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Two years ago, California’s Bureau of Real Estate (formerly the Department of Real Estate) put together a compendium of the seven most important facts that beginners who want to engage in trust deed investments in California should know.
The first 4 facts were covered in the HMLInvestments.com article “7 essential elements for trust deed investors in California collected by the Bureau of Real Estate”. This is a continuation of that article and the last part of the series.
Seven essential elements of trust deed investments (Points 5-7)
- Documents and instruments describing, evidencing, and securing the loan or purchase of the promissory note – Your trust deed investment will either be secured by a “whole” (only one lender or note holder) or a “fractionalized” (more than one lender or note holder) deed of trust. “Fractionalized” promissory notes and deeds of trust are regulated by the CalBRE and the Department of Business Oversight (DBO). Licensed brokers can also offer these “fractionalized” promissory notes through the Department of Business Oversight (DBO) as long as they have obtained a permit.
Law regulates that no more than 10 noteholders (shared investors) can join in in claiming a piece of the trust (you and your spouse would count as one lender or note holder on a single investment). Given the riskiness of these loans, the broker must be licensed and it would be illegal for you to invest more than 10% of your net worth or your annual income. Your loan must be directly secured by the Property (not through another promissory note); the broker may not “self-deal (i.e. he must be totally objective not related to borrower in any way) and (i) your interest and the interests of other lenders or noteholders must be recorded and identical in its underlying terms so that each trust deed holder receives his or her proportionate share of the principal and interest.
For details about documents dealing with fractionalized loans – which are more complex and, because they’re shared, far more risky – see ‘Trust deed investments: what you should know’.
- Loan servicing provisions, authority and compensation – As regards “whole” promissory notes (i.e. when the person is the sole investor rather than sharing it with others in a fractionalized situation), lenders and noteholders may decide whether to handle the loan servicing themselves or authorize the procedure to a servicing agent (i.e. a person licensed as a real estate broker). Conversely, multi-lenders (in the case of fractionalized loans) are obligated by law to hire a servicing agent in order to protect them.
Loan servicing includes collecting payments from borrowers, disbursing payments to lenders or noteholders, mailing appropriate notices, monitoring the status of senior liens and encumbrances, maintaining adequate insurance coverage(s), and coordinating foreclosure proceedings. A servicing agreement discusses each of these.
Many brokers will want the original promissory note and deed of trust to be delivered to the servicing agent (who may be the broker) to be held on behalf of the lenders or noteholders during the term of the servicing agreement.
For multi-lender transactions, the servicing agreement must also require that their trust accounts be inspected every three months by a CPA (with follow-up reports to the servicing agent and the Real Estate Commissioner) whenever the total of payments due in any three consecutive months exceeds $125,000.00, or if the number of persons entitled to payments exceeds 120.
The servicing agreement should outline the servicing agent’s compensation as well as describe how and under what circumstances you or the servicing agent may terminate the loan servicing agency.
You need to receive these and related details before the serving agent does.
You should also receive annual accountings of the unpaid principal balance and the collections and disbursements for that year. For further details of this servicing document see ‘Trust deed investments: what you should know’.
- Recovering your investment when the borrower fails to pay – Both lender and borrower are generally not eager to force foreclosure. Loan payments can be several months late before the lender may feel compelled to force his hand.
California’s Bureau of Real Estate says that it is also crucial that senior liens be monitored since a borrower who overlooks junior liens is likely to overlook the senior ones, too. Senior liens refer to: such as taxes, insurance premiums, and/or deeds of trust.
Related to that, the DBO emphasizes that:
Prior to investing in a junior deed of trust, you should have determined the amount and the payments required to maintain the senior lien(s). To protect your investment during any senior lien (loan) foreclosure, it may be necessary for you to maintain the payments (with your own funds) on all senior liens.
If the Property produces income, you may choose to collect the rents and profits during the foreclosure process to help the borrower straddle his senior lien obligations. As additional security for your loan, you should have received an assignment of the rents and profits (usually contained in the deed of trust).
In a “fractionalized” investment, it is necessary to obtain the agreement of more than half of the lenders or trustees involved in order to start the foreclosure process. The servicing agent should contact each of the other lenders or trustees for you. However, you should be able to directly contact the other lenders or trustees when necessary.
Two methods are used to foreclose deeds of trust: judicial foreclosure and nonjudicial foreclosure. The method depends on you. Most prefer the latter option because it is faster and cheaper.
The short of it all is that you may be forced to try to recover your loss by turning to the property. In this case, the Bureau states that you may not receive income from your trust deed investment. The return of the principal you invested and the income you anticipated may be delayed until the foreclosure sale or, in the absence of a successful third-party bid, until the Property is later sold by you (subsequent to foreclosure).
Fractionalized investments have their own conditions. Again, California’s Bureau of Real Estate fills in all gaps in its ‘Trust deed investments: what you should know’.
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