This article explains how California real estate licensees earn fees arranging business-purpose trust deed investments.
Lessons from the past in private lending
Every recession for the past four decades saw a brisk cyclical upturn in hard money trust deed lending. As we head into the 2023 recession, this time around will prove no different as real estate loses liquidity and cash again becomes king.
Most recently, low interest rates ensured that mortgages for funding the cash needs of buyers and owners were exclusively originated through bond market mortgage pools and institutional investors. As rates jumped in 2022 — returning to a long-term cyclical rise that began in 2013 — a pivot occurred in both the nature of mortgage money sought by real estate owners and buyers and the source of cash to fund those mortgages.
2022 rate increases in FRM and ARM financing have forced conventional buyers to abandon the market and put an end to ATM-like refinancing by owners. Conventional mortgage financing has now driven property sales volume and prices on all types of property into a stark decline, dragging conventional financing activity and related fee-generating services down with them.
At some point in time, likely by end of 2024, property prices will look like a bargain by today’s standards. This will quickly bring out the long-patient private investors, a combination of long-haul income property buyers and professional speculators seeking profits in a resale from market momentum alone.
No longer will mortgage loan broker (MLB) services be primarily for the “safe” consumer-purpose mortgage environment of mortgage loan originators (MLOs) where institutional sources fund home buyers and owners. The dominant near-future mortgage lending picture will be a riskier, more arduous, and more profitable lending environment dependent on private money sources for funding.
Further, the attitude of brokers who prepare mortgage loan marketing packages for funding also changes in a shift to far greater scrutiny. Packaging a consumer-purpose mortgage demands little analysis by a federally registered MLO compared to the extensive detail and analysis demanded by a private lender solicited by a broker acting as a mortgage loan broker (MLB) to fund a business-purpose mortgage.
Owners and buyers of income producing properties ranging from SFRs through all types of commercial property — apartments, offices, retail, industrial and farming property — will need cash. Conventional sources will not stay in or step in during a recession. This is where private money opens up as the source of funding.
Consumer-use mortgages are not the realm of private lenders
The distinction between a consumer mortgage controlled by Federal Mortgage law – arranged by MLO endorsed Department of Real Estate (DRE) licensees – and a business mortgage controlled by California mortgage law must be comprehended. A consumer-use mortgage is established by the borrower’s intended use of the funds to finance the purchase or improvement of a home the borrower with occupy and become security for the funds.
All other purposes for borrowing are business-use mortgage originations — including funds invested in income producing property as discussed in this article. The type of property liened by a trust deed to secure a business-use mortgage is not a distinguishing factor.
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To avoid claims that funds were for consumer-use purposes when the borrower’s personal residence is security for repayment, the MLB requires the borrower to enter into a Loan Purpose Statement. Thus, the broker arranging a business mortgage confirms the borrower is not using the funds to purchase or improve the borrower’s personal residence. On funding, disbursement of the funds needs to be consistent with this purpose. [See RPI Form 202-2]
Yet, the vast majority of brokers, agents and MLOs practicing today have never been trained on or even exposed to private money mortgage lending.
To remain relevant in the coming years of rising interest rates — particularly the next two-to-three recessionary years when investors will make up a significant chunk of real estate transactions — let this be your introduction to negotiating and originating hard money trust deed mortgages of the business-use variety controlled by California rules — not federal mortgage rules.
DRE licensees earn fees arranging hard money mortgages
Hard money lending opens doors for MLO-endorsed DRE licensees. It’s also an opportunity for DRE licensees who do not have an MLO endorsement.
A huge advantage held by a DRE licensee, whether or not MLO endorsed, is that the mortgage arranged — negotiated — by a DRE licensed broker is exempt from California’s 10% usury law interest rate cap. Thus, mortgages originated or modified by a private lender as arranged by a real estate broker may provide annual earnings at a rate exceeding the 10% usury rate ceiling.
Editor’s note — The amount of interest — total annual earnings — a private, non-exempt lender may bargain for and receive is limited to 10% annually by statute and the California Constitution. Collectively, these are referred to as usury laws. [Calif. Constitution, Article XV; Calif. Civil Code §1916-1 through 1916-5]
An investment in a trust deed note
Investors looking for income at higher yields from management-free real estate investments often consider investing cash in trust deed notes with fixed interest rates, particularly during periods of illiquidity for property assets. Thus, during recessions, trust deed investments present a lower risk of loss than an equity position in ownership — but only when brokers and money lenders adhere to sufficient loan-to-value ratios.
A trust deed private money lender invests in a trust deed note in one of three ways, by:
- funding the origination of a mortgage, evidenced by a note executed in favor of the investor and secured by a trust deed lien on real estate purchased or owned by the borrower;
- buying an existing trust deed note on a full assignment from the holder of the note; or
- making a collateral loan evidenced by a note executed in favor of the investor and secured by collateral assignment of an existing note and trust deed lien on the described real estate.
A negotiable instrument, such as a promissory note secured by a trust deed lien on property, contains a promise to pay scheduled dollar amounts of interest and principal to the holder of the note. A trust deed note, being a negotiable instrument, may be sold and assigned to others, such as a trust deed investor.
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Private mortgage money and a seller’s carryback trust deed note
Buying a note and trust deed, such as a carryback mortgage, can be a reliable and profitable investment for trust deed investors, also called private money lenders or hard money lenders.
Hard money lenders typically lend their cash for short periods of time, say, one-to-two years when any remaining unpaid principal is due, called a hard money mortgage. Since most carryback notes are not due for longer periods of time, private lenders do not generally buy the carryback trust deed note or do so with a steep discount.
Rather, the lender makes a collateralize loan evidenced by a note and secured by the seller’s carryback note. Here, the seller retains ownership of the note, but note payments received apply to the debt owed to the private party lender. The result is a shorter payoff period for the collateralized loan than the trust deed note pledged to secure it. Of course, the amount lent against the trust deed note is a fraction of the amount of the trust deed note.
These short-term loans are generally funded by the private lender’s own funds or a line of credit. Private hard money lenders are not institutional lenders but may include small local financial institutions. [See RPI e-book Mortgage Loan Brokering and Lending, Chapter 40]
A trust deed investor assisted by an MLB when acquiring an existing trust deed note, such as a seller’s carryback note, is a transaction comparable to a buyer who enters into a purchase agreement to purchase property with the assistance of a sales agent. Thus, the trust deed broker who locates and solicits an investor owes a duty to the investor to advise of all facts that might have an adverse affect on the value of the note tp the investor, called material facts. [See RPI Form 241]
The trust deed broker – MLB – gathers information provided by the note holder or their broker and reviews the information with their investor. On setting the terms for purchase of the note, the broker prepares an offer on a purchase agreement form for the acquisition of the note and trust deed for the investor’s signature and submission. [See RPI Form 241]
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Information gathered and reviewed includes:
- the terms of the trust deed note;
- the existing title policy insuring the trust deed; and
- a profile on the real estate which is security for the note and broker’s price opinion (BPO).
Editor’s note — A broker is employed by a note holder to act as their exclusive agent to negotiate the sale of the note by entering into a trust deed listing agreement. Without a written employment agreement signed by the client a fee is not collectible from the client by enforcement. [See RPI Form 112]
Mortgage loan brokers do trust deed notes
Consider a mortgage loan broker (MLB) – a DRE licensed Broker – who enters into a listing agreement, employed by the owner of an income producing property to arrange a loan secured by the property for a stated fee. [See RPI Form 104]
The MLB prepares a loan package and solicits a hard money lender who agrees to fund the mortgage sought by the owner. The lender receives the owner’s note as evidence of the debt and a trust deed insured by a title policy as a lien on the property to secure repayment in the event of default on the note.
The hard money lender handles the collection of payments on the note. Later, the lender decides to sell the trust deed note and contacts the MLB.
The MLB is able to locate a trust deed investor willing to purchase the lender’s trust deed note. The MLB, acting as authorized by their DRE license as a trust deed broker, negotiates the sale of the trust deed note.
The originating lender receives cash, and the trust deed investor is assigned and receives the note, trust deed and a title insurance policy. Further, the MLB enters into a loan servicing agreement with the investor to handle collection on the trust deed note — for a fee. [See RPI Form 237]
The owner of the real estate securing the mortgage is notified by the MLB of the assignment of the trust deed note to the new mortgage holder. The property owner is also advised to make future payments to the broker under the loan servicing agreement. [Calif. Civil Code §2937(a); Calif. Commercial Code §9318(3); see RPI Form 238]
Repayment on a default
A hard money mortgage is typically a short-term business-purpose mortgage with a due date for all monies due in three years or less, often one year.
These short-term mortgages generally have high interest rates and upfront costs. The borrower pays the MLB fee, not the lender. The source of the MLB fee most often is received as a discount from the mortgage funds, often called points.
A private trust deed lender’s reasons for lending are not usually based on traditional credit guidelines as are consumer purchase-assist loans originated by institutional lenders. Likewise, private lenders do not have access to default insurance coverage.
Rather, for repayment on a default, the trust deed note holder relies primarily on the value of their security interest held under a recorded trust deed encumbering a position on title to the property — a first or second trust deed lien — to recover their investment in a foreclosure scenario. Occasionally, at the time of a default the property value is insufficient to cover the remaining unpaid debt, and a deficiency is incurred by the note holder.
To collect the amount of the deficiency the note holder turns to their secondary source of recovery: the personal assets of the person who signed the trust deed note. However, to pursue recovery of a deficiency in the value of the property to fully satisfy all sums due, the trust deed holder must complete a judicial foreclose and be awarded a deficiency judgment which they use to enforce collection. Thus, the note holder forgoes the fast recovery remedy of a trustee’s foreclosure sale as a trustee’s sale is a bar to collecting a deficiency.
Hard money mortgages are commonly used to fund real estate purchases by investors who rehabilitate property for resale, called flipping. Typically, they or the property do not presently qualify for conventional financing.
Often, hard money mortgages are evidenced by a straight note, commonly referred to as a bridge loan. A straight note does not call for the property owner to make periodic payments. Thus, the owner is able to complete repairs and either sell the property or refinance before the bridge loan is due. When due, all principal plus accrued interest is paid in a single lump-sum payment. [See RPI Form 423]
Trust deed dealer
A trust deed dealer is in the business of acting on their own account to buy and sell trust deed notes and land sales contracts, sometimes called flipping paper.
Unlike a trust deed broker, a trust deed dealer acts solely as a principal. However, a trust deed dealer buying and selling trust deed notes is required to hold a DRE broker license when:
- they buy, sell or exchange eight or more trust deed notes during a calendar year; and
- a broker has not been retained to negotiate the assignments. [Bus & P C §10131.1]
When a broker is not involved, the trust deed dealer is required to hold a broker license even though they do not act as an agent for anyone. You can never be an agent for yourself, as an agent is another person who acts on your behalf.
Conversely, an individual is not labeled a trust deed dealer and need not be a licensed DRE broker when they:
- resell trust deeds to the public through a DRE-licensed broker; [Bus & P C 10131.1(b)(1)(B)] or
- acquire and hold the paper — trust deed notes — as a long-term investment. [Bus & P C 10131.1(b)(1)(A)]
A trust deed note assigned as collateral for a loan
A trust deed lender may make a loan to a borrower secured by a trust deed note held by the borrower, called a collateralized loan. This is a transaction a real estate broker or their agent may arrange for a fee.
Conceptually, a loan collaterally secured by an existing trust deed note is indirectly secured by real estate. To clarify, when the collateralized loan becomes delinquent, the lender repossesses the trust deed note taking ownership for the trust deed note, not the underlying real estate described in the trust deed.
Also, a default on the collateralized loan is not in default on the note and trust deed securing the loan. On repossession of the collaterally assigned trust deed note due to a delinquency in the collateralized loan, the lender becomes the holder and owner of the trust deed note repossessed to satisfy the collateralized loan.
Consider a carryback seller who holds a note and trust deed received on their installment sale of a property. The carryback seller wants to retain ownership of the note as a steady source of income, not sell it at a steep discount. To borrow money, the carryback seller who holds the trust deed note assigns the note and trust deed to a lender as collateral pledged to secure the loan, a process called hypothecation or collateral assignment.
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Thus, the trust deed lender’s sole security for repayment of the loan to the carryback seller is ownership of the existing carryback trust deed note — not the real estate. To document the collateralized loan transaction, the borrower signs and delivers to the lender a collateral note and security agreement to evidence the debt owed and pledge the trust deed note. [See RPI Form 438]
The borrower also signs a security device which is filed with the country recorder where the real estate is located. The recording puts others on notice of the security link between the new loan and the existing note and trust deed, called a Collateral Assignment of Deed of Trust (and note). [See RPI Form 446]
On a default in the collateralized loan, the trust deed lender repossesses the trust deed note since it is the security for the loan. Again, the lender does not foreclose on the underlying real estate.
Due diligence for trust deed acquisitions
Private lenders either fund the origination of a business mortgage, purchase an existing trust deed note, or make a loan collaterally secured by an existing trust deed note. The trust deed broker presenting one of the investment opportunities to a lender needs to complete a due diligence investigation and documentation for submission to the private lender before the lender advances funds for an origination or a purchase or hypothecation of a trust deed note.
The stages for packaging and arranging a trust deed investment include:
- due diligence investigations into the value of the real estate interest to be pledged as security for recovery of money owed when the property owner defaults on the trust deed note — conditions adversely affecting the property’s value;
- the broker price analysis (BPO), supporting comparative market analysis (CMA) and current profit and loss (P&L) operating statement;
- the borrower’s balance sheet for analysis fo value in other assets; [See RPI Form 318]
- payment history on mortgages with priority to the security interest to be pledged to the private lender;
- any trust deed note purchase agreement or agreement to hypothecate a trust deed note [See RPI Form 241 and 242];
- loan escrow instructions and preliminary title report; and
- any loan servicing agreement employing the broker for the private lender to consider.
During all stages of a trust deed investment analysis and documentation, the trust deed investor needs information concerning the risks and values connected with:
- the property owner’s payment history on any trust deed note with priority;
- the real estate’s attributes, including its physical condition, environmental conditions, title profile, zoning, surrounding area and rental income conditions;
- the borrower’s creditworthiness; and
- the ownership history for any note and trust deed assigned as collateral.
A trust deed broker is retained by a trust deed investor to locate trust deed investments by entering into a written employment agreement. The broker locates owners and buyers needing additional financing, performs a due diligence investigation and documents the process to review with the trust deed investor the risk of loss margin required on the mortgage investment. [See RPI Form 112]
A trust deed broker likely has an inventory of trust deed note listings fully packaged for submission to private lenders for consideration under a transmittal letter. [See RPI Form 233]
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Very educational and impressive article