Discover how to invest in trust deed notes in this two-part series.
Part I of this article series discusses the various methods of investing in trust deed notes and the due diligence investigation and documentation needed for the purchase of an existing trust deed note.
For insight into escrowing the assignment of a trust deed note, see Part II of this article series.
Note and trust deed assignments
Trust deed brokers may consider soliciting individuals who now invest their money in interest-bearing opportunities to consider trust deed note investments. With higher yields and low-risk conditions, individuals do invest directly in trust deed notes, sometimes called paper, rather than buy mortgage-backed bonds (MBBs).
A trust deed investor, acting independent of Wall Street’s MBB market, invests in trust deed notes. To invest in trust deed notes, they use a trust deed broker to assist them with:
- making a loan evidenced by a note in favor of the investor and secured by a trust deed lien on real estate, a process called origination;
- buying an existing trust deed note, called an absolute assignment; or
- making a mortgage-backed loan (MBL) evidenced by a note in favor of the investor and secured by an existing note and trust deed held by the borrower, called hypothecation.
A trust deed as collateral for an MBL
A loan evidenced by a note in favor of the lender, collaterally secured by a trust deed note held by the borrower, called a mortgage-backed loan (MBL), is a loan indirectly secured by real estate. Thus, an MBL, collateralized by a trust deed note and in tandem secured by real estate, is a mortgage-related transaction a trust deed broker may arrange for a fee.
Distinguished from the ownership of a trust deed note, the repayment of an MBL note is secured by a trust deed note. It is the trust deed note, not the underlying real estate, that is repossessed on a default in the MBL note.
Here, the trust deed note secured by the real estate need not also be in default for the MBL note to be in default. On repossession of the hypothecated trust deed note due to a delinquency in an MBL note, the MLB noteholder becomes the owner of the trust deed note in full or partial satisfaction of the MBL they made.
For example, consider a seller who holds a note and trust deed they carried back on an installment sale of property. The carryback seller wants to borrow money for a short term, but does not want to sell the carryback note to obtain the needed funds. To borrow money, the seller offers to pledge by collateral assignment, not an absolute assignment as in a sale, the note and trust deed as security for the loan. [See first tuesday Form 438]
The MBL made by the lender is evidence by a new note (together with a security agreement linking the MBL to the trust deed note). Repayment of the MBL is secured only by the seller’s carryback trust deed note. Thus, on a default in the lender’s MBL, the lender repossesses and becomes the owner of the trust deed note — not the underlying real estate described as security for the hypothecated trust deed note.
Stages of trust deed investment
Whether an investor purchases a trust deed note or makes a loan collateralized by a trust deed note, the investor and their trust deed broker need to consider the due diligence investigation a prudent trust deed investor needs to undertake to purchase or lend on an existing trust deed note.
The stages of this trust deed investment include:
- due diligence investigations;
- entry into a trust deed purchase agreement or agreement to hypothecate [See first tuesday Form 241];
- loan escrow instructions, funding and closing; and
- servicing, reconveyance and foreclosure.
During the due diligence stage of a trust deed investment, the trust deed investor and their broker need to document and analyze the risks connected with:
- the payment history on the trust deed note purchased or collaterally assigned;
- the real estate (physical, title profile, income, location, value);
- the borrower’s creditworthiness;
- the signatories to the note and trust deed; and
- title insurance for the assignment.
An investor’s use of a trust deed broker retained under an employment agreement to assist with the due diligence process and analysis reduces the risks inherent in acquiring a trust deed note. Also, a trust deed broker typically has an inventory of trust deed note listings fully packaged under a transmittal letter for investors to consider. [See first tuesday Form 233]
The trust deed listing agreement
Trust deed noteholders, particularly carryback sellers, often decide to sell their trust deed notes. The task of cashing out a trust deed note investment requires a trust deed investor to be located who is interested in acquiring the note.
A trust deed broker employed to work diligently to locate an investor and negotiate a sale of a trust deed note for a fee needs to enter into a trust deed listing agreement with the noteholder. The listing agreement spells out what the noteholder can expect the broker to do and provides the broker with a fee agreement. [See first tuesday Form 112]
The broker employed always has the general duty to disclose to both parties all facts and terms of the debt evidenced by the note and trust deed to be sold. The disclosures include information that may affect the willingness of the noteholder or the investor to enter into a transaction for the sale or hypothecation of the trust deed note, called material facts. [Barry v. Raskov (1991) 232 CA 3d 447]
The listing agreement calls for the noteholder’s disclosure of all material facts regarding the trust deed note to be assigned. In turn, the broker is duty bound to disclose these facts to a prospective trust deed investor on commencement of negotiations — up front — to acquire or lend on the trust deed note.
The trust deed listing agreement discloses:
- the terms of the trust deed note, including:
- the asking price for the trust deed note;
- the annual yield on the asking price over the remaining life of the note;
- the original amount, principal balance, payment terms and interest rate of the note;
- any due-on-sale, late charge and prepayment penalty provisions in the note or trust deed; and
- the priority of the trust deed on title to the described real estate;
- the information on the real estate securing the note;
- the amount and terms of all encumbrances on the real estate including property taxes, assessments, trust deeds and judgments; and
- any personal property included as additional security for the note. [See first tuesday Form 112]
The trust deed note as personal property
A negotiable instrument, such as a promissory note secured by a trust deed, contains an unconditional promise to pay a dollar amount as scheduled to the noteholder. A trust deed note, being a negotiable instrument, may be absolutely or collaterally assigned to others, such as a trust deed investor.
Buying a trust deed note, 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.
Comparable to a buyer of real estate entering into a purchase agreement with the advice and assistance of their transaction agent (TA), the trust deed investor buying a carryback note does so with the advice and assistance of their trust deed broker. [See first tuesday Form 241]
The investor’s broker gathers information provided by the noteholder prior to preparing an offer to purchase a trust deed note. Relevant information to be collected and reviewed with the investor includes:
- the terms in the trust deed note;
- the existing title policy insuring the trust deed (the note is not insurable);
- the market value of the real estate securing the debt;
- a profile on the real estate that is security for the note; and
- data on the real estate’s operating income and expenses when it is income-producing property.
Additional disclosures to be received and reviewed by the investor and their broker include:
- a trustor’s offset statement from the owner of the secured property; and
- a beneficiary statement from each holder of trust deed notes encumbering the property.
Prudent trust deed brokerage practice compels the investor’s broker to investigate and analyze every document associated with the note and trust deed offered for sale.
If the mortgage being purchased is carryback paper, all the disclosures and agreements from the sale are also obtained from the seller and reviewed to determine both:
- the sufficiency of the property as security; and
- the quality of the note and trust deed.
Further, the investor and their trust deed broker review the hazard and title insurance policies which cover risks of loss and the conditions of title surrounding the trust deed. An appraisal of the property is also appropriate to ensure it functions as sufficient security, as though the investment were the origination of a mortgage.
The purchase agreement to acquire a trust deed note
At some point in the gathering and review of information on the trust deed note, property and title conditions, the broker prepares a note and trust deed purchase agreement. [See first tuesday Form 241]
The note and trust deed purchase agreement is used by the broker as a checklist of conditions when negotiating the purchase of an existing trust deed note held out for sale, to prepare the investor’s offer to purchase the trust deed note. The purchase agreement states the price and terms the trust deed investor offers to purchase the trust deed note. [See first tuesday Form 241]
The note and trust deed purchase agreement contains provisions describing:
- the terms and identity of the note being purchased, such as the payment schedule and the existence of a final/balloon payment, due-on clause or prepayment penalty provision;
- any senior encumbrances of record;
- the real estate securing the debt, including its current fair market value (FMV), the type of property and whether it is owner-occupied;
- the terms of the purchase of the note, such as the purchase price;
- whether the note is to be transferred by way of an assignment or endorsement; and
- the brokerage fee to be paid and by whom. [See first tuesday Form 241]
For further discussion on escrowing the assignment of a trust deed note, see Part II of this article series.
