This is a guest post by Deets LaMoss at freedom595.com. His blog documents the methods and strategies he is using to generate passive income to replace his salary and become financially free by November 15, 2017.
One of the core investments that I use in my passive income machine are trust deeds (aka notes or mortgages). If this is a new topic to you, then please read on as I will share the mechanics of how this works and why I like them.
A trust deed is like mailbox money
Trust deeds or mortgages are one of the best passive income investments I have found. These short term loans, secured by real property, are made to contractor/investors who purchase undervalued homes in desirable areas, rehab them, and then quickly resell them. By acting as the private lender or “banker” you get to participate in the real estate market and earn high returns without worrying about tenants who don’t pay their rent or fixing their leaky toilets. Also, it is really cool to get checks in the mail every month for doing nothing!
How they work
These contractor/investors do not have time to wait on a bank to approve and fund a loan. When they find a property they have to move quickly before someone else gets it. That is why they use private lenders who can fund the project in less than two weeks. They pay a higher interest rate for the convenience of this service because they are borrowing the money for a short period of time (6-18 months) and their anticipated resale price will offset the rehab costs and interest payments yet still produce a handsome profit.
One of the things I really like about this business is the transparency. I work with a team of licensed brokers, attorneys, and title and escrow companies to make sure the paper work is complete and everyone is protected. It’s clean, easy, and secured by real estate.
The other thing I really like is the fact that everybody wins. The borrower is able to close more deals and make more profit. The private lender makes a spread on the interest and sometimes a share of the borrower’s profit. The trust deed investor earns excellent interest (8-10%) and sometimes a back end profit. The service providers (broker, loan servicing, escrow, title, etc.) all benefit from the transaction too. It’s a great business model!
What they fund
There are two primary transactions that are funded by private lenders:
1) Loans to experienced contractor/investors who purchase undervalued homes or commercial properties in desirable areas, rehab them, and then quickly resell them. These are first and second mortgages with a loan term of typically 6-18 months. The total loan to value on the property is usually 70% or less meaning your investment is secured with a lot of equity.
2) Loans to professional developer/investors who purchase pre-approved residential lots in low inventory markets with the intent to either acquire a construction loan and build homes or to flip the property to a national homebuilder with the best offer. These 6-8 month deals tend to pay a better return with a lower loan to value ratio.
Do your homework and meet the people
If this sounds interesting to you, you need to seek out private lender/brokers in your own geographic area. I like to meet every broker that I am going to work with face to face to get a better understanding of the person and their track record in the business. If you want to participate, you will need to be ready to move quickly as these loans typically fund in less than a week. Paperwork varies with each broker, but you typically need to sign at least one notarized document and then wire your funds to escrow. Your interest checks start arriving about 4-6 weeks later (less a small loan servicing fee), but your interest payments are calculated from the date the loan closes. When the property sells, your original principal is returned along with a final interest payment. It really is as simple as it sounds.
Like every investment, there is potential risk. If a borrower stops paying his interest payments, then the property is foreclosed upon and the investors take title to the property. That means it can be sold to recoup the original investment and potentially earn a profit since there is a nice cushion (called protected equity) with the loan to value ratio of 70% or less. Also, a project may end up taking longer than anticipated which requires a rewrite of the loan. When that happens, there is usually a 4-6 week delay in the interest payments, but the interest continues to accrue and is paid when the new loan is in place.
Start with first trust deeds since this puts you first in line in the event of a foreclosure. Second position notes can deliver higher returns, but there is also more risk. I wrote another blog post on this subject that you can read here: How do foreclosures affect my Trust Deeds?
As of April 2015, I have funded a total of 31 loans. The number of open loans in my portfolio currently is 13. Most of my closed loans have returned my principal and interest just as I have described. I had quite a few go longer than anticipated which delayed interest for a while, but in the end everything was paid off as expected. I have two that got tied up in bankruptcy by the borrower, but I expect to receive my principal back once the legal shenanigans are completed.
There are new trust deed opportunities popping up all the time. Start with the minimum investment that your broker/private lender will offer usually $25-50K. See how it works for you and if you like it then start creating a portfolio of first position trust deeds to diversify your risk. If you don’t have that much to invest, then check out Patch of Land. This is a Peer to Peer (P2P) or crowdfunding site that allows you invest as little as $5,000 per trust deed. Today you need to be an accredited investor, but the SEC may make changes in the near future that would remove this qualification and open it up to all investors.
Best of luck on your own journey to financial freedom!
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