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Trust Deed investments make an excellent option for investors seeking consistent, monthly cashflow with the security of real estate. In this article, we are going to explain a trust deed investment and the top five mistakes investors make when investing.
A trust deed investment involves an investor providing a loan to a borrower, secured by real estate as collateral. Similar to a bank, the investor (referred to as the lender) lends funds, and the borrower pledges real estate as security for the loan. The borrower then makes monthly payments to the lender over a specified period, known as the loan term. The terms of the loan are outlined in a document called the “promissory note.”
The term “trust deed” originates from the security instrument recorded against the property to secure the loan. If the borrower fails to meet the obligations outlined in the promissory note, the lender has the legal right to initiate foreclosure to recover the principal, unpaid interest, and any associated costs.
Trust deeds are an appealing investment option because they provide consistent monthly cash flow. Additionally, investors often have the opportunity to invest locally. Unlike owning income properties, trust deed investments do not require purchasing or selling properties, handling property maintenance, or managing tenants.
The following are a list of the top 5 risks of investing in trust deeds.
There is a common misconception in the trust deed industry that only borrowers with poor credit turn to private lenders. In reality, many creditworthy real estate investors utilize private lenders to finance their transactions when traditional banks are unable or unwilling to meet their needs.
For instance, consider a borrower purchasing a single-family home to renovate and sell for a profit. Most banks are unwilling to fund such transactions because they involve properties in poor condition and short loan repayment periods, often under 12 months. In this scenario, the borrower’s only viable option is to secure financing through a private lender.
Another example involves borrowers who need to close quickly. This typically occurs when a bank pre-approves a loan but, due to delays in their underwriting process, cannot fund it in time. These borrowers often have strong credit and established relationships with their banks, but the bank’s inability to expedite the loan forces them to seek private financing.
However, a scenario to avoid is lending to borrowers with poor credit, a history of bankruptcy, or repeated late mortgage payments. Borrowers with such patterns rarely change their habits, and a history of late payments is likely to continue with your loan, increasing the risk of default.
Your investment in a trust deed is backed by the underlying collateral, which could include a single-family home, multi-family property, commercial asset, or another type of real estate. Among these, single-family homes are often considered the safest and most liquid assets. They typically generate steady cash flow through rental income, have a large pool of potential buyers if you decide to sell, and are easier to finance compared to other property types. In contrast, raw land usually provides no cash flow, has a limited buyer pool, and is more challenging to finance.
When evaluating a trust deed investment, ensure you are comfortable owning the type of property securing the loan. For instance, if you are not confident managing a mixed-use commercial or residential property, it’s best to avoid trust deeds tied to such assets. Always align your investment choices with your expertise and risk tolerance.
One of the most common mistakes trust deed investors make is funding construction or land development loans simply because they promise higher returns. The primary risk with these types of loans lies in the fact that the full value of the collateral is not realized until the project is completed.
For example, when you finance the construction of a single-family home, your collateral is a partially built house until the project is finished. If foreclosure becomes necessary, you would be responsible for completing the construction to recover your investment. The same risk applies to land development loans, where the collateral may hold limited value until the development is finalized.
Identifying, underwriting, and funding a trust deed investment represents only half of the process. The other half involves managing the loan, commonly referred to as loan servicing. Loan servicing includes tasks such as collecting payments from the borrower, issuing monthly statements, providing year-end tax documents, and initiating foreclosure proceedings if the borrower fails to meet the loan terms.
It is crucial for a trust deed investor to take prompt action if a borrower fails to meet their loan obligations. Delayed action on issues such as missed payments, an overdue loan maturity date, or failure to maintain property tax and insurance payments can create complications when initiating foreclosure proceedings.
The most common reasons investors hesitate to act are lack of attention, uncertainty about the steps to take, or discomfort in approaching the borrower directly. For these reasons, it is highly recommended to engage a third-party loan servicing company to manage the loan. This ensures the responsibility of contacting the borrower and addressing issues is handled professionally and efficiently.
Investing in trust deeds in California can be an appealing option for those seeking consistent monthly cash flow and the added security of real estate-backed investments. However, it’s essential for investors to approach these opportunities with caution and implement strategies to manage associated risks effectively. By carefully evaluating potential investments, recognizing warning signs, and conducting thorough due diligence, investors can enjoy the benefits of trust deed investing while minimizing their risk exposure. Ultimately, understanding the unique characteristics and potential risks of trust deed investments is critical to making informed and successful investment decisions.
Brock VandenBerg serves as the President of TaliMar Financial and the Fund Manager of TaliMar Income Fund I. Since founding TaliMar Financial in 2008, he has successfully funded over 1,000 loans, amounting to more than $500 million. Brock currently manages a loan portfolio consisting of over 105 loans, totaling more than $105 million. Through TaliMar Income Fund I, he pools investor capital to finance short-term residential and commercial bridge loans across California. Before establishing TaliMar Financial, Brock gained valuable experience working for two years with the Federal Deposit Insurance Corporation and five years with KeyBank’s Private Equity Group.
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