the deed of trust. Trust deeds are held by the trustees for the benefit of the lenders, also known as the beneficiaries. The most significant difference between a mortgage and a trust deed (or mortgage with out of sale) is that there is no right of redemption following the trustee's sale. The trustee's sale is absolutely final and the purchaser can take possession immediately.
Senior vs. Junior Positions
Trust deeds can also be in the form of senior and junior loans. Junior liens are behind senior liens in priority when the security is realized and debts paid. Because the second trust deed is in a subordinate position to the first trust deed, the junior lien holder is in a relatively higher risk position than the first trust deed holder. In the event of a default, a senior lender would usually give the junior lender a chance to step in and make the delinquent payments. The junior lender will then be in a position to foreclose against the collateral property and protect their interest.
Purchase Money Trust Deeds
Purchase money trust deeds are used to finance the purchase of real estate (as opposed to loans against property already owned by the borrower). It is important to note the distinction between purchase money trust deeds and other trust deeds, as California Law has separate rules for such trust deeds which materially affect investors' rights.
Why Borrowers Choose Private Money Loans
The question often arises as to why borrowers would borrow private money on real estate transactions at the high rates that private money demands. The immediate assumption is that these are high-risk ventures and the borrowers do not have the credit-worthiness that would allow them to borrow from regular and conventional sources. There are in fact a wide variety of factors that determine whether or not a borrower would be a candidate for a private money loan. Let's look at several more common reasons below:
• Quick Funding of a Time Sensitive Loan
Banks and conventional financial institutions normally take much longer than private money lenders to close a loan due to strict regulatory oversight over conventional banks and lending institutions.
• Reduction of Red Tape and Paperwork Hassles
Traditional lenders require substantially more documentation than private money lenders and have more stringent loan committee processes. When time is of the essence, traditional lenders typically cannot meet the time demands of the borrower.
• Flexibility and Creative Problem Solving
Private money lenders are more creative with complex loan situations. They can offer options like cross-collateralization of other properties, or offer more flexible terms than traditional lenders. The property may also have issues that make it difficult for conventional lenders to finance such as the need for improvements to increase the occupancy of a building, or partially completed construction, etc. Additionally, traditional lenders will not lend on raw or un-entitled land due to their strict underwriting guidelines.
• Nature of the Loan and Market Conditions
The constant change in market conditions in the real estate market forces conventional financial institutions into taking even more time and thus have become even more conservative in approving loans. Private money lenders on the other hand have the ability to assess the property or project's risk and charge an appropriate fee for the perceived risk. In essence, private money lenders are equity based and the most important component of the loan funding is the evaluation of the real estate. A borrower's past history and level of commitment plays a part in determining the viability of the loan but is not as paramount to the decision making process.
• Reduction of Equity Participation
Borrowers may also consider private money for a portion of the traditional equity component of a project. Equity investors require a preferred rate of interest, normally around 9%, plus a share of profit of up to 60%. This makes private loans a cheap alternative for a portion of the equity component.
• Borrower Circumstances
Again, these are not just limited to credit problems or a past or current bankruptcy as is most often assumed. There may be tax liens or other liens that need to be paid, or the property may be entering into foreclosure for a variety of reasons. The property may be held up in probate, or involved in a divorce or other family situation. There may be unemployment or a medical emergency, the list is endless but the principle is basically the same; private money lenders lend on the value of the asset first, and the strength of the borrower second. Ultimately, the decision resides with an experienced underwriter to evaluate the "whole story" when evaluating a potential borrower.
Private money is used by a wide variety of borrowers ranging from very high net worth individuals to sophisticated real estate investors and developers, all of whom prefer the speed and the simplicity of completing the loan process to credit-challenged borrowers who have limited choices for financing.
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