Most investors understand the ownership process of diamonds, gold, silver, other precious metals, collectibles such as rare coins & artifacts, Faberge & Imperial Eggs, specialty & collectible automobiles, and paintings.
Most material items may be possessed physically or by operation of law. By operation of law, the ownership of the asset will be evidenced an ownership certificate. Examples include an automobile pink slip issued by a state agency for an automobile or a real estate ownership certificate called a recorded grant deed. In real estate, an executed grant deed that is recorded at a county recorder’s office serves as constructive notice to the public that the chain of title has changed to reflect the new ownership.
Investments, such as stocks, bonds, mutual funds, U.S. treasuries, bank savings accounts, pension plans accounts, IRA accounts, and other securities, are regarded as personal property. This is as opposed to real property. These personal property investments were defined as securities under the Securities Act of 1933 and the Securities Exchange Act of 1934. The U.S. Securities and Exchange Commission was established June 6, 1934, in the aftermath of the 1929 Wall Street Crash as a government agency to oversee all securities transactions to prevent fraud and intentional misrepresentation.
What is a Deed of Trust?
A Deed of Trust, which is also referred to as a trust deed, is a written agreement between a lender (beneficiary) and a borrower (trustor) that creates an agreement between the parties to convey the legal title of the real property to a neutral third party who serves as an independent trustee. The conveyance is done in consideration of a loan secured by the real estate.
Who are the Parties to a Deed of Trust?
Consider that someone decides to purchase a trust deed investment secured by real property. The language in the actual deed of trust has a different definition from that of a family trust relating to the three parties involved.
Trustor
A truster is the person or entity which owns the property. The trustor is sometimes referred to as the grantor. The owner/trustor/grantor may decide to borrow money and use the property as collateral for a loan. A lien called a deed of trust would be drawn, signed, and recorded against the property at the county recorder’s office. A deed of trust is also referred to as a security instrument. Public records will then reflect constructive notice of that lien.
Trustee
A deed of trust requires a third-party entity, generally a title company, which holds what is referred to as a bare equitable title on behalf of the beneficiaries, or investors in the loan transaction. This is considered the Trustee. The trustee is given three powers; 1) to foreclose 2) to re-convey and 3) to modify the trust deed per agreement.
A trustee cannot benefit from the ownership of a property but is hired only as an ownership placeholder in trust deed states. The trustee is an intermediary with a fiduciary responsibility to the stated beneficiaries. Their job is to protect the beneficiary’s rights and act in their best interest in the event of default. Also, when a borrower/trustor pays off the loan, the trustee instructs the title company to record a reconveyance, thereby removing the lien from public records and returning full ownership to the borrower/trustor.
Some states use a mortgage security document rather than a deed of trust. A mortgage document only requires two parties. One is the borrower/trustor, and the other is the lender/beneficiary. There is no trustee required.
Beneficiaries
Beneficiaries are the trust deed investor/lenders who invest capital and receive a recorded deed of trust or mortgage document and promissory note signed by the borrower/trustor as collateral.
A trustor (borrower) is a person or entity who owns real estate that may be willing to use their property as collateral for a loan. They will sign a promissory note, which promises to paythe lender/beneficiaries an agreed-upon principal amount, interest rate, timely payments, and payment schedule. The lender/beneficiaries or servicing agent, on behalf of the investor(s), by the agreement may hold the original promissory note, the original recorded deed of trust, and a policy of title insurance. These are the most critical parts and substantial evidence of completed loan transaction.
Here are some handy reference materials issued by the Department of Real Estate:
- Trust Deed Investments, What You Should Know! https://www.dre.ca.gov/files/pdf/re35.pdf
Trust Deed Investments are Securities
As defined in the 1933 Federal Securities Act, a security is “any evidence of indebtedness. The security definition can be found in the Securities Act of 1940, section 2(a)(36): “Security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
- To review the Investment Company Act of 1940, visit the following website: https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf
Real estate loans evidenced by a note and deed of trust (or mortgage instrument) are defined as securities. Certain lawyers believe that under certain circumstances notes and deeds of trust are not securities. I will leave that to the lawyers.
The Federal Securities Exchange Commission allows each state to draft its own securities regulations. Each state in the union has its own securities rules. California has the California Corporations Commissions as a consolidated department of the newly formed California Department of Financial Protection and Innovation (DFPI).
A tradable financial asset is commonly referred to as a financial instrument. A financial indebtedness refers to an obligation to pay or repayment of money. A promissory note is evidence of indebtedness and is a security.
The California definition of a security can be found in The California Corporations Code 25019.
https://codes.findlaw.com/ca/corporations-code/corp-sect-25019.html
- A licensed real estate broker in California, who engages in the sale of securities, must apply appropriate state securities exemptions to avoid the requirement of registration of the offering.
Review Corporate Commissioner rule 25206.
https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=CORP§ionNum=25206
The common California exemptions from registration are 25100(p), 25102 (e) (f) (n), 25102.5, and 25113 of the Corporate Commissioners Rules. Technical readers may want to review these exemptions. Also, interested parties should consult competent counsel.
https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=CORP§ionNum=25102.
Who are the Lenders, Investors, and Beneficiaries?
So, who are the lenders/investors/beneficiaries? The borrowing public usually assumes that the lender is a bank, credit union, Wall Street-based lender, or a government sponsored entity (GSE) such as Fanny Mae or Freddy Mac. That is not all ways be the case!
As individuals or through some formed entity (pool), private parties may invest their capital into one or more loan transactions.
Private parties serve as an alternative source of available financing to institutional banks by providing far more flexible underwriting and terms.
Regulations for the real estate lending and trust deed Industry.
Real property lending and trust deed investment(s) are highly regulated by multiple government agencies, sometimes creating redundant and cumbersome oversite.
A dual regulatory oversite exists since trust deeds are involved in real estate transactions and securities. California’s primary governing body is the Department of Real Estate (DRE), a stand-alone agency. The securities portion of the transaction is governed by the Department of Corporations (DOC).
The DOC was consolidated into a new agency called the Department of Financial Protection and Innovation (DFPI). As of January 1, 2021, the DFPI has gained the authority to regulate and enforce California Laws applying to “…persons (entities) offering or providing consumer financial products or services in the state.”
Here are some handy reference materials issued by the Department of Real Estate: Mortgage Loan Broker Compliance Evaluation Manual: https://www.dre.ca.gov/files/pdf/re7.pdf
Private Money, Hard Money, or Bridge Lending
The real estate lending industry refers to loans funded by private parties as private money or hard money. Licensed Department of Real Estate mortgage brokers act as intermediaries, soliciting real property loan transactions, and at the same time, soliciting private party lenders/investors who may want to invest in purchasing all or a portion of the loan.
The mortgage brokers have an agency (fiduciary duty) to act in the investor’s best interest and with full disclosure. The mortgage broker may or may not represent the borrower as his agent. In some cases, the broker would be required to serve as a dual agent.
Agency and Fiduciary Responsibilities of the Real Estate Brokerage
The real estate broker who operates in the lending and trust deed arena has many responsibilities, including state and possible federal licensing, regulatory, and best practices business procedures. These responsibilities include understanding the real estate and market(s), loan program requirements, property types & usage, and geographic locational differences.
Establishing procedures to procure new loans, processing, underwriting the loan file, and closing transactions are paramount. Upon closing, the loan transaction closing statement must be balanced and interest prorations forwarded to the investors. The file is then bundled and transferred to the loan servicing department.
Trust Deed Investment Yields
Private parties elect to invest in trust deeds because of reasonably high yields and a stable expected stream of monthly payments. Annualized yields on first trust deeds may range from 6 % per annum to 9% per annum. Annualized yields on second trust deeds usually range from 8 % to 12%. Risk/Reward applies. Yields may ever vary from the above estimates. These yields will also vary by loan type, property usage, income production, borrower strength, and by the state in which the loan is originated.
All participants are relying on the services of third-party vendors.
The broker’s responsibilities include assembling the most qualified real estate support professionals to ensure the best quality output and eliminate costly mistakes. These third-party service providers include licensed appraisers, title insurance companies, escrow companies, environmental engineers, credit reporting agencies, property inspectors, and realtors in the geographic area of the property.
Additionally, a company that compiles data analytics to help in online computer-assisted research for personal and companies’ background searches of borrowers and legal analysis is needed. The purpose is to uncover information to get a complete picture of the borrower(s). One excellent company is LexisNexis.
Legal Counsel/Documentation
I have combined these two for a reason. Some brokers/lenders use outside third-party legal document preparation companies. Since the lender/broker is responsible for state and federally required documentation, a third-party legal counsel or knowledgeable consultant may be appropriate.
Commercial lending is sometimes characterized by loaning to trustees on behalf of family trusts, corporations, limited partnerships, and limited liability companies. There are a required technical understanding of the laws relating to these entity types and the document differences that each will need. There is also the problem of lien priority.
Documentation complexities can be compounded when the lien priority and tenancy problems are added to the mix. The borrower may own a property in a family limited partnership, occupy the same property as an operating business as a corporation, and have other unrelated tenants that rent under various entity types.
The matching of trust deed investors with available new loan transactions is a systematic process for the brokers specializing in the business.
Mortgage brokers must constantly solicit for new loan transactions. The broker should have a group of repeat investors who want to invest. The broker should also have a group of repeat real estate brokerage relationships to bring new loan transactions and a stable of sophisticated repeat investors.
These loans are usually short-term (referred to as bridge loans), from 12 to 60 months, and frequently pay off earlier. The investor(s) will receive their distributable portion of interest payments and capital back to their bank account when the loans are paid in full. In most cases, an investor will elect to locate a new trust deed investment to replace the one that just paid off.
Managing this process between payoffs and investing in new loan transactions is stressful because the investor’s yield plummets to close to zero while his proceeds sit in his bank saving account. A few investors become frustrated while waiting for new investments.
A full list of these responsibilities by be reviewed here: https://dre.ca.gov/files/pdf/The_Real_Estate_Brokerage_as_Fiduciary.pdf
Does an Investor Purchase All or a Portion of a Trust Deed Investment?
Lender/investors/beneficiaries have the choice of purchasing a whole promissory note and trust deed (100%) or purchasing a fractional portion of the whole. Fractional investors hold their share with others as tenants-in-common. For example, a $500,000 trust deed investment may have multiple investors/beneficiaries. For example, Party-A owns $100,000 or a 20% undivided interest, Party-B owns $50,000 or a 10% undivided interest, Party-Cowns $200,000 or an undivided 40%, and so on up to 100% ownership. All investors own their distributive share as tenants-in-common.
The trust deed will be recorded with the fractional investors named as beneficiaries. The recorded document will become a matter of public record. Also, all fractional investors will be named as insured beneficiaries on the title insurance policy.
An investor who purchases a one or multiple trust deeds up to $1,000,000 may have an average monthly yield of 8%, with a monthly cash flow of $6,667 to assist in their financial quality of life. Usually, other investments that yield 8% or more may require additional risks, management involvement, and responsibility.
Who may invest? Individuals, trustees on behalf of a family trust, corporations, LLC’s, IRA’s, 401k’s, and pools (securities) consisting of many investors created for the sole purpose of investing in trust deeds or mortgages.
What Disclosures Should an Investor Expect?
Each lender/investor will receive a material disclosure package that summarizes the proposed loan transaction, borrower(s) application, credit report, financials, preliminary title, loan documents, and related federal and state disclosure documents. Investors should make an informed decision to invest after reviewing the entire package. The lender/investor should base their decisions upon their background of knowledge, experience, and assessment of the risk/reward.
What Should Investors Expect from a Loan Servicing Agent?
An essential part of an investor’s decision to invest rests with the competency of the loan servicer. Do they have the background, knowledge, and experience to handle unanticipated loan servicing problems and to communicate with the borrowers, investors, and third-party vendors about decisions to protect the interest of all?
As part of the funding and closing of a trust deed investment, the investors will enter a loan servicing relationship with the trust deed broker or servicing agent. The investor will agree to covey multiple delegated rights (rather than absolute rights) to the servicing party to take specific actions that protect the investors interest.
Conveying delegated rights to the servicing agent is similar whether there is one investor or multiple investors. The agreement to delegate rights to the servicing agent will include: a) giving the servicing agent the authority to collect borrower’s interest payments, b) depositing them into the broker’s trust account, c) forwarding payments to the investors their portion of the interest payments, or loan payoffs, d) communicate with borrower parties about the status of any late payments, due dates, e) monitor the payment of property taxes, property insurance, e) and handling the loan payoff with final distributions of the payoff proceeds upon maturity.
The servicer may also electronically deposit payments directly into an investor/lender’s bank account if the investor chooses.
These delegated rights are written into a loan servicing agreement, and should include the following:
- Appointment of a loan servicer to manage the collection and payments process.
- Definition of the relationship between the servicing agent and the principal party. The servicer is an agent and fiduciary of the investors/lenders.
- Instructions that allow the servicer to receive funds from loan payoffs to be deposited into a brokerage trust account and dispersed to the principals (investors).
- Instructions about what actions to take by the servicer, in the event of borrower default.
- Authorization for serving agent to hold original loan documents safely, such as a designated fireproof and tamper-proof safe.
- Provisions for a limited power of attorney relating to the servicer’s authority to carry out and enforce the terms of the loan documents.
The day-to day-management of a loan servicer is made much easier by a dedicated loan servicing software package designed for single and multiple/fractional investors. Loan origination, active monthly payment collections, the investor’s ability to check the payment status online, and loan payoff demands can all be software-driven.
Investors can expect to receive monthly communication from the loan servicing broker with interest payments or communication about the disposition if payments are not received timely. The mortgage brokerage will be full-service in many cases, handling all functions from procuring new loans, lender/investors interface, and loan servicing. If the lender/investor is dissatisfied, they will not reinvest. Here lies the mortgage broker’s life pressure to perform professionally every day.
Additional Reading
Supporting articles written by Dan Harkey intended to help interested parties gain knowledge of private party real estate lending. Any of these articles will be forwarded upon request.
- “Liens and Encumbrances Affecting Real Property Transactions.” A Discussion of the difference between a first and second trust deed and lien priorities can be found in this article.
- “Private Money Real Estate Loans: An Overview of Good Reasons.’ There are many reasons for a borrower to pay more for a private party loan than a bank loan.
- “The Capitalization Approach to Income Property Valuation”
- “Business Purpose vs. Consumer Purpose Lending: An overview”
- “DBO Was Renamed DFPI and CCFPL.” During the 2019/2020 California Legislative Session, AB-1864 was enacted, renaming the Department of Business Oversight (DBO), formerly identified as the Department of Corporations (DOC), to the Department of Financial Protection and Innovation (DFPI). This measure added the California Consumer Financial Protection Law (CCFPL) subject to regulation and enforcement by the DFPI.
This article is an overview for a general educational purpose only. The information presented should not be relied upon without the advice of counsel.
Dan Harkey is a contributing author to Weekly Real Estate News and is a Business & Financial Consultant. He can be contacted at 949-533-8315 or [email protected].
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