For Most, Buying Trust Deeds Can Be a Risky Business

It’s easy to earn up to 15% a year on your money. Or, at least, that’s what some seminars and real estate brokers are telling people about investing in trust deeds.

The truth, of course, is that some people can earn 15% a year--but only if they really know what they’re doing. For most others, investing in trust deeds is probably very risky.

Trust deeds are basically three-party legal instruments that are created to secure real estate loans. In California, when a property owner (called the trustor) borrows money from a lender (called the beneficiary), he or she does so by signing a promissory note to repay the debt. The borrower also signs a trust deed giving a neutral third party (called the trustee) the power to foreclose and sell the property if the borrower doesn’t make good on his or her loan obligation.

Investors can enjoy handsome returns by essentially becoming lenders and funding trust deeds. Profiting from this type of investment, however, requires some more savvy and knowledge about the underlying real property than many people have.

“You can get some really good deals, but there are a lot of pitfalls,” said Kevin Saunders, a buyer of trust deeds through TransCalifornia Capital Inc. in Chatsworth.

When reviewing a loan for a possible purchase, Saunders advises investors to carefully study what they’re about to buy. The most important factors are the property demographics, a recent appraisal, the findings of a title search, a title company’s policy insuring the investor, and a credit report on the borrower, or payor.

“This is not a get-rich-quick scheme. There’s a lot of hard work,” Saunders said. “Those people who are selling investors on get-rich seminars are ruining this business for the professionals.”

One warning is that not all those who are out hustling investors on trust deeds have to be licensed brokers. While those people who act as a “broker” need to be licensed, individuals can sell up to seven trust deeds a year without a license. And those who are putting on seminars in hotel ballrooms all over the San Fernando Valley and Ventura County don’t usually come under the purview of the California Department of Real Estate, said Steve Ellis, Los Angeles district office manager for the DRE. “You could lie to the public all day long and the DRE couldn’t do anything about it.”

Most successful TD investors have money they can afford to lose, Ellis said. He also warned investors that “there are more people out there with money to invest than there are loans worth buying.” As a result, many unsophisticated investors get burned.

Ellis noted that successful investors are usually the type who will be ready to foreclose on a borrower without sentimentality. Prospective investors should ask themselves, he said, “Are you the kind of person who is ready to foreclose if necessary on a family or an older person or someone who’s down on their luck?”

Sherman Oaks resident Alec Mitchel said he has been successful as a TD investor by staying on top of his borrowers and making sure that they’re paying on time. “I don’t want to hear a hard-luck story,” he said.

Once a borrower gets 30 days behind, Mitchel said, he starts the foreclosure process.

Mitchel claims that he’s been consistently earning 13% to 15% annually on his money. It’s important to note, however, that Mitchel has invested in about 20 residential trust deeds. Most of these loans are recommended to him by brokers that he’s developed a professional relationship with, he said. And he makes it a point to do his own homework and view every property that is the subject of a prospective trust deed.

“I make my own appraisals by visiting the properties and calling the other brokers in the area,” Mitchel said. He also safeguards his investment by making sure that the borrower, or trustor, has at least a 35% equity stake in the property. That way, Mitchel said, if the property declines in value or if the trustor defaults on another loan, there’s still enough value left in the property to repay Mitchel.

Finding good deals, though, is very tough. After all, why would a borrower with lots of equity and good credit be willing to accept a loan with an interest rate of 13% to 15%? The answer is that only a few borrowers who are either uneducated or hard up would be willing to accept such so-called “hard-money” mortgage loans.

“I’ve seen a lot of people making a lot of mistakes when investing in trust deeds,” said Paul D. Johnson, a TD broker based in Simi Valley and the author of a guide to investing in TDs.

TD investors should know all the pitfalls before they invest their money, Johnson said. “Different properties and loans have different risks,” he said, but there are some universal things to keep in mind.

First, many of the TDs sold to investors are hard-money loans made to borrowers who have been turned down for loans by more conventional lenders.

Second, many of the TDs sold to investors are second or third mortgages. If a borrower fails to pay on a second mortgage, the beneficiary can, of course, foreclose. The beneficiary, however, has to be prepared to keep paying any senior mortgages, or pay those senior mortgages off in cash.

Third, collecting mortgage payments from the borrower is a problem if the borrower can’t or won’t pay. Foreclosing on a loan can be both cumbersome and expensive.

Johnson advised that investors should neither service the loan themselves nor allow the broker who sold them the investment do the servicing. “There are too many potential conflicts of interest.” Besides, Johnson added, “some brokers are dangerously incompetent in servicing loans.”

“Unfortunately, in our business, there are a lot of unscrupulous, unethical and unlicensed individuals,” said Rick Kapko, president of National Home Equity Corp., Van Nuys. “They prey on people and give everybody in the business a bad name.”

Kapko’s company has been in business since 1981 and primarily buys TDs for its own portfolio. His company also services loans and does the documentation for so-called purchase money lenders who make a loan to help sell their homes. These loans are also known as discounted trust deeds because the only way that they can be sold to investors is at a discount from their face value.

Kapko advises other TD investors to thoroughly check out any brokers who recommend investing in TDs. These brokers should have a clean record with the California Department of Real Estate and the brokers should be willing to furnish a list of referrals with names and phone numbers of current and former clients, and check court records to see if they’ve been sued.

In the end, investing in trust deeds is profitable for some, but risky for most.