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.
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.