When investing in trust deeds, investors have two options. They can invest in a new origination note or they can buy an existing note at a discount and have the deed and insurance documents assigned to them. Each of these choices brings with it its own unique set of processes and benefits.
Underwriting includes all the analysis necessary to confirm valuation, income, property condition and the borrower’s capacity to execute on its repayment strategy. When you invest in a new origination, you have the benefit of reviewing the buyer, the property and any associated risks before you agree to the investment. As a new note investor you can:
- Review the property’s assessed value and make sure that you find it a reasonable appraisal. You can also request a new appraisal if you think the appraiser was overly generous or optimistic.
- Review the borrower’s plans for development of the property and exit strategy for paying off the loan.
- Receive proof of the borrower’s income to ensure he or she is reasonably able to pay back the loan.
- Determine the loan to value ratio and ensure that the equity is equal to the risk.
- Speak with the borrower before signing off on the loan.
Unfortunately, when you are buying an existing note, you get no say in the underwriting. If you want to buy the note you must accept the buyer and the loan as it is written even if you think the property assessment was too high, the development plans naïve and the equity too low.
New note originations are like blank pieces of paper. On them, you can impose all the terms that you want and that suit your needs. For instance, you can impose terms that require:
- Pre-payment penalties to ensure you get a certain yield.
- Extra points on the interest rate as incentive to waive the pre-payment penalties.
- An interest rate that offers you an attractive return.
When purchasing an existing note, you are left with no bargaining chips and no ability to influence the terms since they have already been agreed upon and signed into permanence.
When it comes to interest, an existing note can benefit you as long as the interest earned is not outweighed by the risks discussed above. When you purchase an existing note, you do so at a discount. Consider the original loan amount par. Each loan is invested in at par and receives interest that is generated by applying the interest rate to the loan amount. When you buy an existing note, you are buying it for less than par (less than the loan amount) but your interest earned is still based on the original loan amount effectively increasing your yield. In essence, this works like buying a bond at a discount. But unlike a non-callable bond, existing trust deeds without prepayment penalties carry the risk that the borrower may pay off the loan early. If this happens you will have less time earning the higher yield and will have a lower return than you might have wanted.
While new notes and note assignments each have their own benefits and drawbacks, investors would be hard pressed to beat the discretionary authority, control, and decision making choices offered by new notes. As an investor, the feeling of empowerment you get from creating your own terms for the trust deed and by choosing which borrowers to lend to and which properties to invest in is unrivaled by any other investment. Whether you consider stocks, bonds, note assignments or mutual funds you will not find another investment that offers investors the control, level of engagement, satisfaction and confidence as a new trust deed note.