In previous posts we’ve described what trust deed investing is and how it compares to other readily available investment options. Now we want to tackle exactly how one goes about investing in trust deeds. Well, I’m glad you asked.

There are three basic methods of trust deed investing:

• Direct investment.
• Fractionalized investment.
• A pooled fund.

Direct Investment

The oldest and most labor intensive method is for you, the investor, to put together the investment yourself. This entails you going out to find prospective borrowers, underwriting the properties, doing your due diligence and assessing the risk, preparing the documentation and, once funded, servicing the loan yourself. In this scenario the investor makes all the decisions, does all the work, and generally concentrates all the risk on one loan and one property. If you have enough money risk can be somewhat diversified by repeating the process multiple time and making loans on several properties.

A variation on this approach is to have a broker find the loan for you. In this case you are still making all the decisions and generally concentrating your risk, but the broker can absorb some of the work by prospecting for borrowers and preparing the documentation. Of course the broker gets paid a commission for this work. However, you must still perform your own due diligence. A broker can be very helpful in this regard but it is up to you decide if it’s a good deal.

Fractionalized Trust Deeds

A fractionalized trust deed is basically a brokered investment but with multiple investors taking a piece of the deal. For example, if it’s a $1 million loan you could provide 10% of the capital required and let other investors take the balance. You would then receive your proportionate share of interest payments. The advantage of fractionalized trust deed investments is that you can participate in larger loans, which are often of better quality, and/or diversify your capital further by investing in small portions of a variety of properties. As in the direct investment method you are a named note holder and recorded on the deed of trust. Although the investor makes the ultimate decision in both these methods, this level of involvement has a price.

Unless you have unlimited capital your investments will still be relatively concentrated in a small number of loans. And each of these loans will require you to review 2 to 3 inches of loan documentation. There is no anonymity as you are named on the deed of trust and, with fractional deals, there is no autonomy in decision making. If there is a problem with the loan you may be required to contribute additional capital. And once your loan pays off your capital will likely sit idle until you locate another qualified deal. The simple interest you earn would make Albert Einstein turn over in his grave. Finally, in some states there may be licensing issues for acting as a lender.

Pool Trust Deed Funds

These funds are essentially private mutual funds for trust deed investments. Investors place their capital in a fund managed by a professional lender. The manager does all the work of finding good loans, underwriting the deals and performing due diligence, assessing risk, preparing all the necessary legal documentation, servicing the closed loans and distributing payments to investors. In additional to assessing risk on each loan the manager manages the risk on the overall portfolio, ensuring that the fund’s capital is diversified across property types and markets. Loans are closed in the name of the fund, rather than the individual names of the investors.

The fund manager makes the decisions as to what loans to make, but investors know the criteria up front as it should be clearly defined in an offering memorandum. The advantages to the investor are:

• Immediate diversification of investment.
• Simplicity: little to no involvement with individual borrowers or brokers.
• Your money is working for you every day of the year.
• You maintain your anonymity and are shielded from personal liabilty.
• You can reinvest your dividends to earn compound interest.
• And you’ll generally get higher yields and improved liquidity.

Ultimately you as the investor must evaluate which method works best for you. For the majority of non-real estate or finance professionals a professionally managed trust deed fund would be the way to go.

 
Trust deed investing has been around for many generations, yet today it seems few people are familiar with how it works or how it compares to other investment options. The economic signals today are mixed and confusing, and investors are understandably unsure about what to do. Invest or sit on cash? Invest in what? Trust deed investments offer one of the best opportunities, and risk-adjusted yields, available today when compared to the other major alternatives: stocks and private equities.

First let’s understand the inherent value of risk-adjusted yield. Simply put it is the return potential of a given investment relative to its risk, where the risk is generally measured by volatility. Commercial trust deed funds historically yield consistent returns in the 9%-12% range annually, with very little volatility. Other assets, say small cap stocks or funds for example, have the potential for much higher returns but with much greater chance of loss as well. So the commercial trust deed fund would have a higher risk-adjusted yield.

Stock Market

Commercial trust deeds funds show much less volatility than stocks.

If we now look at the major stock market indexes and compare them to commercial mortgage funds we see how this pattern plays out. The chart shows three major stock market indexes versus the lower end average of commercial trust deed funds. While there are slight variations among the indexes they all follow a similar path, and all show a lot of volatility. It’s interesting to note that this particular chart shows the stock market during the best part of the recent economic bubble, and stops before the market imploded in August of 2008. While there are periods where the market outperforms trust deeds it is impossible to time the market perfectly, and as we’ve all painfully learned recently those profits can disappear quite literally overnight.

Another important distinction is the collateral behind the investment. Theoretically an equity holder’s investment is backed by the company’s assets, but in reality your capital can disappear into the wind. (Just ask shareholders of Lehman Brothers or the Madoff funds.) Trust deeds are backed by valuable, and tangible hard assets: real estate. While real property can and does drop in value it is not subject to the minute-by-minute trading of wall street, and most real estate will always have some economic value. If the private money lenders do their job right there is ample collateral backing every trust deed investment. And don’t forget, when things go bad the lender (trust deed holder) is first to get paid, but the equity holder stands at the back of the line.

Private Equity
Private equity is exactly what it sounds like: investing money directly into a private company in exchange for an ownership stake. The attraction, of course, is that these mostly smaller, early stage companies offer the chance for eye-popping profits if and when they become successful.

Trust deed funds provide a better, more accessible option for most investors.

Of course, that’s a big IF. Truth is most of these companies fail, or at least fail to achieve any sort of real value. On top of which investing in private companies is a tremendous amount of work and generally requires significant expertise. This is why it is mostly done through private equity or venture capital funds. (We’ll ignore Angel investing for the time being.)

So what about those eye-popping returns? Well, private equity and venture funds operate on basic portfolio theory. That is, out of every 10 investment about 6 will go completely bust, 4 or 5 will do ok and 1 or 2 will knock it so far out of the park that the fund overall provides a decent return. Nothing wrong with that if you have the stomach for that level of risk. Think of it as the extreme sports of the investing world. In fact, the amount of money required is so high and the risk so great that this is generally an investment class relegated to institutions and the extremely rich.

Stocks, bonds, mutual funds, and even private equity can be valuable tools in your investment toolbox. But the familiar, understandable, reliable and secure commercial trust deed fund should hold a prominent role in most investor’s portfolios.

Trust deed investments offer a highly secure alternative to the traditional menu of stocks, bonds, and mutual funds.

After the stock market went into a tailspin last year a lot of money went into hiding in money market accounts and other cash equivalents. Why not? An annual yield of 1% is better than devastating loses, already at 40% or more. While the stock market has come back quite a bit from its March lows it is still extremely volatile and economic recovery uncertain. So what to do with all that cash sitting around earning next to nothing? Trust deed investments offer a highly secure alternative to the traditional menu of stocks, bonds, and mutual funds while providing returns far greater than money market or savings accounts.

A trust deed is essentially a mortgage. (The actual differences between the two I will leave for a later post, but for this discussion they are really negligible.) Investing in trust deeds means you are lending money against a piece of real estate – a mortgage in standard terms, but a private mortgage. You, or the mortgage investment sponsor, set the terms of the loan, and get paid regular interest at the rate agreed upon. When the loan term is up you get your capital back and can do it all over again. Most private mortgages pay you a much higher interest rate than the rate on a traditional bank loan; generally 10% or more in today’s market.

All investments entail a certain degree of risk, but a trust deed investment provides a level of security most other commonly available investments cannot: they are backed by tangible assets – equity in real estate. I know, you’re thinking “that didn’t seem to help the big banks much.” I said the security is equity in real estate. The big banks were lending 80%, 90%, sometimes 110% of the value of the property. Not much equity there. A key to successful trust deed investing is always making sure there is significant protective equity in the collateral property so if the worst case scenario occurs there is plenty of cushion and you can feel confident that you will get your capital back. If necessary you can even use more than one property owned by a borrower to backstop a single loan. These are often called a blanket loans.

Trust deed investments are available to everyone, not just the rich and famous. One of the best ways to invest is with your retirement funds, through a self-directed IRA. It’s a little known fact that you can invest your IRA in almost anything you want, not just the mutual fund pushed by the big brokerage houses. Imagine if you could consistently earn just a 10% compound annual return while paying no taxes on the earnings. A $100,000 dollar investment of this type over the last 10 years would have delivered almost 17x the return of the same investment in the S&P 500, with much less volatility!

Security, consistency, and great returns: if you follow the right formula with trust deed investments the recent mortgage crisis may be just the opportunity you’ve been waiting for.

A $100,000 dollar investment over the last 10 years would have delivered 17x the return of the S&P 500.

This is the first in a series of discussions on Trust Deed Investing. In subsequent articles we will discuss how mortgage investments compare to other common investment vehicles, how to find investments, how they are structured, and what to watch out for.

REOs are attractive today but may be “fools” gold.

REO investing can be lucrative but requires specialized knowledge and skills as well as a solid capital base.

In the charred ashes of today’s economy there emerges incredible opportunities for investments, both long and short-term. Everyday I see great opportunities to lend money on real estate for great returns, acquire commercial properties for long-term cash flow, or acquire residential properties for either cash flow or quick profits. One of the seemingly most accessible opportunities is REO houses. These are properties that were taken back by banks through the foreclosure process, and they want to sell them quickly, sometimes for far below market value. As a hard money lender I get calls almost daily from people looking for financing on REO deals. 95% of the time I graciously end the call within a few minutes.

Why? REOs are not as easy as everybody thinks, and few of the optimists chasing them today really have the skills, knowledge, networks, or finances to turn it into a successful venture. There are three distinct phases of successful REO investing, each with its own complex and often specialized range of activities.

The whole process can take a lot of time and upfront money to do it right. This brings me back to all those phone calls. Most people who call, aside from not having adequate experience, seem to think a lender will give them most or all of the acquisition and the rehab money. This is simply not the case. A good rule of thumb is that a hard money lender may provide up to 65% of the ARV (After Repair Value) or 80% of acquisition price. Keep in mind that these are absolute maximums, and your deal may attract lower loan amounts. This means you need to be well capitalized and financially prepared. If you don’t have a solid balance sheet going into the process most lenders won’t provide you any funding at all.

New investment strategies don’t stray far from traditional products.

As I was catching up on my back issues of the Wall Street Journal I came across an article telling me that in this new economic environment investment advisers are embracing new tactics and turning their clients to alternative investments. (Advisers Ditch ‘Buy and Hold’ For New Tactics, WSJ 4/29) My first thought was “it’s about time.” As I read the article though I realized that when the investing establishment talks about alternative products they are mostly referring to new flavors of the same old menu of stocks and bonds.

The biggest disappointment here is that most money managers are simply becoming more active traders rather than just following the traditional buy and hold approach. In fairness, for the small percentage of investment advisers that truly know how to do this, it is probably a good thing for their clients. But what would really be much better for most investors is the recognition that there are other asset classes available to them, and that they offer significant portfolio enhancements in terms of diversification, returns, and security. Unfortunately it appears that the “new” investment tactics consist of exchange-traded funds, structured products such as derivatives, asset allocation funds and hedge funds, or taking a more quantitative approach to investment decisions. A very small number of advisers are looking for true alternative assets to expand their clients portfolios, but most shy away because their knowledge and experience doesn’t stray too far from the tried, and tired, world of stocks and bonds.  True alternatives include various real estate investments, currencies, commodities such as gold, and even oil and gas exploration.

Real estate, if approached the right way, is still one of the safest and best investments available to most investors today. There are dozens of great real estate investment approaches that vary by risk-return, time horizon, and level of investor involvement and control.

Trust deed investments offer one of the highest levels of security, quickest return, and least management hassles in the market today. On the opposite end of the spectrum is pre-developed land investments (which we previously discussed in Identifying High Growth Areas.) In the middle are direct commercial or residential income investments, or buying REO properties which we discuss in the next article.

What the investing establishment doesn’t want you to know is that these investment opportunities are accessible to most investors, including through IRAs or 401ks providing tax free or tax deferred growth, and offer viable alternatives to the volatile and unpredictable stock market.