The Pitfalls of Trust Deed Investing - Pitfall 1
Updated: Apr 19, 2021
Who is your broker really working for?
The comments are all too familiar. "It’s too good to be true...”
“You’re going to lose all my money in that real estate deal…”
“Trust Deed investments are for suckers…”
“Real estate investing is too much work with minimal financial reward…”
If you know what the pitfalls are then you will know how to avoid them and experience the success of investing in real estate. The next few blogs will discuss 3 pitfalls and solutions that every aspiring real estate investor should know.
PITFALL #1 - Conflict of Interest
A conflict of interest may arise with how and when the mortgage broker is paid. Does the mortgage broker consider the borrower or the investor to be their client? Can it be both? Should it be both? That is for you to decide. Mortgage brokers seek or are approached by homebuilders and developers (borrowers) that need financing for their real estate project(s). Mortgage brokers also advertise for investors to lend their money to these borrowers with the intent to invest in a collateralized real estate investment earning passive income. The mortgage broker serves as the middle person in the real estate transaction to bring the borrower together with the investors to fund the real estate transaction. This is a standard practice with mortgage brokers that offer Trust Deed investments. The conflict of interest comes when a mortgage broker arranges the closing of the transaction to include and exorbitant origination fee at a rate of 6 to 10 percent of the loan amount. This may not seem like much, but when you look at how this correlates to the payday for the mortgage broker it may begin to matter to you. A $3,000,000 real estate transaction at an 8% origination fee charged by a mortgage broker, equals $240,000. This is a lucrative payday for the mortgage broker prior to you experiencing the investment performance of the real estate loan. This is not to say the mortgage broker should not get paid for originating and underwriting the loan. Where the concern arises is when the mortgage broker does not service the loan and they pass the servicing on to another company, hence getting paid upfront and walking away with $240,000. Why not stay involved? The mortgage broker should know the loan better than anyone else as they completed the underwriting process and should be able to stand behind the loan they underwrote.
Ask yourself, “Who is the mortgage broker really working for?” If they are getting paid by the borrower upfront to sell the loan to investors and have no interest in the loan performance, the mortgage broker is only incentivized to sell the loan to investors. If they are not servicing the loan, their client is the borrower not the investor. The mortgage broker has no incentive to make sure the loan they are selling to the investors is of high quality. Therefore, what is the incentive to the mortgage broker to uphold quality underwriting standards? What is their incentive to make sure that the investors will get their interest paid on-time and principle returned? There is not any. With this type of mortgage broker their job is over before your investment begins. They outsource the servicing of the loan and move on to the next real estate transaction to pay them a large payday. This is referred to as ORIGINATE, FUND and DONE!
“If they are getting paid by the borrower upfront to sell the loan to investors and have no interest in the loan performance, the mortgage broker is only incentivized to sell the loan to investors. If they are not servicing the loan, their client is the borrower not the investor.
If you are the investor what happens next? The mortgage broker has outsourced the servicing to another company to collect payments from the borrower. The loan servicer is responsible for collecting the payments from the borrower of which they earn an agreed upon servicing fee and then distribute the remaining interest payments to the investors. If the borrower continues to make regularly scheduled interest payments everything is great. The servicing company is happy because they are getting paid, and you are happy because you are getting paid. But what happens if the borrower stops making their payments? You are not going to receive your regularly scheduled interest payments and the servicing company is no longer going to get their fee for servicing the loan. When the servicing company stops getting paid, they have a few options; wipe their hands of the loan and sell the loan to a collection company, communicate to the investors that they need to send in an assessment of costs to the servicing company to attempt collection of the property, or worse, hand the loan over to the investors and suggest they find an attorney to begin the foreclosure process. Do any of the options sound good to you? And where is the mortgage broker who sold you this investment?
Let us consider those three options. The first option was to sell the loan to a collection company. No need to wonder what they are going to charge you to sell the loan because a little research will tell you that they will collect a commission upon the sale of the property of up to 6% in addition to recouping any hard cost spent to take back the property. When do you see your original invested amount returned to you? Well, that all depends on the sales price the collection company negotiated for the property. This amount could also be defined by the market conditions at the time. If the market conditions are good and they sell the property above the original loan amount and there are additional proceeds from the sale after the 6% commission and the hard costs, then the collection company may return 100% of your original invested amount and keep the rest. What…? Keep the rest. Yes, you read that correctly. That is the reward they get for doing a good job. Were you expecting something different? Well, you should because this again goes back to the pitfall of the mortgage broker who walked away from you after getting paid the origination fee.
The second and third scenario are not much better and arguably worse than the first. Can you imagine getting 100% consensus on a capital call to cover expenses of a foreclosure or 100% consensus from all investors as to the direction to proceed. Getting every investor to pay their prorated share of the expenses and having them collected by a reputable representative that knows the proper course of action and allocates the investors funds with their best interests in mind to successfully take back the property is like giving a 2-year-old $100 and asking them to hold on to the money for you for 4 months until you ask for it back. You are certainly taking your chances with the outcome. Or how about electing one investor as the representative for a group of 50 investors to determine the best course of action. This person would be taking the input and consensus of 50 people to make decisions on; how to proceed with taking back the property, cost allocations amongst the group, and the sales price accepted for the property which will ultimately determine the capital return to the investor, good or bad. When is the last time you have heard of a group of 50 people who were all on the same page when it comes to money?
Where is that mortgage broker that sold you that investment? Nowhere to be found. This pitfall helps make the familiar comments of “You’re going to lose all my money in that real estate deal…” or “Real estate investing is too much work with minimal financial reward…” a very possible reality.