While anyone can invest in a deed of trust or note, investors are encouraged to seek expert advice in this rather complicated investment arena, especially with respect to real estate valuation, project management, legal and financing. Partnering with competent professionals not only makes investing less time consuming, it greatly reduces risk. Below are a few considerations that any prospective investor should explore before investing in trust deeds.
One of the most important factors in note / trust deed investing is the value of the property securing the loan. In conventional financing, banks and other institutional lenders rely heavily on borrower credit history to determine whether the lender should loan to the borrower. Private-money, or asset-based lending, is different. The main underwriting component of a private-money loan is the actual property itself. One way to reduce the risk is to make certain that the amount of the loan is well below the value of the property. Generally, trust deed investors look for a loan-to-value (LTV) ratio of 70% or less. For a property valued at $100,000, a loan with 70% LTV would be $70,000. The lower the LTV the better because the leftover equity in the property (the other 30%) can protect the investment in the event of default.
Determining Loan-to-value Ratio
The first step in determining LTV is to determine the value of the property, something that can be a lot trickier than it sounds. At ICCG, we take a three-step approach to property valuation:
1. Broker Price Opinion (BPO). When we examine a potential loan our first step is to conduct a BPO, which provides us with relative values of comparable properties in the neighborhood. Keep in mind this is not an automated valuation through a website service. A proper BPO is conducted by a professional who visits the property, knows the neighborhood and can evaluate the property against comparable sales.
2. Appraisal. The second step to proper evaluation involves a real estate appraisal prepared by our approved licensed appraiser. At ICCG, we don’t just want to know the current value and the estimated after-repaired value. We also want the appraisal to indicate the values if the property had to be liquidated quickly. This “liquidation” valuation gives additional security that if the loan defaults the trust deed investor can sell the property for a profit.
3. Renovation Scope. Valuation for renovation and construction projects can be more difficult to perform because you’re valuing the cost of the work to be done and estimating the value of the property after the project is complete. You must have knowledge of the type of construction project involved, including the range of costs to complete the project. Without adequate information, a trust deed investor could loan on a property to find out later that the borrower had vastly underestimated the cost of renovation and is unable to complete the project. At ICCG, we closely scrutinize construction costs. We also require firm bids and, in most cases, on-site inspections prior to funding the loan.
While borrower credit score may not be as critical a factor in private loan underwriting, borrower credit character is certainly important. Successful trust deed investors examine the credit character of each borrower to assess risk.
Another consideration for trust deed investors is whether the borrower will occupy the home, or whether the borrower is acquiring the real estate for investment purposes. While owner-occupants may have a stronger interest to pay the loan because they want to stay in their home, lending to owner-occupant borrowers opens the door to ample regulatory compliance issues with respect to the loans. Real estate investors are in the business of acquiring and selling real estate. Consequently, they require private-money loans that allow them to complete transactions efficiently and successfully.
With this in mind, ICCG lends only to commercial purpose, non-owner occupant borrowers.
Lien Position and Trust Deeds
When a trust deed is recorded with the county clerk and recorder, it is placed in a lien position. If it is the first lien recorded, it will be in first position. A trust deed recorded after the first trust deed on the same property takes second position and so on. The recording position of the trust deed is important because the trust deed in the highest priority position will receive payment from a foreclosure sale, before any lower priority positions. Thus, second lien trust deeds carry more risk of loss than first lien trust deeds.
Some trust deed investors will invest only in first liens, while some trust deed investors will accept the additional risk, with potentially higher returns, to invest in second lien trust deeds.
The trust deeds managed by ICCG are exclusively first lien trust deeds. We believe the additional risk of second lien trust deeds outweighs the benefit of moderately higher returns. We have found ample opportunity to achieve high rates of return with first position trust deeds.
The maturity date for a loan is also a significant consideration for a trust deed investor. If the loan is for 15 or 20 years, the investor must be willing to have those funds out for the full term of the loan. This may not leave a lot of room for emergencies. The investor must also be comfortable with vast market fluctuations that may occur during the term of a 15- to 20-year loan.
ICCG focuses on short-term loans (many as short as 9 to 12 months). Short-term loans have several advantages, the main one being the liquidity of the investor. Many investors are more comfortable extending funds for a short-term investment, as opposed to a 15- or 10-year note investment. Plus, the shorter term also insulates trust deed investors from changes in the real estate market. During a short period of time, a drastic decline in property values would have to occur in order to lose a significant portion of the security of the investment.
Documentation & Protection
It goes without saying that property documentation is key to protecting the security of a trust deed investment. Not only must the loan and security documents be accurate and complete, the trust deed investor must ensure the title of the property is clear of any prior liens or defects that could impair the investor’s interest in the property.
At ICCG, all of our trust deed investments are insured by title insurance and we also insist that all projects are insured to protect against hazards.
When lending money to a borrower that is an entity, such as an LLC or corporation, you should always consider a personal guarantee. This means that the owners of the entity make themselves personally responsible for repayment of the loan. If the business is unable to pay or goes out of business, the guarantors will still be responsible for repaying you personally.
Ongoing Management Needs
Trust deed investors must be aware of ongoing management issues after a loan is placed. For many trust deed investments, the borrower uses funds for renovations or construction. This requires ongoing management of the project to ensure the work is being completed, the contractors are paid and the title remains clear of contactor liens.
Some trust deed investors will manage the servicing of their own investment loans, while others will utilize companies, such as ICCG, to manage the loan for them. Regardless of the method, the trust deed investor (or the management company) must have mechanisms in place to properly service the loans, including required IRS reporting procedures and systems to deal with defaults and foreclosures.