Private Trust Deed Investments – Finding the Diamond in the Rough
A private trust deed is simply a loan made against a real estate investor’s property. In other words, it is a private mortgage. Trust deeds and mortgages have slight differences, but for this discussion it’s fine to think of them as very similar.
Over 10 years ago, we sat with a prospective client reviewing his portfolio and discussing his financial planning goals and objectives. When we got to one of holdings he said he really liked this investment and wanted us to take a closer look at it. He saw no reason why he shouldn’t put all of his money into it. The investment was a private trust deed fund.
We told him, on the contrary, that most likely we’d be advising him to take all of his money out of it.
We explained that we had reviewed many investments of this type for our clients in the past and had not recommended a single one for their use. We further explained that the past trust deed investments we reviewed had the following negative characteristics:
Their loan to value ratios were high which made them too risky for our taste.
They had too much leverage.
They had high internal expenses.
They were not transparent. It was difficult to understand what type of loans were being made.
They were fraught with conflicts of interest. Management may have incentives to make risky loans rather than keep money in cash and wait for a less risky loan.
The managers did not have enough of their own skin in the game.
They were illiquid and required investors to tie up their money for a substantial amount of time.
This Investment was Different
Surprisingly, after a detailed review of this investment, we found that this particular trust deed investment defied our negative expectations. It seemed like the quintessential diamond in the rough as it seemed to exhibit the following characteristics:
The investment only contained short term 1st trust deeds that had an average loan to value of roughly 50%.
There was no leverage.
The internal expenses were just 30 basis points (3/10 of 1%). The managers kept the points as their compensation and the points were reasonable.
The investment was completely transparent. A monthly report detailed every new loan that was made, modified or paid off. All problem loans were listed and described in detail each month. All cash invested into and withdrawn from the fund was reconciled and reported on a monthly basis.
The managers of the fund had millions of dollars of their own money invested right alongside all of the passive investors and they serviced all of their own loans.
They had a reasonable redemption policy that provided investors adequate liquidity.
Next we interviewed the principals of the firm as well as their employees. We were impressed, and to make a long story short we told our client we liked his investment and that he should keep it. In fact, we liked it so much we began incorporating it into our other clients’ portfolios and have been using it successfully for over 12 years now. During that time it performed very well and weathered several downturns.
Due to the new 2018 tax law changes this investment changed its legal structure to a REIT and now 20% of the distributions received are free from Federal income taxes. Not all first trust deed investments qualify as REITs, but this one does.
Be Careful and Do Your Due Diligence!
There are several pearls of wisdom that can be gleaned from this story about trust deed investments, and about investing in general.
The most pertinent takeaway is the extremely high importance of conducting thorough due diligence every single time you commit your money to an investment. As we described, our skeptical view turned out to be incorrect. Many times it goes the other way, where overly optimistic attitudes can be proven wrong. We’ve seen that as well.
It may seem basic, but don’t let your emotions or any preconceived notions bias your investment strategy. This can be hard to do as even the best of us are subject to our emotions as humans.
Also, realize how drastically investments of a particular type can vary from one to the next. As you heard in this case, trust deed investments can make excellent investments — but they can also be much, much riskier than you realize.
If you are ever presented with such an investment opportunity, be careful and make sure you thoroughly understand all aspects of the investment, the management team running it and the amount of risk that is being taken to generate the advertised returns. And remember, if the returns seem too good to be true, they probably are.
The diamonds in the rough are out there, but they don’t come along without a great deal of time, effort, and objective consideration. Over the years we’ve acted as a resource clients trust to make this call. For more information about how we go about our process, please contact us.