Trust Deed Investments – Mitigating the Loss of Capital Risk

There are 9 real risks to investing in trust deeds or becoming a private lender that loans money secured by real estate. Today, I will be discussing with you the risk of loss of capital and how to help mitigate that risk.

First, let’s talk about what the risk is. When you loan money secured against a property, there are many things that can happen that could result in loss of all or some of your initial investment. Some of you may be surprised to hear this, but similar risks apply to most investments including investing in stocks of small and publicly traded businesses and yes, even some so called guaranteed investments are susceptible to partial or total loss of your investment.

It is probably clear to most readers that if you invest $500,000 in a stock and that stock decreases in value such that your initial investment is only worth $100,000, that you will incur a loss on your initial investment if you were to sell. You can probably also see that if you invested $500,000 in the stock of a company and that company went completely out of business that you could possibly have a total loss of your entire investment.

What may not be so clear is if you invested $500,000 in a CD at a bank–even one that was FDIC insured–and that bank failed, that you could see a loss of your investment as well. Without getting into the specifics of the FDIC insurance program, you should know that as of this writing the insurance only covers the first $250,000 (and it was as low as $100,000 not that long ago) of a deposit with each bank. So, you may, depending on the exact situation, be looking at a loss of half of your capital with an investment that many experts claim is the safest one available: certificates of deposit. If the bank was not FDIC insured, you could face a complete loss of capital.

Now let’s look at how you could have a loss of capital when investing in trust deeds and how to mitigate that risk. One way that you could experience a total loss of capital when investing in trust deeds is if a borrower neglects to pay on their obligation to you, and you failed to protect your position. One way that this could occur is if you took a junior position, for example, lending on a property as a second mortgage holder. If the borrower fails to pay on the first mortgage and you do not protect your junior position by bringing the first mortgage current or paying it off in full, the first mortgage holder could foreclose on the property and you could have a total loss of capital.

So, how do we protect ourselves and mitigate this risk? There are several ways. First, you may want to lend only when you hold the most senior lien on the property. Or, at a minimum, when you feel comfortable with any liens that are senior to you. Of course, there are unusual situations where even a senior first lien holder can be pushed into second position like in the case of unpaid property taxes. In cases where you are in a junior lien position from the beginning, or are put there due to unusual circumstances like unpaid property taxes, be prepared to protect your position and start foreclosure proceedings yourself if the borrower does not pay. You need to be ready to put up additional capital to protect your position, such as making up back payments on a senior lien and paying an attorney to foreclose.

But that’s only part of the way to significantly reduce this risk. There are two other major factors: know your borrower and know your property. Finding the right borrower can significantly reduce this risk. Lending to borrowers that cannot afford the property does not make good business sense; don’t do it. Lending against properties whose values are uncertain or are too close to the loan amount is also bad business; again, don’t do it.

Following these guidelines can reduce the risk of loss of capital associated with trust deed investing and, in my opinion, make the rewards of the usually high, fixed rate of returns on these types of investments worthwhile.

Until my next post,

James

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