If investing in first trust deeds was as easy as picking a few high-yielding first mortgages, everyone would be rich. Succeeding in first trust deeds is unfortunately not that easy.
You can lose big money in first trust deeds, especially in high-yield loans. In fact, the hardest lesson for most trust deed investors to learn is that the lower the yield, usually the better the deal.
If you find yourself saying, "Oh, look, here's a delicious 12% first trust deed," perhaps you should stay away from investing in first trust deeds until you have studied a little more.
The hardest lesson for most investors
to learn is that the lower the yield,
usually the better the deal.
The truly "good ones" are those paltry 7% or 8% trust deeds that many investors immediately dismiss. In a future blog article, I will explain Blackburne's Law, which hypothesizes that a portfolio of 8% and 9% first trust deeds will outperform a portfolio of 11% and 12% deals over a seven-year holding period.
But let's move on to today's subject - surviving in first trust deeds during the next real estate depression. I have used the word "depression" because real estate crashed by almost exactly 45% during the S&L Crisis, the Dot-Com Meltdown, and the Great Recession. The same amount - 45%. Hmmm.
Real estate seems to crash by 45% every ten to fourteen years. It has now been fourteen years since the Great Recession. Why does real estate crash so violently? It is the natural tendency of humans to forget the lessons of thrift - to save money for a rainy day, to avoid debt, and not to speculate.
If you are going to regularly invest in first trust deeds, it's pretty hard to avoid getting caught "in the market" when a real estate crash hits.
You probably don't want to be completely out of the trust deed market anyway. You still need monthly income, even during bad recessions. In addition, you could be off by three years as to the timing of the next crash, losing thereby 9% interest for three years, which is a whopping 27%! You will never be able to exactly time the market.
But you still need to avoid getting badly mauled. Here are some tips:
1. Stick to deals where the borrower can afford to make his monthly payments. If your borrower just keeps making his payments, you don't really care if the value of the borrower's little industrial building temporarily (say, for three years) falls by 45%. You just want your monthly payments, and the collateral will likely recover over time.
2. Never try to invest a whole lot into any single deal. Spread your money out among a dozen different loans for diversification reasons. Remember that story about how an old coal mine suddenly collapsed and literally swallowed a small residential care home. Stuff happens.
3. Always maintain some liquidity. All foreclosed property needs to be renovated before it will lease or sell.
4. If you ever want to speculate in first trust deeds, which I think is insane, do so immediately after a real estate crash, when prices are 45% lower. At the bottom of a crash, you might even make a 12%, high-LTV commercial loan (normally a very stupid risk) because real estate values usually soar after bouncing off their bottoms. Down-down-down-leveling-SOARING.
5. But as you move along in time, say, seven years, after a real estate crash, you should start moving your money into lower-yielding, less-risky loans at lower loan-to-value ratios. The Dot-Com Bubble burst in 2000, and just eight years later, the Great Recession hit. You don't always get a full ten to fourteen years between crashes, so about year seven, start moving into less risky deals.
6. Stick to small loans. Small loans have small payments, which are easier to make. Remember this mantra: You want your borrower to succeed.
7. Spread your money out geographically. The Great California Earthquake is 22 years past due, and imagine the effect on the California economy if water prices tripled? Increased five-fold?
8. Why not just invest in a hard money or bridge loan fund? That gives you diversity, right? During real estate crashes, bridge loan funds almost always collapse. I will blog on this far greater detail in a few weeks.
9. You can achieve more than enough diversification by investing $10,000 in each of ten to fifteen different first trust deeds.
What Are Trust Deeds?
Trust deeds (or mortgages, depending on the state) are investments in a loan, secured by real estate, directly to the borrower. Rather than putting your money in the bank and having the bank make the real estate loan, private investors can actually make the loan directly.
The trust deed investment business is huge in California, and it has been around at least 80 years. Recent law changes now allow investors from every state to invest in trust deeds, as long as they are accredited investors. The good news is that you can earn 8% to 12% interest in first trust deeds. The bad news is that you, not the bank, take the loss if the loan goes bad.
Scary Disclosure Stuff:
Investing in first trust deeds involves substantial risk. A large and prolonged decline in real estate values is possible. Always maintain some liquidity. Foreclosed property always needs to be renovated. Before you invest with Blackburne & Sons, my own hard money shop, or any other reputable hard money outfit, you will be given a huge Offering Circular, which discloses many of the risks. Please be sure to read it, especially the Risk Factors section.