In California, trust deed investing was a sure fire way to make money for the last decade. With bank interest rates giving such a low rate of return, investors began turning to mortgage brokers, mortgage pools and REITs to get into the private money (or "hard money") lending.
The way it worked: investors would find a reputable mortgage broker. The mortgage broker (a DRE licensee or CFL lender) would then place the funds after finding a borrower with sufficient equity in their home. What type of borrower? Well, private money lending is most often in the form of a 2nd mortgage, or 2nd Deed of Trust. This means that the investor becomes the beneficiary under that second deed of trust and is behind or junior to the purchase money lender. The purchase money lender is usually a bank like Washington Mutual or Countrywide.
The borrowers usually had credit scores below 650, and had difficulty qualifying for a 2nd loan or Home Equity Line of Credit ("HELOC") with their first lender.
A junior lender’s security interest is only adequately protected if two things happen: 1)borrowers continue to make payments to the senior lender and 2) the property maintains or increases in value.
With San Francisco Bay Area and Silicon Valley real estate prices soaring in the last decade, trust deed investing was flourishing on equity lending alone–regardless of whether or not the senior lenders were being paid. If the borrower went into default with the senior lender, the junior lender would advance the funds to bring the loan current and then conduct their own Trustee’s sale. Those defaults rarely went to sale as the borrower would simply refinance the loan because new appraisal reports would show more equity was available in the property.
Well, those times are changing. Real estate prices have leveled out. If a borrower can’t keep up with his or her mortgage, they will likely face foreclosure but with a lower probability of a bailout from a new lender.
Many trust deed investors and brokers (and banks) are not interested in owning the real estate but find they will be (or have been) taking back more real estate on these defaulted loans. These rising foreclosure rates have caused national attention to focus on lending and underwriting practices. Legislators are now talking about "suitability" of borrowers taking precedence over equity. If this type of legislation passes, mortgage brokers and private money lenders are going to less willing to underwrite loans to borrowers.
This scrutiny is nothing new, as "predatory lending" has always been sufficiently vague and ripe for interpretation by plaintiff’s lawyers. However, products such as the "stated income loan" are going to vanish quickly in an effort to comply with the new legislation sure to come.
As always, good underwriting practices and responsible lending will allow investors to continue and ride out this present cycle until the next upsurge. Lenders would be wise to evaluate their appetite for risk and scrutinize appraisal reports closely.