Investors weigh the pros and cons of individual deeds of trust versus funds.

Investors choosing to invest in individual deeds of trust instead of a fund have been frustrated over the past year, especially in California. Just after the Great Recession, individual deeds of trust not only were plentiful but also earned a relatively high rate and at a conservative loan to value. Thus, a triple threat existed, so to speak, that attracted investor capital: a high yield, conservative underwriting and a variety from which to choose.

Mark Hanf, president of Pacific Private Money, a California-based alternative real estate lender, called this period “the best kept secret in investing.” However, as interest rates dropped, investors desiring a fairly high rate of return had to look to “alternative investments,” as they are called.

Bank rates for depositors was close to zero. T-bills, T-notes and T-bonds did not produce a much higher yield. Corporate bonds could produce a better distribution rate than banks or Treasurys, but there were a few risks. Corporate bonds trade similar to stocks but not nearly at the same volume; thus, the liquidity of many corporate bonds does not give as much assurance to the investor should the investor desire to sell. In addition, since bonds are traded, the price upon a sale may produce a loss of principal.

Deeds of Trust
Deeds of trust are considered “alternative investments” because they are not freely negotiated as stocks and bonds are. Thus, they are considered illiquid.

Most investors in the alternative space desire to lend short term—less than five years. Generally, they do not want to tie up their money for a long time and in an illiquid investment. The problem, however, with investing in short-term loans is that they turn over quickly due to their nature. Most borrowers either sell the property or refinance.

The usual premise for a borrower using alternative financing—compared to a conventional loan—is the speed: A private lender can fund faster than a bank. Another reason for the need for alternative financing may be due to a glitch in credit by the borrower, but these two issues—speed and credit—are usually short-term problems.

Most loans do not carry a prepayment penalty, or if they do, it is usually six months or less. Alternative lending rates are much higher than a bank would charge, so there is an incentive for borrowers to pay these short-term loans as fast as possible. This leaves the lender with the problem of finding another loan to fund. If no loan is found, these paid-off funds sit idle rather than earning a decent interest rate.

Quality individual loans that pay interest at 8% or more are getting harder to find, as this “best kept secret” is no longer a secret. Competition for these loans has driven rates down from where they hovered at about 10% just a few years ago. This is known as yield compression, and it is based on the laws of supply and demand. The more supply (money available, in the case of lending), the lower the price.

Funds as an Alternative
Here is where we discuss the cost of waiting. Many alternative lending companies have started a fund, wherein the fund allows investors to buy shares/units like a mutual fund. The fund makes the loans, and the investors enjoy the benefits of the interest rate charged to the borrowers.

The cost to the investor is usually no more than 2%. This 2% may be a management fee or may be divided between a management fee and a service fee (for servicing the loan payments). The fund has a licensed broker who makes the loans and charges the borrower in terms of points—either keeping these points or sharing them with the fund.

The dilemma facing investors who desire to own individual deeds of trust—as compared to investing in a fund—is that the fund also faces the same issues regarding borrower payoffs and idle money waiting for a new loan opportunity. Thus, when a loan situation is presented to the fund, the fund will make the loan if it has money available. That is almost always the case in today’s lending environment since borrowers are constantly refinancing and competition is stiff.

Fund managers are constantly looking at the loan scenarios presented, and some loans are given a downright “no” answer due to their risk. If the loan is too risky in the manager’s opinion or the loan does not fit the criteria of the fund’s underwriting guidelines (e.g., the loan request being a third mortgage), the fund manager may then present this loan to individuals who are interested in owning loans in their own portfolio versus investing in a fund where the manager uses discretion as to which loans should be in the fund.

Since the fund’s manager wants to give the highest yield with the lowest risk to the fund, the loans that are presented to individuals are not quite the quality caliber that the individual investors have been accustomed to in the past. Thus, individual investors may be presented with several loans with which to invest but which do not fit their investment strategy criteria. Many individual investors remember the Great Recession and are reluctant to lower their standards of lending due to the fear of losing money.

The Dilemma
So, individual investors face a dilemma. Do they lower their standards and take on more risk? Or, do they let their money sit idle, earning no interest while waiting for a loan that needs capital?

The other choice is for the individual investors to keep standards high and accept a much lower rate of interest. In some cases, loans charging borrowers in the 6% range are not uncommon if they are of high quality (e.g., the borrower has a FICO score in the high 700s or the loan to value of the collateral is under 40%).

The decision these investors must make is whether it’s better to invest in a fund where the distributions are usually above 7% in today’s market and where the money never sits idle. Most funds have a lock-up period in which investors cannot access principal for at least one year. This should not be problematic, as investors willing to invest in an individual loan would most likely have to wait more than a year to get the money back because the loan terms dictate how long the loan will last (e.g., subject to the sale or refinance of the collateral).

Individuals desiring to invest in loans that earn 7% will only earn the full rate if their money is always working instead of sitting as idle funds waiting for a new loan to fund. In many cases, individuals are finding that their money is sitting idle for much longer than they anticipated because they are not willing to lend on loans that are being presented to them. Shrewd investors realize that accepting a lower quality loan, especially at a lower rate than they desire, will cost them in the long run.

Problem borrowers may cost the lender time, money and aggravation. Some borrowers file bankruptcy. Although the collateral may cover the loan, bankruptcies can take years to resolve. During this time, the lender may not receive any interest payments. The lender may get “crammed down,” meaning that a bankruptcy judge changes the interest rate on the loan to a lower rate. The lender hires an attorney. The judge may or may not allow all the legal fees the lender has incurred to be recovered in the bankruptcy.

Individual investors must determine whether these potential problems are worth choosing the loans to invest in or having a fund manager deal with these issues. People who invest in a mutual fund that invests in stocks are basically handing the decision-making process over to the manager of the mutual fund to choose the stocks. That’s not too much different than investing in a fund that makes real estate loans.

As time goes on, if the real estate lending market stays competitive, individual investors will continue to see fewer quality loans at potentially lower rates. This will continue to present problems for investors who want to stay the course of investing in individual loans instead of investing in a fund that matches the investor’s objectives regarding quality of loans, perpetuation of money continually working and a desired rate of return. Many investors may choose to change course and invest in mortgage funds, as the cost of waiting proves to be too much for the individual lender to bear.