If you have ever considered lending money secured by real estate to get a higher return, then you will want to know about the 8 risk factors of trust deed investing. These are the real risks that you will face as a private lender, for which I have also included some brief tips on how to mitigate these risks.
First, there is a chance that you could lose all of the amount you have invested and you could need additional funds beyond what you’ve already invested. It is true that if your borrower stops paying, you may need to come up with additional funds to foreclose (usually by hiring an attorney to do it on your behalf) and to maintain or protect the property. If you fail to do this, there is a chance that you could lose your entire investment. That is why it is critically important to know your borrower and have additional resources beyond what you have invested in the event that you need to protect your initial investment.
Second, it may be difficult to determine the true value of the property. It is much easier to lend $70,000 against a property that you know beyond any doubt is worth $100,000, but what do you do when it is hard to determine the value of a property? Make sure you feel comfortable and confident in the value of the property you are lending against because if the lender does not pay, you might end up getting the property and have to sell it.
Third, you may need to foreclose. Foreclosing can take time and as I mentioned above, it can also cost you additional money at a time when you’re likely not receiving payments on the loan to begin with. I strongly encourage you to hire an attorney to complete this process for you, but there is definitely an expense to that. Provided you know that your loan is at a very low value compared to the value of the property you are foreclosing on, you can expect to foreclose and recoup your initial principal, back interest, as well as legal fees and occasionally even more.
Fourth, there is a danger for junior lien holders. If you are the second lender (or later) lender on a property, you do need to be concerned with liens senior to you. If they are not being paid, you will need to protect their interest in the property to maintain your security position. Often this means making up back payments so that you can start the foreclosure process. It can, depending on the senior lien, require you to pay off the entire senior lien. To protect yourself, make sure you thoroughly understand the risks of being a junior lien holder or only invest in deals where you are in first position.
Fifth, there is a lack of liquidity with trust deed investing. While strides have been made to create a secondary market for selling trust deeds and notes, these types of investments are still considered very illiquid investments. This means that you must be prepared to invest for the long term and must be prepared to accept the fact that there
is likely no willing buyer to take over your position if you need to get out early. Some borrowers may have the resources to help replace you as a lender, but this lack of liquidity is best considered before you invest.
Sixth, bankruptcy by the borrower could delay and discount your investment. Since a bankruptcy will often stop a borrower from making required payments and stall foreclosure proceedings, you could be left waiting for a bankruptcy ruling with no income from the note. Knowing your borrower and their ability to repay the loan will reduce, but not completely eliminate this risk.
Seventh, not having hazard insurance could open you up to the risk of fire and other catastrophe. Making sure your borrower has purchased adequate insurance on the property and named you as additional insured as lender can help offset this risk.
Eighth, there may be a conflict of interest since the borrower or owner of the trust deed may also be presenting the investment opportunity to you. Just like in any transaction, it is important to realize who is an independent third party and who is not independent and is involved in the transaction.
In conclusion, even with these 8 risk factors–many of which are similar to those of other investments–the high fixed rate of return of trust deeds and the fact that they are secured against real property make them extremely attractive investment alternatives.