Part II of this article series analyzes the investor’s and their mortgage loan broker’s (MLB’s) need to investigate and analyze conditions which affect the trust deed note’s and the property’s value.
For insight into the due diligence investigation to be conducted by a MLB into a trust deed note available for purchase by their trust deed investor, see Part I of this article series.
The condition of title and past activity
A property profile obtained from a title company discloses the trust deed liens of record which were recorded prior to and after the trust deed securing the note was recorded. Any recorded assignment or subordination of a trust deed will be reflected, including any affecting the trust deed securing the note. However, a property profile is not to be relied on as a guarantee or warranty that the title is as represented.
The property profile discloses the current vesting, general and special taxes, assessments, bonds, encumbrances and liens of others which are recorded against the property. This is crucial information for the mortgage loan broker (MLB) to present to the investor since the risk of the owner’s default increases as the property is further encumbered with liens.
A further check of the county recorder’s general index through the title company, usually done by obtaining a preliminary title report, will disclose any involuntary judgment liens that have attached to title under this or a prior ownership. As with a property profile, a preliminary title report is not a guarantee, warranty or representation that the title is subject to the liens reported or that the report includes all the liens that might affect title to the property.
The MLB’s review of the title insurance policy held by the seller of the trust deed note confirms the trust deed’s priority on title (but does not cover the investor if they acquire the trust deed note as they are not a named insured).
Although an assignment of a junior trust deed does not itself trigger due-on clauses, a copy of any senior trust deed received from a title company is reviewed to confirm the existence and nature of the senior mortgage holder’s due–on rights to challenge the original creation of the junior trust deed being purchased.
The mortgage holder may call the mortgage due on discovery of the junior lien if:
- the senior mortgage holder’s trust deed contains a due-on provision; and
- the property owner did not obtain the mortgage holder’s written consent for the junior trust deed.
The senior mortgage holder may also call the mortgage due if the buyer in a carryback financing arrangement did not formally assume the senior mortgage on the sale of the property. If the buyer did assume the senior mortgage and the junior trust deed was not referenced in the purchase agreement or escrow instructions, the senior mortgage holder can call the mortgage on discovery of its existence since it was not known to them on entering into an assumption agreement.
Such a conflicting position with the mortgage holder requires the trust deed investor to resolve the due-on issue with the seller of the junior trust deed note before proceeding with their purchase of the note.
If a due-on clause exists in the senior trust deed, the MLB ascertains whether the senior mortgage holder has either:
- consented to the recording of the junior trust deed as a further encumbrance on the property; or
- waived their right to call the mortgage due.
When mortgage rates are rising, the junior trust deed investor needs to appreciate that the due-on clause in the senior trust deed is a time bomb. If the property owner does anything to trigger the first trust deed’s due-on clause before or after the investor acquires the trust deed note, the senior mortgage holder may either:
- call the mortgage, demanding the full amount remaining due to be paid immediately, also known as acceleration; or
- recast the mortgage, requiring a modification of the note’s terms as a condition for the mortgage holder’s consent to a transfer, called a waiver by consent.
Thus, the investor has to be ready to absorb the risks of funding a payoff or negotiating a modification of the senior trust deed note, unless the lender has previously consented to the existence of the second.
Due-on waivers from the underlying mortgage holder are required documentation to protect the trust deed investor’s junior position on title to the property.
A written waiver of the senior mortgage holder’s future enforcement of the due-on clause bars them from calling the mortgage and protects the investor while they have an interest in the property. The waiver agreement assures the investor they can protect their security interest in the title without due-on interference from the senior mortgage holder. [See first tuesday Form 410]
To best protect their trust deed, the investor needs to have the senior mortgage holder waive their right to call the loan:
- on the conveyance and further encumbrance of the property;
- for as long a period as the investor has a position on title to the property; and
- on the investor’s acquisition of title to the property if the investor has to complete a foreclosure on the property or accepts a deed-in-lieu of foreclosure.
The waiver needs to be in writing to be enforceable against the senior mortgage holder. [12 Code of Federal Regulations §591.5(b)(4)]
Further, a due-on clause in the junior trust deed being acquired by assignment protects the investor if the property owner later sells or further encumbers the property. Without a due-on clause, the investor is forced to accept a new owner (one who is potentially less creditworthy) or a further encumbrance of the property by the owner, possibly creating an unreasonable risk of loss due to the owner’s diminished equity in the property.
However, on an owner-occupied, one-to-four unit residential property, the creation of a junior lien when the property owner continues to occupy the property does not trigger due-on enforcement. Thus, the senior mortgage holder’s due-on enforcement based on a further encumbrance of an owner-occupied, one-to-four unit residential property is not permitted, even though the owner’s equity in the property is diminished. Conversely, any foreclosure sale by the junior mortgage holder triggers the senior trust deed’s due-on clause. [12 CFR §591.5(b)(1)(i)]
The trust deed note’s loan-to-value ratio
The loan-to-value ratio (LTV) of a trust deed note indicates the extent of the investor’s risk of loss on the note. The risk arises when a deficiency exists in the secured property’s value on a default.
The LTV represents the amount of the note’s principal, together with amounts of any senior mortgages, stated as a percentage of the secured property’s value.
The LTV is calculated as follows:
- add the price the investor intends to pay for the note (not the note’s unpaid principal) to the total amount of principal unpaid on any senior mortgage of record; and
- divide this total dollar amount by the current fair market value (FMV) of the property.
For example, a second mortgage purchased for $50,000 is added to unpaid senior mortgages totaling $150,000 for a total of $200,000 in encumbrances. This total mortgage debt is then divided by the property’s value of $250,000. The result is an LTV of 80%.
MLBs need to take into consideration the LTV ceilings on syndicated trust deed note investments:
- 80% for owner-occupied, single family residences (SFRs);
- 75% for non-owner occupied SFRs;
- 65% for commercial and income-producing property;
- 65% for single family, residential-zoned lots or parcels;
- 50% for undeveloped commercial- or residential-zoned land;
- 35% for other real estate; or
- the percent of value set by any private mortgage insurance (PMI) coverage issued for the note. [Calif. Business and Professions Code §10238(h)(1); see first tuesday Form 234]
Editor’s note — Unique circumstances may exist allowing the MLB syndicating a trust deed note investment to exceed the statutory LTVs if they can justify in writing their reasons for exceeding the limits. However, the LTV must never exceed 80% of improved real estate or 50% of unimproved property, except for single family, residential-zoned vacant parcels for which the LTV cannot exceed 65%.
The MLB keeps the statement containing the justification for exceeding the LTV limits in their files. They also provide the trust deed investors with a copy of the LTV statement as an attachment to the lender disclosure statement. [Bus & P C §10238(h)(2); see first tuesday Form 235-2]
Conditions affecting property value
It is foreseeable a mortgage holder may have to foreclose and become the owner of the real estate securing the trust deed note if a default occurs on either the note or trust deed.
Thus, a mortgage holder’s interest in the real estate which secures performance of the trust deed note is significant. The real estate interest liened by the trust deed – fee or leasehold, first or second – is the source of recovery which minimizes the mortgage holder’s risk of loss on a default.
An investigation into the conditions affecting the value of the secured property, by the trust deed investor or by their MLB, is required to analyze the risk of loss if the investor has to resort to the real estate to recover their investment.
The conditions of the secured real estate are reflected by:
- the physical condition of the property [See first tuesday Form 304];
- title conditions;
- the income and expenses the property produces [See first tuesday Form 352]; and
- the location and area surrounding the property.
The MLB needs to provide the investor with an estimated FMV of the property securing the note either by:
- independent appraisal; or
- the MLB’s written estimated FMV including the objective data used to determine the FMV, if the investor first waived the requirement of an independent appraisal in writing. [Bus & P C §10232.5(a)(2),(3); see first tuesday Form 318]
Also, the MLB has a general duty to disclose to the trust deed investor any adverse conditions of the property which might affect the investor’s decision to purchase the trust deed note, or which affect the note’s value. [Barry v. Raskov (1991) 232 CA3d 447]
Physical condition of the property
The MLB needs to encourage the trust deed investor to personally inspect the property and observe its location and improvements. Prudent practice calls for the MLB to walk through the property with the investor. If the real estate securing the note is improved commercial property, the investor will usually have adequate access to the interior to view its care and maintenance while inspecting the exterior.
For residential property, the investor may, at the least, visit the property and assure themselves the exterior is being cared for and maintained.
When a trust deed investor purchases carryback paper, it is an acknowledgement the trust deed note was created to pay for real estate. Faced with this fact, the investor and the MLB automatically request:
- a copy of the condition of property disclosure the seller handed to the buyer [See first tuesday Form 304];
- a copy of the annual property operating data (APOD) for income property presented to the buyer [See first tuesday Form 352]; and
- a copy of the escrow instruction used in the sale which created the carryback mortgage.
With a quick review of these disclosures and documents, the MLB can determine both the physical condition and net operating income (NOI) of the property at the time of the sale. They can also determine whether irregularities on the sale may have taken place presenting a defense to payment of the carryback note.
Further, a trust deed investor needs to be wary of investing in notes secured by property located outside geographic areas they are familiar with. The investor who is not familiar with an area will find distance a barrier to thorough inspection and investigation of the secured real estate.
Location and surrounding area
Consider the trust deed investor who investigates the conditions of the real estate securing a trust deed note offered for sale. The investor is satisfied with the physical condition, operating data and appraised value of the secured real estate. However, the property is in a neighborhood and urban area experiencing deterioration in property resale values.
The location and economic status of the area surrounding the secured real estate materially affect the value of the investor’s security. Thus, an analysis of the location of the property must be included in an investigation of the property.
A visual inspection of the surrounding neighborhood gives the investor an impression of the future direction of the secured property’s value. As an indicator of value, the investor’s observations of the location are factored into their determination of price and their decision to buy the trust deed note.
However, an MLB needs to avoid inducing elements of improper discrimination when referencing the surrounding neighborhood. They must never call attention to a particular classification of people as influencing the value of the property, whether positive or negative. [Calif. Government Code §12955]
Further, a broker is not required to disclose the existence of a licensed care facility, such as a Residential Care Facilities for the Elderly (RCFE), which serves six or fewer people, operating in an SFR in the area. This too fosters unacceptable and unrealistic discrimination.
However, the broker may choose to disclose the location of a facility in a factual manner, without opinion or innuendo which fosters discrimination. [73 Ops.Cal.Atty.Gen. 58 (1990)]
Licensed care facilities for six or fewer people need to be treated as any other SFRs. [Calif. Health and Safety Code §1566 et seq]
Property income and expenses
If the trust deed note being purchased is secured by income-producing property, the investor also needs to:
- obtain current income and expense data on the property [See first tuesday Form 352]; and
- review the existing rental and lease agreements.
The investor’s MLB has a duty to disclose financial information affecting the property owner’s ability to pay the mortgage. Income and expense information on rental properties, such as contained in an APOD, inherently affects the owner’s ability to make mortgage payments. [Calif. Bureau of Real Estate Regulations §2785(b)(2)(c)]
The MLB or the investor need to request and obtain rental property operating information from the property manager, or compile the information from other sources, such as:
- the property owner’s books; and
- utility companies, maintenance firms, property management and homeowners’ associations.
For a discussion about the MLB’s need to conduct due diligence investigation into a trust deed note available for purchase by their trust deed investor, see Part I of this article series.