A trust deed is a type of agreement securing a real estate loan that’s made between a lender and borrower to have the main property held in a trust by an independent and neutral third party until the loan is paid off. The third party, know as the trustee, that the property may be transferred to is typically an escrow company, title company, bank or loan servicer. Even though trust deeds aren’t as common as they once were, they can still be used in 20 states, one of which is California.

Investing in trust deeds means that you will be investing in loans that are secured by real estate. The majority of these investments are short-term loans, typically 5 years or less, which means that it won’t take long for you to determine if the investment was a smart decision. Trust deed investing fills a void in the real estate lending market because banks typically only provide long-term mortgages, as opposed to short-term bridge loans. As a trust deed investor, you effectively replace the bank in this void by making short term real estate secured loans.

This void has grown because banks have become less and less interested in providing short-term trust deed loans following the 2008 financial crisis, primarily due to the large volume of non-performing or bad loans on their balance sheets. If you’re interested in learning more about trust deed investing and the kind of opportunities it provides, the following offers a helpful guide.

The Differences Between Trust Deeds and Mortgages

To understand trust deed investing, you should first know the difference between trust deeds and mortgages. There are two primary differences between a trust deed and a mortgage. The first difference is that a trust deed is comprised of three separate parties, which include the lender, the borrower, and a trustee. The trustee holds the property in trust for the benefit of the lender. In the event that the lender is paid on time and as promised, they will no longer have any claim to the property. Whereas, a mortgage is between two parties — the borrower and the lender.

The second primary difference between a trust deed and a mortgage is what happens if the borrower defaults on the loan. If a borrower defaults on a mortgage loan, the lender has to pursue the foreclosure process through the courts to try to secure the title to the property to satisfy the borrower’s debt. In contrast, if a borrower defaults on a trust deed loan, the trustee can pursue a non-judicial foreclosure process that is typically quicker and less costly, as discussed further below. With a deed of trust, the trustee who holds onto the property title will be in charge of pursuing the final foreclosure process if the loan goes into default.

One of the main reasons that banks choose to invest in mortgages as opposed to trust deeds is that mortgages are typically long-term, investments that are paid out over 15-30 years at a low, but stable, interest rate. On the other hand, trust deed investments are typically short-term investments that typically mature in 5 years or less, but pay a higher interest rate.

Advantages of Trust Deed Investing

There are many advantages to trust deed investing that makes it an attractive investment vehicle for sophisticated high-net-worth individuals seeking to diversify their portfolios. One key advantage is that your investment is typically made at a significant discount to the actual value of the property. For example, typical trust deed loans in California are made at 70% or less of the property value. In other words, if a borrower is purchasing a property valued at $1,000,000, a trust deed loan secured by that property will typically be in the amount of $700,000 or less. That fact provides a safety cushion to account for market corrections or other expenses that may be incurred in the event of a default.

Another key advantage to trust deed investing is that your investment is secured by tangible property that you can take title to in the event the borrower defaults on its loan obligations. This is unlike a stock investment where you don’t have recourse to the assets of the company if your stock doesn’t perform well. As set forth above, and different from a mortgage, in the event the borrower doesn’t make its payments, the trustee there are certain laws in place that make it easier for the trustee to sell the property to satisfy the debt.

The lender will have the ability to begin a quick and less expensive foreclosure that’s non-judicial in nature. A non-judicial foreclosure provides the lender with the ability to bypass the court system and instead use the terms of the trust deed as well as State law. Since the courts aren’t involved, the process can typically be completed in a more timely and cost efficient manner compared to a judicial foreclosure through the courts.

In California, the non-judicial foreclosure process begins when the lender records and provides the borrower with a Notice of Default, which gives the borrower no less than 90 days to correct if possible. If the borrower does not cure the default and repay any outstanding amounts, a Notice of Trustee’s Sale will be filed, and no less than 21 days after which the property can be sold at a foreclosure sale. Because this process is typically quicker and easier than any type of judicial redress, it minimizes some of the risks that come with making a trust deed investment.

Because of the protective equity cushion, mentioned above, if the property value is relatively high in comparison to the outstanding loan amount, the investment shouldn’t lose any money if the borrower ends up defaulting on the loan. Since the lender can foreclose on the property and sell it, it’s possible to regain the money that was invested, which isn’t possible with many other investment types.

Yet another advantage of trust deed investing is that it typically provides an appealing yield with low risk relative to the returns. Because trust deed investments are generally shorter in duration and extended to borrowers who may not satisfy bank lending criteria, you should be able to earn annual returns in the high single digits to low double digits, depending on the characteristics of the loan and the assessed risk. These returns are typically paid to you at a monthly fixed rate with the principal investment amount paid in full when the loan matures. This type of investment is a great way to obtain passive income since you won’t be required to actively manage your investment. Instead, if the loan performs as expected, you can relax while bringing in income from the payments that are made by the borrower each month.

Disadvantages of Trust Deed Investing

While trust deed investing can provide you with attractive risk-adjusted returns, there are some disadvantages that you should know about before you invest your money into a trust deed. For one, these investments aren’t liquid, which means, unlike a stock, you can’t decide to take your money back when the investment starts to show warning signs. Instead, you have to plan to commit to the investment for the full term of the trust deed investment because you typically won’t be paid off until the loan fully matures.

There’s also no capital appreciation or equity, which means that the asset won’t increase in value during the term of the loan. You will be paid a stated interest rate only. While the investment can provide you with a relatively high return relative to the risk, there won’t be any unexpected increases or significant upside in the return that you receive.

If you want to invest directly into a trust deed, you will also be required to evaluate borrowers, negotiate and assess the terms that you’re providing to the borrower, perform due diligence on the property and the borrower, and navigate the many laws and regulations that govern real estate lending. If you don’t have experience doing this, it can be a risky and time-consuming process and increase the likelihood that you agree to a bad deal or make a poor investment decision.

In addition, all documentation, which can be lengthy and complicated, must be properly perfected. Small errors in the documentation or problems with your due diligence could cause the borrower or another interested party to claim that your documentation is incorrect or that they have interest in the property that is just as valid as yours. Consequently, the borrower may ultimately be able to challenge the terms or the validity of the loan, and potentially take you to court at significant cost and expense. No matter what the claim is, not doing your due diligence or fully and properly documenting the loan exposes you to the possibility that a very safe investment is suddenly a risky one that could cause you to lose your money.