Trust deed investments can offer high returns with low risk. Trust deeds are similar in function to traditional mortgages. The primary difference is that while mortgages involve only two parties, a borrower and a lender, trust deeds involve three: a borrower, a lender and a trustee. The trustee is a third party who holds legal title to the property in question on behalf of the lender until the loan is paid in full. In the event of default, the lender can take possession of the property. Investors can invest in trust deeds either by directly making a loan or by purchasing an existing promissory note.
The double-digit returns on trust deed investments touted by mortgage brokers can sound enticing, but investors must be sure to complete proper due diligence on potential trust deed investments before jumping in based on the promise of high returns. The borrower’s property secures the investment, so it is vital to thoroughly research the property’s market value and title status. Investors should request a Preliminary Title Report from within the past 90 days and review it for any factors that could adversely affect the market value. Issues that should raise red flags include a lack of direct access to a public road, a significant difference between assessed value and appraised value, unexplained encumbrances and unresolved legal concerns, according to the California Department of Real Estate (CDRE). If an investor purchases a promissory note for a property with these or other unaddressed issues, it could make it difficult or impossible to recover the investment in the event of foreclosure.
Trust deed investments are not insured by the FDIC or any other government agency, and difficulties such as economic conditions and borrower default may cause some or all of the investment to be lost. And if a borrower files for bankruptcy, it could affect the foreclosure process and cost investors large amounts of money on resultant legal fees.
“[T]he court could modify the terms of the loan by extending the due date, changing the interest rate and payment structure, or causing the priority of the loan to be subordinated to a bankruptcy court-approved financing plan,” according to a Cushman Rexrode Capital Corporation publication.
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Whole trust deed investments offer investors the opportunity to purchase 100 percent of a single trust deed, giving them full ownership of the note. The lender receives a promissory note and insurance documents recorded in their name. Investors interested in purchasing whole trust deeds must have enough capital to finance the entire loan amount.
In fractionalized trust deed investments, multiple investors contribute funds to purchase undivided interests in the trust deed. Since a single investor does not need to put down the entire sum, this method may be preferable for those with less money to invest. But complications could arise in the event that the borrower defaults if there is disagreement on how to proceed. It is also possible that investors in fractionalized trust deeds may not have possession of original documents, which could present problems down the line, according to V.I.P. Trust Deed Company. Fractionalized trust deed investments are typically limited to 10 or fewer lenders.
Mortgage pools are similar in function to mutual funds, except that they hold trust deeds instead of stocks and bonds. Investors are limited partners in the pool and investments are diversified over multiple trust deeds, which helps decrease financial risk.
Another important factor to consider is whether or not one is investing in a first trust deed. First trust deeds are recorded first and have priority over subsequent claims. Second trust deeds can be far riskier because the first trust deed holder’s claim must be settled first. In the event that there is not enough money to satisfy both debts, it is the second trust deed holder that will come up short.
The CDRE states that the funding of a loan or a purchase of a promissory note should be conducted through an escrow. Instructions are made which specify what conditions must be met before the money can be transferred to the borrower, including recording the deed of trust, selecting title insurance coverage and the resolution of existing title issues. “The escrow instructions should require the promissory note and deed of trust be delivered to you or an independent custodian on your behalf at the close of escrow,” according to the CDRE.
Investors can locate trust deed investments through a mortgage loan broker. Before deciding on a broker, the CDRE recommends investors request that the broker provide them with a professional profile that includes the number of loans which resulted in foreclosure. Investors would also be wise to check the broker’s status with the Better Business Bureau and the relevant department of real estate before proceeding.