Three common mistakes to avoid when deed of trust investing
Mistake #1- Chasing yield.
Chasing yield is classic in all investment arenas and contributes to more losses than any other investment faux pas. Here’s how it usually goes: The investor chases yield and rationalizes that the quality and risk is the same as a more conservative version of the investment, ignoring quality. For a while it seems to work, but then suddenly, the investor’s previous returns are wiped out with one bad transaction, including a loss of some principle. This happens in stocks, bonds, real estate and even services like legal advice. One attorney bills less per hour than another but perhaps is less efficient, less experienced and less effective- ultimately costing many times more than the more experienced attorney. The lesson is- quit focusing on yield until you fully understand the risks involved. As soon as you are “wooed” by yield prior to risk assessment, your vision gets cloudy and your desire to “profit now” can over shadows sensible action. Of course you want a good yield, but not at the expense of your principle. A consistent and prudent 6% return is usually better than chasing 10%. A consistent and prudent 10% is usually better that chasing 15%, and so on. Let the higher
|returns come as a by product of wise investing, not yield chasing. It all comes down to quality and capital protection first, then appropriate yield.
Lesson: Think safety first, yield second.
Mistake #2- Under estimating the relevance of the securing property’s marketability.
This classic mistake is tied directly to deed of trust investing. The investor focuses on loan to value (LTV) and not depth of market for the securing property. As an investor, I would much rather invest at a 70% loan to value on a high demand property with plenty of financing options than 30% loan to value on an old special use building in a “B” grade location. Remember, easy in doesn’t mean easy out. Usually this gets back to the investor not having enough choices of quality alternatives, so they chase yield all the way to Green Bay Wisconsin, or Kalamazoo Michigan. Ask yourself a couple questions first:
1) Is there a sufficient buyer pool, wanting the property, should it be offered for sale somewhere close to the appraised value? If not, it could take years to get back to cash. Especially in a slow market.
2) Is there a history of adequate financing available for the securing property type, at reasonably attractive rates? If not, you will be that lender for quite some time. Today more than ever, deed of trust investors must know their borrowers exit options, including the availability of new financing for prospective buyers. It’s best to stay with highly marketable properties that attract large buyer pools. Getting back to cash in a reasonable time, can be very important.
Lesson: Think quality first, yield second.
Mistake #3- Underestimating the importance of a quality borrower.
Over the years, it has been common for private money lenders to discount the value of a quality borrower, focusing entirely on the collateral. While it is agreed that in asset based lending, “collateral is king” and should be thoroughly analyzed, there is more to successful underwriting than just collateral analysis. The borrower’s impact on the success or failure of the loan should not be discounted- especially on performance based loans like construction or income property. If the success of the loan requires the borrower to wisely manage cash flow, tenants, or complete construction- you must upgrade your credit tolerance considerably. After years of experience, we’ve seen this reality proven out numerous times. Good credit borrowers have something to protect, especially during tough markets. Good credit borrowers generally solve problems and make smart decisions. Bad credit borrowers do the opposite. Yes collateral remains the primary piece to a successful deed of trust investment. But in most cases, bad credit borrowers negatively impacting the securing property’s value by making poor and self serving decisions, and add considerable time to the process of foreclosure. Time is money. Limit your exposure to poor character borrowers and over the long haul, your yield will improve, and so will your enjoyment of investing.
Lesson: Borrower quality matters, and should be at least 30-40% of your analysis, even with excellent collateral.
The last several years provided an economic rising tide, which masked many investment mistakes. In 2008 and 2009 there has been nowhere to hide. If your underwriting was sloppy yesterday, you lost money today. If your underwriting had major flaws, you lost a lot of money. As Warren Buffet said, “you never know who’s been swimming naked until the tide goes out”. So many in the real estate lending industry were swimming naked; even the hard money industry. Today, those investments have been exposed.
At Seattle Funding Group, we have been involved in successfully underwriting hundreds of millions of dollars in deed of trust investments. Today we are one of the most successful companies of our kind in the nation. Over the years we have learned what works and what doesn’t- in all markets. We have written our top twelve lessons in deed of trust investing and will be making it available to investors in July of 2009. The lessons discussed here are three of the twelve. If investor’s adhere to these twelve lessons when investing in deeds of trust, we believe they will better keep their principle secure, consistently make strong returns, and enjoy the peace of mind deed of trust investing can provide... especially today.