The very fact that your hard money broker is offering you a first trust deed with a rate 2% lower than usual is evidence that he believes that this particular loan is much less risky than the typical deal. For example, if most of his deals are at 10%, and he suddenly offers you a deal at just 8%, he is probably doing so because the investment has a stronger borrower, a better location, a lower loan-to-value ratio, and/or a better cash flow than usual.
The smart old-timers know that these 8% deals are the "good ones," not the deals with a 12% yield. Blackburne's Law says that, "A portfolio of 8% to 9% loans will outperform a portfolio of 11% to 12% loans over a seven-year holding period."
Eight percent and 9% deals will outperform
11% and 12% deals over 7 years.
Be careful with Blackburne's Law. It is not the product of any careful statistical research. It is just the observation of a battle-scarred old veteran who has seen too many high-yield trust deeds go bad.
Why seven years, as in "over seven years?" Over seven years, this mini-portfolio of 8% and 12% deals will surely experience a recession. It is during recessions that most foreclosures and losses in first trust deeds occur.
But won't the higher returns on the 12% deals cover any losses. No. Next question? [Chuckle.] Folks, it really is true that a portfolio of 8% and 9% deals will out perform a portfolio of 11% and 12% deals. You need to fight the urge to reach for higher yields. The "good ones" are NOT the higher-yielding deals.
Two weeks ago, I shared that if you pick a good first trust deed, and the borrower just keeps making his payments, you don't really care what happens to the economy or to real estate.
Real estate could fall by 45% again, but what do you care if your borrower just keeps paying? After falling by 45%, real estate historically (no guarantees, folks) recovers to new highs about 2.5 year after bouncing off the bottom.
My point today is this is a good time to accept a lower yield in order to grab some stronger trust deeds. Winter is coming.
A recession may arrive soon, so the wise
investor should be looking for
a nice, low-yielding loan.
If you are invested in a hard money mortgage fund right now... you're probably toast. Sorry. The smart money has already asked to withdraw, so the line to withdraw is unfortunately now much too long. The problem with hard money mortgage funds is that the sponsors themselves - the guys who clean up after the elephant - almost always fail.
Going forward, you need to adjust your risk tolerance to where we are in the real estate cycle. Three years from now, after real estate has cratered, you can go absolutely nuts (sorta) on high-yield deals and high loan-to-value ratios. Right now, stick to quality.
Lastly, I have a comment that may surprise you. Even if I absolutely positively knew that another great recession was coming, I would rather have my money in first trust deeds, rather than any other asset class. BUT... (1) I would take a tiny piece of lots of different deals; (2) I would spread my trust deed investments all across the country (earthquakes, floods, hurricanes, tornadoes, riots, aliens - haha - AI* - not so ha-ha) (3) they would all be small loans; and lastly (4) they would be LOW-yielding deals to small business owners.
* Just read the book, Our Final Invention. No wonder Elon Musk is in a hurry to get off the planet.
Would you please do me a great favor?
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 7% 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.