Trust deed investing has long been misunderstood by investors and is often labeled as an “alternative” investment. Trust deed Ponzi schemes, like those pushed by the infamous Dan Holbrook of San Diego, took many investors for a wild ride leading up to the Great Recession. Further tarnishing the image of trust deed investing. Investment blogs pushing stocks and mutual funds warn investors about “oddball investments” like trust deeds. Realistically though, it isn’t so much the image of trust deed investments that prevent brokerage companies and broker dealers from peddling them to their clients. Here are four reasons brokerage companies and big broker dealers don’t commonly offer trust deed investments alongside of other investment opportunities:
- Not Easy to Scale: Trust deed investing is not easy to sell to investors on a mass scale like many securities and mutual funds. The primary reason it’s not an easily scalable investment is because there are a lot of moving parts required to both underwrite, and then manage each trust deed investment. These moving parts include mortgage brokers, real estate agents and/or brokers, title and escrow services, appraisers, insurance agents, home inspectors, property management services and in some cases, home remodeling experts. In order to underwrite a trust deed investment for risk, the investment broker – often called a private money broker – must obtain property value opinions from realtors or appraisers and analyze them, validate adequacy of insurance coverage, analyze title reports, perform site inspections, etc. Once the trust deed investment is sold, another army of moving parts may be required to manage the investment including property managers, contractors, and other real estate related specialists. For large brokerage companies, this type of an investment could seem like a large hassle and difficult to scale, when compared to strictly paper investments.
- Not Easily Packaged and Sold Downstream: Unlike many of the securities offered by brokerage companies, trust deed investments are trickier to package and sell to Wall Street. Unlike the widely criticized collateralized debt obligations (CDOs) that have been blamed for the subprime crisis leading to the Great Recession; trust deed investments are not 30-year mortgages. Trust deed investments have shorter durations, or loan terms, varying from six months to five years. But why not package all the investments with the same term? For example, packaging a cluster of one-year balloons together and selling it. Because of the higher rates associated with trust deed investments, a borrower on a one-year loan may pay the investor off within three months. It is just this particular aspect of trust deed investments that makes them more difficult to package and sell to Wall Street.
- Difficult to Price: Because each trust deed investment is given such a wide range of risk factors, it becomes difficult to price each investment uniformly. These factors include, but are not limited to, loan to value ratio, location of collateral, credit score of borrower, condition of collateral, income producing or vacant property, cash position of borrower, experience or track record of borrower. For example, one property used to collateralize a trust deed investment may be located in a rural community in the Midwest, while another property may be located in an upscale neighborhood in Los Angeles. But what if the borrower in the rural community in the Midwest is bringing in a 50 percent down payment, while the borrower in Los Angeles is only bringing in 10 percent down payment? How would someone price these different trust deeds based on these particular risk factors? This seems like a pretty daunting task for someone who is not experienced with trust deed investing. This complex approach to pricing trust deed investments tends to overwhelm a traditional brokerage company that is used to relying on credit rating services – like Moody’s – to rate the risk of the investments it sells to investors. But as many furious investors found out the hard way, credit rating services can mislead brokerage companies. As evidenced by Moody’s blunder in rating mortgage back securities as AAA investments leading up to the financial crisis. According to a report submitted by the Financial Crisis Inquiry Commission in January 2011, “The three credit-rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval.”
- Trust Deed Investing is Widely Misunderstood: The reputation of trust deed investing received its first big blow in the early 1980s from the implosion of Boileau and Johnson. Taking advantage of the 10-year real estate boom in Southern California from 1970 to 1980, Boileau and Johnson offered very high risk second, third, and fourth trust deed investments to mostly elderly clients. Reported to be an investment Ponzi scheme, the firm lost $20 million given to them by approximately 1,800 investors to invest in trust deeds. In the 1990s, Gary Naiman of Pioneer Mortgage followed the same path as Boileau and Johnson, further damaging the reputation of trust deed investing. Naiman mismanaged and lost $200 million given to him by approximately 2,300 investors to invest in trust deeds. Most of Naiman’s investments were second and third trust deeds, which resulted in massive losses when the real estate market began to tank at the end of the 1980s. The tremendous fall out of investment firms like these have compromised the reputation of trust deed investments, leaving many investors confused about how they work. Because of the financial disasters of firms like Boileau and Johnson and Pioneer Mortgage, trust deed investing is widely misunderstood, and is often categorized as an extremely high risk, “alternative” investment. For this reason, many brokerage companies also tend to misunderstand trust deed investing, and thus do not consider offering it to their clients.
For those who understand how trust deed investing works, it can be quite a rewarding and lucrative investment vehicle. The four reasons listed above are why these investments are not traditionally offered from brokerage companies or the large broker dealers. This is good news for private money brokers who specialize in trust deed investments. Meaning, they can maintain their unique niches, and can offer superior returns to those investors who understand them and seek them out.
Corey Curwick Dutton’s article originally appeared in Private Lender magazine: May/June 2017.