These deeds can provide a steady stream of income, but let the buyer beware.
THE ORANGE COUNTY REGISTER

Brandt Davis would seem the perfect person to invest in trust deeds. The Mission Viejo certified property manager knows how to evaluate property, scrutinize financials and weigh a borrower's creditworthiness. As a result, his investments in trust deeds have been profitable. He earns an average 11.5 percent on his portfolio.

But there was that one time 10 years ago when he lost $42,000. The mortgage broker pocketed the money and later was convicted of fraud.

Davis' experience shows the opportunities and pitfalls of trust deed investing. Trust deeds can provide steady income at attractive yields. And, unlike a stock, bond or real estate mutual fund, the investment is secured by property. But if the transaction is not properly analyzed, the borrower can't pay or there's fraud, it can take time to get your money back – or even be a total loss.

Still – even at this juncture in a slowing real estate market – financial experts say trust deeds are worth considering as a way to diversify a portfolio. They may be particularly attractive to aging baby boomers looking for a consistent source of retirement income.

The trick is finding borrowers with a high likelihood of repaying loans on properties that provide good collateral.

"If you do the homework, I think it's a good alternative," says Guy Puccio, a former advisory commissioner for the state Department of Real Estate who wrote the agency's brochure on trust deed investing.

Many California homebuyers are familiar with trust deeds as part of the documentation they get when they obtain their home loan. When the borrower gets the money, he signs a note promising to repay the loan to the lender. The house is used as collateral.

The trust deed is the document recorded with the county recorder's office that transfers title to the property to a third-party trustee, who holds it until the note is repaid to the lender. If the borrower defaults, the trustee can foreclose on the property and resell it to regain the lender's principal.

Although most homeowners get a loan through a bank or financial institution, private investors also can act as lenders. These investors act just like banks, lending money on everything from single-family, owner-occupied homes to apartments, shopping centers and office buildings and for infrastructure for planned developments. There is a note, which is a promise to repay, and a deed of trust, which is the security for the repayment.

Individuals can invest in trust deeds in single properties or in a pool, in which the money is combined with that of other investors in numerous properties. Borrowers typically turn to private lending because:

•They need the money quickly. •They only need it for a relatively short period.

•They have minor credit problems or the property has problems that might make it difficult to get a bank loan.

In return for this convenience, trust deeds charge higher interest. Investors typically earn 10 percent to 12 percent, paid monthly. Standard fees are around 2 percent. The interest is taxed as ordinary income.

But experts warn that investors need to understand they are investing in a loan – not buying property – and their money will be tied up, usually for several years.

Although investors will get paid interest monthly, they generally won't get their principal back until the loan is repaid. (In some investment pools, you can get some of your principal back after two years.)

"They are not in the real estate business; they are in the securities business," Puccio says.

Trust deed investing has waxed and waned over the years, depending on what is happening with stocks and bonds. Experts expect them to attract more interest as the stock market cools and investors look for other ways to earn income on their money.

But before investing, people need to understand how trust deeds are different from other income-producing investments.

Unlike CDs or a money market account, trust deeds are not insured, so there's a higher level of risk that goes along with the higher return. That means it's not something you want to invest your rent money in or funds you may need quickly.

Financial experts recommend most investors limit these alternative investments to 10 percent of their portfolio, although retirees may make them a larger part of their fixed-income portfolio. Investors can further reduce their risk by spreading their money among several trust deeds or investing in a pool. Most investors use a broker, who will analyze the transaction, put together the loan package, handle the paperwork, and service the loan on behalf of the borrower and the lender.

But trust deeds are ripe for scams. Some of the biggest scams are Ponzi schemes, in which early investors are paid with new investors' money – until the money runs out.

The best way to check out the broker is not only by reputation but also through the state and federal agencies that license them. If the license is suspended or if there have been disciplinary actions, it should raise a red flag. Investors also should review the trust deed investment, making sure it's properly underwritten, that the borrower is creditworthy and that there's an independent third-party appraisal and title insurance.

Dan J. Harkey, president of Point Center Financial Inc. in San Juan Capistrano, which has done privately financed residential, commercial and construction lending for 30 years, wants to make sure his investors are fully informed.

He sends out a disclosure package as thick as a phone book including a loan summary, photos and maps of the property, the appraisal, a copy of the promissory note, trust deed and a preliminary title report.

"It is prudent for the investor to understand what they are doing before they invest," he says.

Investors need to know all these details because things can go wrong. If the borrower can't pay, the lender can foreclose, but if the property is in a bad location or was overvalued, investors might not be able to get all of their money back. And even if they do, foreclosure can take a while.

Many experts also warn against investing in second trust deeds, which often pay higher interest but at much greater risk. If the borrower defaults, the lender on a second trust deed is second in line to collect their money.

Ads promoting high interest rates often lure investors who don't realize the investment is in risky second trust deeds, says Frederick T. Westberg, president of Westberg Investment Corp. in Long Beach.

Westberg, who began in mortgage banking in Orange County more than 20 years ago, cited a recent mailing he got offering 19.9 percent interest, without explaining the investment was in second trust deeds.

He says any investment promising that kind of return is a tip-off the loans are very risky.

"I don't see how they can (pay 19.9 percent)," he says.

Despite all the potential pitfalls, experts say trust deeds have a place in a portfolio, even as a core holding.

But they advise investors to take a page from President Reagan: Trust, but

verify.

Contact the writer: 714-796-3646 or mmilbourn@ocregister.com