TRUST DEED INVESTMENT STRATEGY
AND CHANGES IN TODAY'S MARKET
by Richard C. Temme
Most of you are experienced investors and we do not want to insult your intelligence with a review of the basics. It is important to note, however, the availability and nature of trust deed investments has, and is, undergoing considerable change.
LOAN TERM
Investors traditionally have indicated a preference for an approximate three year period on their trust deed investments. However, the new federal lending laws that became effective October 1, 1995 (Section 32), in many instances forbid a balloon payment on owner occupied 1 to 4 unit residences if the balloon payment occurs in less than five years. Not all loans are subject to this new rule. Further, while we still have shorter term loans available, most borrowers are demanding even longer term loans. That may not be so bad. We can say from 20 years of experience that longer term, fully amortized loans have far fewer problems than interest only loans with balloon payments. Further, they usually pay off early.
HOW DOES AN INVESTOR COPE WITH THE LIQUIDITY CONCERNS
OF INVESTING IN LONGER TERM TRUST DEEDS?
Few investors want to tie up their funds for 10, 15 or 20 years. Yet, many investors who may have a need for liquidity nearer term, are doing just that. WHY????
Traditionally, many large loan companies claim to have experienced average payoff periods of 3 to 5 years on 15 year fully amortized loans. We like to suggest that a 4 to 7 year average period is a more conservative expectation. That means investors who invest in loans or a small portion of many different longer term loans will, statistically, receive most of their money long before the scheduled 15 year maturity. Even the few loans that may actually take 15 years to pay off are usually fully amortized. Fifteen year fully amortized loans are scheduled to return to the investor approximately 26% of the principal balance during the first seven years and approximately 1/2 of the principal balance in the first 10 1/2 years.
Investors looking for further proof of early payoff statistics need only to look in the Wall Street Journal for the average payoff periods of GNMA passthroughs. GNMA Passthroughs are pools of 30 year FHA and VA loans. Most of the dollars invested in these GNMA pools are loaned to a borrower profile with a small equity, a relatively low rate of interest and
someone who is likely to stay put. Even these pools of 30 year government loans often show a weighted average life of only seven to twelve years. We believe privately funded 15 year loans through R.C. Temme Corporation, by their nature, should have a much shorter average payoff period than GNMA pools.
Most of our investors have recognized that the best way to take advantage of these early pay off statistics is to diversify their investments into smaller portions of as many different loans as possible. For example, an investor investing in $10,000.00 portions of many different first deeds of trust may actually have one or two loans out of ten take a full 15 years to pay off. The balance will pay off, on an unscheduled basis, over the life of the loan, with a few loans likely paying off in the first two or three years. These statistics will vary somewhat depending on interest rate, prepayment penalty and property type.
PROPERTY MIX AND LOAN AVAILABILITY HAVE CHANGED
Wall street is now competing with private investors to place money with borrowers who may be credit impaired or cannot prove their income and must rely primarily on the equity in their property to entice a lender to loan. These are borrowers who have traditionally borrowed from private investors. Companies such as Aames Home Loan, First Alliance, Quality Mortgage, Option One, Long Beach Bank, The Money Store, Weyerhauser, Countrywide and others are now making 30 year loans to this profile of borrower who traditionally would have borrowed from private investors. These loans are then usually securitized via Wall street at rates much lower than would be acceptable to private investors. In addition, the six year decline in residential property values has also contributed to the shortage of available loans. As a result of those two factors, there are not as many good loans on residential property, available to private investors, as had previously been available.
Most investors, through the years, have preferred lending on single family homes. In Southern California, single family home values peaked, generally, in spring or summer of 1989. They did not appear to bottom until the fall of 1994. Some areas displayed softening prices well into 1996, although generally at a much slower rate of decline than had previously taken place. A few areas still may not have completely bottomed.
Southern California commercial properties and apartment houses probably peaked in 1987 or 1988, the result of the 1986 Income Tax Reform Act only to be followed by the Banking Reform Act. This combination of removing tax incentives then removing cheap financing for many properties contributed to a disastrous decline in values of many investment properties. Many commercial properties and apartment houses declined more than 50% in value. The timing varies according to location in Southern California and property type, however, in approximately fall of 1994 to mid 1995 commercial properties, and in some areas apartment houses, appeared to have bottomed. Certain large upper end, commercial properties generally bottomed earlier and, in many cases since, have actually experienced a significant increase in value.
Less expensive commercial properties, such as properties on which private investors may loan, have not generally displayed the price rebounds apparent in large shopping malls, etc. However, in most areas the vacancy factor is declining and investment interest is developing in commercial properties.
Prices on commercial properties fell so deeply, compared to the rental income being generated, that potential investors stopped worrying about declining values, tax incentives or financing availability. Investment properties were once again purchased for the income. This return to the basics has helped to create a floor on prices of commercial and other investment properties.
TRUST DEED INVESTORS HAVE NEW OPTIONS
Some investors, staying with what they understand, will continue to select their trust deed investments only from the dwindling supply of available loans on single family residences. We cannot fault that thinking. However, consideration of loans on investment properties may be worthwhile due to a variety of additional advantages offered.
Perhaps the biggest issue with investors is security. Now that many investment properties have fallen in price relatively much more than the more modest declines in rental income generated by these properties, trust deed investors are viewing the huge monthly rents as a new source of security for their investments. In a foreclosure scenario investors may now choose to hire a competent property manager to take care of the property, allowing the investors to collect net rental income sometimes for as much, or more, monthly as the accruing interest on their trust deed investment.
NEW ENVIRONMENTAL LEGISLATION
Environmental contamination has, for a number of years, been a concern to real estate lenders and investors in all types of property. Properties other than single family residential have created more concern than small residential properties.
The American Bankers Association, and other lenders, have recently been successful in lobbying for passage of new legislation at both state and federal levels that now give protective exemptions to innocent lenders who acquire contaminated property as a result of foreclosure. Special procedures must still be followed and discussed with counsel prior to completing a foreclosure on property that is suspected of having contamination.
OTHER LEGISLATIVE CHANGES
Two recent additional changes in the law have also encouraged lending on investment properties.
1. Bankruptcy laws were changed in the fall of 1994 to help enforce lender's rights, particularly in one asset bankruptcies which were a common problem with loans on investment properties.
2. Effective January 1, 1997, changes in Civil Code Section 2938 and Code of Civil Procedure Section 564 made it easier for rents to be collected on a lender's behalf when a loan is in default.
OTHER OBSERVATIONS
A little noticed advantage to lending on commercial properties is that many commercial property borrowers are very strong financially with excellent credit references. They did not necessarily borrow through R.C. Temme Corporation because of bad credit or inability to prove income. They, instead, sometimes borrowed because R.C. Temme Corporation could often arrange a better loan than FDIC insured institutions. One reason is the Banking Reform Act, passed in the late 1980's. This Act had the effect of increasing reserve requirements to insured institutions which in turn caused many institutions to raise rates on loans secured by certain investment properties. Additionally, most institutions want a variable rate on loans secured by commercial property and many borrowers prefer the fixed rate loan offered by R.C. Temme Corporation.
Most foreclosed properties sell for less than the original appraised value. Presuming that the appraisal was correct to start, the lower sales price usually results from anxious sellers dumping the property to cut down on holding costs and loss of interest income on their invested funds. Rental properties give investors more flexibility, they can be rented following a foreclosure. When rent from the property is paying a reasonable return on invested capital, a number of additional options avail themselves to the investor. Perhaps the biggest advantage is that there is usually no financial pressure to sell, thus allowing investors to hold out for a full market price or a better market when they do sell. Again, a good property manager can make this a relatively carefree experience.
Investors who in a foreclosure scenario and, instead of reselling the property, are inclined to own the property to collect rents, may have other tax advantages available over and above the obvious depreciation deductions. It is important to remember that these tax advantages do not accrue to all investors. They are sometimes complex and should be discussed with your tax counsel before relying on them.
March, 1997
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