If you’re in the research phase of trust deed investing, you are probably looking online, talking to mortgage...
Guide to Trust Deed Investing
If you are a seasoned investor, you have probably heard about hard money loans and trust deed investing. Maybe you have friends who have diversified their investment portfolio by loaning money out to real estate investors on a project. Or, maybe you personally have borrowed from a hard money lender on one of your real estate projects and “being the bank” caught your attention, so here you are wanting to learn more about how you can do the same thing with your capital.
This guide to trust deed investing will answer the most common questions we receive from trust deed investors, whether they’re brand new to trust deeds or they’re new to working with my company, First Capital Trust Deeds, as a source for new funding opportunities. I’ll cover multiple topics, starting with the basics of hard money loans to more detailed information that trust deed investors need to know before funding a loan or working with a new mortgage broker.
Below are the trust deed investing topics I’ll cover:
- What is Hard Money Lending?
- Hard money versus private money
- Business purpose versus consumer purpose
- Why do borrowers use hard money loans?
- What is Trust Deed Investing?
- Three different ways to participate in trust deed investing
- How is Trust Deed Investing Regulated?
- What are the Yields?
- What are the Pros & Cons of Trust Deed Investing?
- 10 problems with trust deed investments
- Potential for margin erosion on a trust deed investment
- Judicial versus non-judicial foreclosure
- Examples of trust deed investments
- Mortgage Broker Role in Trust Deed Investing
- Underwriting and due diligence
- Generate loan documents
- Manage closing tasks
- Loan servicing setup
- Payoff – property sale or refinance
- Additional Resources for Trust Deed Investing
- Get Started Trust Deed Investing
Here we go…
What is Hard Money Lending?
Hard Money Lending, also known as private money lending, is a loan secured by real estate, usually in the form of a short-term bridge loan made by a private individual or nonbank lender. The loans are mostly made to real estate investors, like house flippers or home builders, who need to close quickly on a property or need to reposition debt across their real estate portfolio.
Hard money loans forego traditional bank underwriting and appraisals, which allows the loans to close quickly but at a higher price than a bank loan. With less underwriting, leverage on hard money loans can sometimes be lower than what an investor could obtain with a bank.
Hard Money Versus Private Money
You’ll often hear “hard money” and “private money” used interchangeably. The general public, industry professionals such as real estate agents, conventional mortgage lenders, and title & escrow officers generally use “hard money.” People in the hard money lending industry, like myself, use “private money” to describe by what we do.
Yet, when I looked up “hard money loans” and “private money loans” in SEMRush, it showed that people searched for hard money nearly ten times more than private money. Therefore, I decided to use hard money in this guide and on our website to be more in line with online searches.
Hard Money Loans
“Hard money loans” have historically been equity-based, or asset-based loans, with no credit or income verification. Hard money lenders would simply look at the loan amount against the value of the property, known as the Loan-To-Value (LTV), and decide to make the loan. If the borrower defaulted on the payments, the lender knew that they could foreclose on the property and recoup their money.
Individual trust deed investors often make hard money loans to real estate investors. These loans tend to be more expensive to the borrower and yield higher returns for the lender.
Private Money Loans
Private money loans are equity-based loans that take in several additional factors, including:
- Credit Scores
- Income (Borrower, Rent Rolls, Etc.)
- Appraisal (AS-IS Value and After Repair Value (ARV))
Private money loans have more underwriting criteria and usually come with lower pricing for the borrower and lower yields for the lender. High-leverage Fix & Flip + Rehab loans would be considered private money loans, as the lenders performed greater underwriting due diligence verifying borrower financial strength along with present and future appraised value.
An example of a private money lender is what we refer to as a “conduit lender”, which operates an “originate to sell” business model, acting a passthrough to the secondary mortgage market. Most of the larger fix & flip lenders are conduit lenders, where newly originated loans are held on the books for only about two weeks until they’re sold to a pension fund or another fixed income investor.
Usually, individual trust deed investors will fund hard money loans whereas conduit lenders originate private money loans.
Business Purpose Versus Consumer Purpose
Hard money lenders and mortgage brokers are very conscientious about the distinction between business purpose and consumer purpose loans. The use of loan funds is very important to know how to underwrite a loan and where to place the loan with a trust deed investor.
Business Purpose Loans
Business purpose loans are used for investment properties or for a legitimate business purpose, such as taking cash out on a primary residence with proceeds going toward the investment into one’s business, like buying industrial kitchen equipment for a commercial catering business.
Below are examples of Business Purpose Loans:
- Bridge (purchase / refinance of investment property)
- Fix & Flip projects
- Ground-Up construction (spec, build-to-rental, etc.)
- Second Trust Deed
- Cash-Out on primary residence where proceeds are going toward a bona fide business use
It’s important to have the borrower write, in their own handwriting, what the use of funds will go to. This is done with the initial loan disclosures and in the final loan documents, which protects the lender and mortgage broker down the road in the event of a default.
Consumer Purpose Loans
As a trust deed investor, it’s not very likely that you’ll be presented with a consumer purpose trust deed investment opportunity. On the few occasions that FCTD has a consumer loan scenario, like where an investor client needs financing on their primary residence or second home, we’ll place those loans with institutional lenders like a conventional, jumbo, NonQM, or a mortgage fund.
Below, are a few examples of hard money Consumer Purpose loan scenarios:
- Bridge loan to acquire a new primary residence
- Paying personal income taxes
- Personal judgments
- Personal credit cards
- Paying off a Chapter 13 personal bankruptcy
- Financing an owner-occupied Manufactured Home (we get this request a lot)
- Second mortgage for debt consolidation and home remodel
FCTD receives many online inquiries for these loan scenarios but points borrowers in the direction of either a community bank, credit union, friends, or family when it come to paying off credit cards and judgments.
Hard money loans, as we see it, should be used for real estate investors securing a business purpose loan against an investment property.
Why Do Borrowers Use Hard Money Loans?
People use hard money loans for numerous reasons, which I wrote about in this blog post, listing twenty different scenarios we’ve had over the last few years. The truth is, I could have written 100 scenarios of why people use hard money loans.
The common misconception is that hard money loans are for people with bad credit, which might be true 5% of the time. Most of FCTD’s borrowers are highly qualified and creditworthy. They just have a scenario where the situation calls for hard money as opposed to bank financing.
The most common reasons why borrowers go with hard money loans are:
- Property is unfinanceable (major repairs needed)
- Fix & Flip (banks don’t fund these loans)
- 3-Day Notice to Perform
- Acquiring an empty building
- Construction completion
- 1031 Exchanges
- Cross-Collateral Blanket loans
What is Trust Deed Investing?
Trust deed investing involves a private investor lending money to a borrower secured by real estate. A borrower will sign a Promissory Note that is secured to the title of the property through a Deed of Trust.
There are several ways that investors participate in trust deed investing, including:
- Individual Trust Deeds
- Multi-Lender Loans / Fractional Loans
- Mortgage Funds
Individual Trust Deeds
Individual trust deeds are exactly what it sounds like - one investor funding one loan on a single property or several properties.
Multi-Lender Loans / Fractional Loans
Multi-lender loans, or fractionalized loans, consist of two or more investors funding a loan for a borrower. FCTD has originated numerous multi-lender loans and the most investors that we’ve had on a single loan were four, which consisted of one investor using three of his entities while the other investor used only one entity.
Most multi-lender loans FCTD originates have been funded with family members or close friends. Rarely, do we combine multiple investors who do not know each other onto a single trust deed.
I wrote a blog post about how multi-lender loans work, funding loans at origination, buying notes where you could be paired with a stranger and have an intercreditor agreement, and structuring it with various risk levels.
Another way to invest in trust deeds is through mortgage funds. The benefits of placing your money in a mortgage fund is that you’re a passive investor and do not need to manage funding new loans, payoffs, or potential defaults, and you’re diversified across all the loans in the fund. The fund manager handles all the details with the loans in the portfolio, taking an annual management fee in addition to the upfront origination fees they charge to the borrower. Most funds are structured to allow investors to reinvest dividends back into the fund, which most investors elect to do.
How is Trust Deed Investing Regulated?
Trust deed investing is regulated at the state level and usually does not apply to individual trust deed investors, who do not have any licensing or reporting requirements.
Mortgage brokers, mortgage lenders, and mortgage servicers are responsible for complying with each state they operate in and if the regulator requires, to be registered with the Nationwide Multistate Licensing System (NMLS). Through the NMLS, licensees must report quarterly and annual loan activities.
Most states in the western United States require mortgage brokers to be licensed to originate business purpose loans funded by trust deed investors. This includes California, Oregon, Idaho, Montana, Utah, Arizona, and Nevada. Some states, like Florida, do not have a license requirement for business purpose loans vested in an LLC or corporation. However, if vesting is individually or in a trust, the state of Florida requires a mortgage broker to be licensed, but not the trust deed investor.
FCTD is currently licensed in California with both the Department of Real Estate (DRE) and Department of Financial Protection and Innovation (DFPI), Oregon, Washington, Idaho, and Florida.
What are the Yields on Trust Deed Investments?
Yields on trust deeds vary depending on lien position (first, second, or third), geography, and loan type. Over the past five years, FCTD loans have averaged 9.00% yield with a few very low-leverage bridge loans at 5.50% and some higher-leverage second mortgages at 13.00%.
With the Federal Reserve aggressively raising interest rates in the second half of 2022, I expect to see the yields on trust deed investments rising as well.
What are the Pros & Cons of Trust Deed Investing?
Like all investments, trust deed investing comes with risks. Over the years, FCTD has placed over $350 million through trust deed investors which have had low single digit default rates. When I say default, I’m referring to a late payment or two, maturity default, or first-payment default where the investor recouped their money through foreclosure.
FCTD’s success could be due to a rising real estate market where borrowers could always refinance or sell into that rising market. It also could be that FCTD has matched individual trust deed investors with safer, lower-leverage bridge loans while placing the more complicated, higher-leverage loans (fix & flip + rehab or ground-up construction loans) with conduit lenders and mortgage funds. It’s probably a combination of both scenarios.
10 Problems with Trust Deed Investments
It’s important to know the potential problems that could arise with a trust deed investment before you start. The probability is low that you’ll experience one of these situations, but over time, you’ll most likely have to work through one or more.
The ten most common problems I’ve seen include:
- Death – Probate or Non-Probate
- Equity Erosion
- Flat or Declining Real Estate Market
- Slow Permitting Process / Supply Chain Delays
- Divorces or Business Partnership Splits
- Natural Disasters
I covered these ten topics in more detail in this blog post.
Potential for Margin Erosion on a Trust Deed Investment
Margin erosion is when the protective equity between your trust deed and the value of the property decreases. I wrote about a pre-development loan FCTD originated in Portland where the borrower wanted to demolish the vacant SFR while completing entitlements and obtaining permits on a new 18-unit project. This was not allowed in the Loan Agreement and would have triggered an immediate acceleration of the loan. The situation worked out and FCTD secured a construction loan within a few months, paying off the existing trust deed. Once the new construction loan was in place, the borrower could demolish the single family home.
Judicial Versus Non-Judicial Foreclosure
Each state has a different set of foreclosure laws:
- Judicial foreclosure (court filing)
- Non-Judicial foreclosure (trustee files to foreclose)
Most of the states FCTD operates in are non-judicial states, so the foreclosure process can be a little faster than it would be in a judicial state.
The American Association of Private Lenders has a simple explainer on the difference between both types of foreclosure that I recommend you read.
Examples of Trust Deed Investments
FCTD has placed loans with trust deed investors in over 20 states. The majority of these loans are lower-leverage mortgages for real estate investors with a definite exit strategy.
Mortgage Broker Role in Trust Deed Investing
What is the role of the mortgage broker in trust deed investing?
As I mentioned above, mortgage brokers need to be licensed in some states, but not all, to originate business purpose loans. Each state has specific laws that mortgage brokers and lenders must comply with.
For example, in Oregon, where I live, I act as the licensed Mortgage Loan Originator (MLO) for California-based lenders who need to fund a loan but don’t have an Oregon licensed MLO on staff. Same with Idaho.
FCTD is currently licensed to originate in five states, adding another seven states in 2023.
Generating New Loan Opportunities
The mortgage broker generates new funding opportunities for trust deed investors. FCTD has generated inbound business through content marketing (like this!), a monthly email newsletter, previous relationships with borrowers and industry sources like real estate agents, mortgage lenders, accountants, and attorneys.
Underwriting & Due Diligence
Even on asset-based or equity-based hard money loans, mortgage brokers perform significant due diligence with new potential borrowers, including:
- Credit Report
- Background Check
- Financial Statements
- Real Estate Portfolio Verification
- Previous Project History
- Title Report with Lien Search
Generate Loan Documents
FCTD uses Geraci Law Firm’s Lightning Docs to generate loan docs for any situation in any state. When I say any situation, I’m talking about:
- Multi-Lender Loans
- Cross-Collateral Blanket Loans
- Different Vesting for Each Property
- First, Second, Third, & Fourth Lien Position
- Lender’s Instructions
- State Specific Disclosures
- Title Coverage Requirements
The great thing about Lightning Docs is that FCTD’s Funding Manager, Aida Ojeda, can generate loans docs within 20 minutes. She’s also able to make corrections as needed.
When loan docs are ready, Aida sends to the trust deed investor for approval and then onto escrow to schedule signing.
Manage Closing Tasks
After the borrower signs loan docs, FCTD verifies the borrower has signed, dated, and initialed all places in the loan docs. If they missed something, it is sent back for completion.
Certified buyer funds are confirmed. Buyer funds must be into title before lender funds.
Lender’s Instructions signed by the Title Officer. The Lender’s Instructions contain directions for disbursement of funds and where original loan documents shall be mailed to the lender.
Lender wires loan funds to Title for funding and Title records the Deed of Trust with the county, or counties, in the case of a cross-collateralized blanket loan.
Post-Closing / Loan Servicing Setup
Within 15 days from the close of escrow, Martha Ramirez, FCTD’s Servicing Manager, sends out borrower and lender servicing setup forms through DocuSign to set loan servicing through FCI Lender Services in Anaheim Hills.
For repeat trust deed investors, FCTD maintains all servicing information, which populates servicing setup forms, which many investors find convenient.
Payoff – Property Sale or Refinance
Throughout the life of the loan, FCTD is in contact with the borrowers, discussing their project or their exit strategy, which is either the sale of the property or refinancing into a construction loan (in the case of a predevelopment bridge loan) or long-term financing on a rental property.
When FCI receives payoff requests, they will send an email out to the trust deed investor and will usually copy the mortgage broker. I review each payoff request to make sure it matches the loan and to be able to answer any questions that the investor may have.
FCTD’s goal when working with trust deed investors is to make the process as simple as possible for the investor. As a mortgage broker, my partners and I have made significant investments into processes, procedures, and software automation to make it so that with just a few clicks a trust deed investor will have all the information they would need or to quickly set up loan servicing.
Additional Resources for Trust Deed Investing
I’ve included these additional resources below because I value their knowledge and find the educational content they publish to be excellent. I highly recommend you check out their websites for additional trust deed investing information.
- American Association of Private Lenders (AAPL)
- Doss Law
- Geraci Law Firm
- Trust Deed Investments – What You Should Know!
Get Started Trust Deed Investing
If everything that you’ve read in this Guide to Trust Deed Investing resonates with you and you want to fund hard money loans through FCTD, please reach out to us to get started.
If you need to do more research on FCTD or what the process would be like, this blog post has additional information about the trust deed investing process, taking you from start to finish on a single loan.