If you’re researching trust deed investments or looking for new mortgage brokers to fund or buy existing Notes...
Ten Problems with Trust Deed Investments
If you’re in the research phase of trust deed investing, you are probably looking online, talking to mortgage brokers and to friends who have experience funding private money loans. There is a lot of information available about the Note, Deed of Trust, and Security Instrument. However, there’s not much information about the real-life problems that arise with trust deed investments.
This article will cover ten problems with trust deed investments that FCTD has experienced and worked through with our trust deed investors, borrowers, and other third parties to find a resolution.
I’ll cover the following ten problems in this blog post:
- Death – Probate & Non-Probate
- Equity Erosion
- Flattening or Declining Real Estate Market
- Slow Permitting Process / Supply Chain Delays
- Divorces or Business Partnership Splits
- Natural Disasters
Default on Payments
Borrowers will default on their monthly payments from time to time. It happens but not as often as some people might think, especially when the note rates on private money loans FCTD has originated over the past 3-4 years have averaged 9.00%. Our borrowers have been very good at making on-time payments, which we’ve been able to monitor through our broker portal account with FCI Loan Servicing.
When borrowers are 10-15 days late on payments, however, it can cause concern for any individual trust deed investor, including those with a loan portfolio of $1-2 million and fund managers with a $250 million fund. As the originating broker, we get the call from the lender every time a payment is late to make sure everything is okay with the borrower and that to confirm that payment will be made.
If it’s clear that payments will not be or cannot be made, then we notify all parties (borrower, servicer, lender) so they can fulfill their duties as specified in the Loan Agreement.
After the big runup in real estate values since the start of COVID in March 2020, I’d expect bankruptcy filings to increase in the years to come as the real estate market cools off with The Fed raising interest rates to battle inflation.
Some bankruptcies will be simple, like a Chapter 7 liquidation or Chapter 13 workout. Others, like a Chapter 11 business bankruptcy, can become complex.
In 2008-2010, I worked for distressed asset manager Kondaur Capital, managing a portfolio of defaulted loans nationwide, some of which were in bankruptcy. Since most of the mortgages were for primary residences, the bankruptcies were relatively simple. In relation to the debt owed on their home, the borrowers either wanted to walk away (Ch 7 BK) or wanted to stay in their home, making the mortgage payment plus arrears (usually 10-20% of total arrears is what I saw), and other secured and unsecured debts (Ch 13 BK), spread out over a five-year bankruptcy plan.
I had a loan Massachusetts where the homeowners filed Chapter 13 four times in two years, usually an emergency filing the morning of the foreclosure auction. The bankruptcy filing stopped the foreclosure sale from going through, allowing the homeowners to remain in their home until that bankruptcy was dismissed and the clock started on the next foreclosure sale date. After the third bankruptcy filing, an In Rem was granted which allowed for the foreclosure sale to go through even if the borrowers filed another emergency bankruptcy petition the morning of the next foreclosure auction (which they did). The court recognized that all the loss mitigation strategies had been exhausted and at that point, the homeowners were abusing the bankruptcy process. Thus, the In Rem allowed the foreclosure sale to go through and Kondaur took back the property.
With business-purpose private money lending, the bankruptcies could become more complex since the borrowers are mostly real estate investors (house flipper or landlords), home builders and developers, real estate professionals, or some combination of all the above.
Trust deed investors need to be aware that bankruptcies can be as little as six months or as long as six years. (Yes, we have a scenario where a former Fortune 500 company bankruptcy has tied up a property sale where a private money loan is involved – long story!).
Death / Probate / Non-Probate
FCTD has only has one case where a borrower passed away and another where a trust deed investor died having 5-6 loans outstanding. In both cases, the individuals had a trust in place to handle their estate in the event of their passing. In the case of the trust deed investor, the surviving spouse continues to fund loans.
Having a trust and working with an attorney and/or accountant can eliminate confusion that surviving family members may have, including:
- How many loans are out?
- Liquidation of the loans – immediate note sale or hold until maturity?
- Bank accounts:
Does the family, accountant, or attorney know which bank account interest payments are going to?
Do they have access to the bank account?
In multi-lender loans, or fractional loans, it’s good practice for the mortgage broker to have an attorney and family member contact information on file in the event of a trust deed investor passing away.
Another situation I’ve seen several times is when we are funding a loan where our borrower is acquiring a non-probate sale where the adult children are selling the longtime family home. The adult children, who are usually not in real estate and have very limited real estate transaction experience besides owning a primary residence, will call escrow 4-5 times a day for two weeks before the scheduled close date, asking if the buyer’s loan docs arrived and if the sale can close early. If there are 3 adult children, the escrow officer may get 12-15 calls per day for two weeks asking about buyer loan docs.
The way this impacts a trust deed investor is that we may ask you to fund a week or two earlier to accommodate the sellers. And the escrow officer.
Equity Erosion of Trust Deed Investment
I wrote about an equity erosion case FCTD had in 2018-2019 in Portland, where an investor acquired an SFR and let the property go during the entitlement period when converting from an SFR to an 18-unit apartment. The investor wanted to demolish the house since he thought it would be more valuable as fully entitled dirt than an unmaintained and vacant SFR.
Flattening or Declining Real Estate Market
As of this writing in July 2022, interest rates on conventional and NonQM loans have nearly doubled from the start of the year. This has led to a significant increase in the monthly carrying costs, pushing the upper bounds of affordability for many would be buyers. The impact of higher mortgage rates usually takes 6-12 months to be reflected in the sale prices of homes rather than being instantaneous.
Going forward, trust deed investors should not expect that borrowers will be able to sell or refinance into a rising real estate market. There may be market driven equity erosion in the years to come and investors should take this into consideration when funding loans by making sure the exit strategy (sale or refinance) is viable.
Litigation occurs in trust deed investing just like in all other industries. There are cases where a borrower had a dispute with the general contractor ten months after taking out the loan. They could hire an attorney to file a lawsuit primarily against the GC and include all the other parties to the initial transaction with professional liability insurance including the lender, mortgage broker, escrow, title, funds control administrator, and loan servicing company.
Or if a borrower defaults on the loan after making 6 payments on-time because they ran into a cash crunch managing several projects that ran into unforeseen delays (supplies, contractors getting COVID, buyer financing delays, etc.). Delays in real estate are inevitable. If loan modification, extension, and/or loss mitigation efforts cannot remedy the default, some borrowers may chose litigation.
FCTD has had a few fraud situations over the years, which is why we use background checks with new borrowers. Fraudsters think that using private money loans, which they believe are simple, equity-based loans with limited due diligence, are the easiest way to carry out a real estate fraud scheme.
Background checks, credit reports, and title information are vital when working with a new borrower.
Intuition when something doesn’t seem right also plays a part. Real estate investors talk a certain way. When a new prospective borrower calls in and they don’t talk that way or are evasive to standard questions, it immediately raises red flags.
Slow Permitting Process / Supply Chain Delays
I have an experienced builder in Portland whose permitting process has taken nearly 12 months due to delays with the city during the COVID pandemic. The construction loan was originally written for 12 months but has been modified to 24 months to accommodate the delays.
Another builder had a 2-3 month delay with garage doors to complete five homes and receive the Certificate of Occupancy. The homes were completed with OSB plywood garage doors sealing the garage until the garage doors could be deliver and installed.
Both loans above were funded by institutional lenders selling into securitization pools and not individual trust deed investors. Institutional lenders have the scale to handle construction whereas individual investors are better suited for bridge loans without the construction reimbursement component.
Borrower Divorces / Business Partnership Splits
Divorces can be difficult for the parties involved and the non-related parties, including a private money lender. FCTD originated a loan and the couple filed for divorce right before the first payment was due. Each person wanted the other to make the mortgage payment, neither did, and it led to a first payment default where the interest rate increased from the note rate of 9.50% to default interest at 18.00%. The notice of default, which usually is filed on a first payment default, was not filed because one of the borrowers made the first payment, albeit 25 days late.
From 2015-2017, FCTD originated several loans on cannabis properties in Oregon and California. Within a year of taking out the loan, I received calls from two different borrowers needing to refinance the loan to buyout a partner. The properties had only appreciated 5% during the previous year so there wasn’t equity to use for the buyout. Fortunately, they negotiated different buyouts than using the real estate and the on-time payments continued (and are still on the books 5-6 years later in July 2022).
Summer fire season and winter snow storms seem to be getting bigger and more catastrophic to life and property over the past few years. The property is the collateral for the private money loan and we make sure that insurance coverage is in force and a full year of premiums have either been paid prior to closing the loan.
With loan terms longer than 12 months, the lender will be notified by the insurance company in writing of cancellation thirty days prior to expiration of coverage and ten days for non-payment.
See here for standard insurance requirements on business purpose bridge loans.
The majority of trust deeds FCTD has originated over the past decade have performed without any issues. We’ve been fortunate to lend in a low interest rate and rising property value market where mistakes could be absorbed by the market. However, we’re starting to see rising interest rates and inventory across every market which will lead to either flattening or falling real estate values. Which isn’t a bad thing, considering how much real estate values increased during the COVID 19 pandemic.
Hopefully, this gives you a good idea of some of the pitfalls and problems that can occur with trust deed investments. It’s good to be aware going in what could happen and know that FCTD has worked through several default situations in the past and have a network of professionals to help navigate the process.