Trust Deed Note Investing in Times of Inflation

It’s the understatement of the decade to say that the financial landscape has changed a lot in the last few months. Inflation has soared, the Fed cranked up interest rates in response, and capital markets are in trouble. Every attentive investor is taking a good long look at their portfolio, pondering next moves and new strategies.

So what about trust deed note investments? How do they do in periods of inflation? What should first-time and experienced note investors be prepared for?

A Refresher … What Is Trust Deed Investing?

First things first, let’s remind ourselves what we’re talking about. Trust deed investing means buying debt secured by real estate. 

Consider a mortgage — there’s the borrower and the lender. Most real estate investors take the position of the borrower, buying property with all the incumbent risk and borrowing money from a lender to leverage their equity.

Trust deed investors, on the other hand, take on the lender’s position in the transaction. They lend some (or all) of the money for the purchase, and the borrower is bound to repay the loan through a deed of trust, a kind of ownership deed with a lien attached to it. If the borrower defaults, the lender can foreclose — go to court to exercise the lien on the trust deed to seize the property.

This makes trust deed investing relatively low-risk — you get paid no matter what, with fixed payments and a set interest rate. If the borrower doesn’t pay, you get the property.

Lending money isn’t the only way to invest in trust deeds. You can also buy existing mortgage notes on the secondary market (sometimes at a discount), or buy partial rights to a note to collect payments for a period of time (usually 5 years or less).

Pros of Investing in Trust Deed Notes

• High yield potential, up to 12% or more with creative strategy.

• Truly passive income, fixed payments that require no maintenance or operational responsibility. 

• Secured by real estate. You get paid, or you get the property.

Cons of Investing in Trust Deed Notes

• Taxed as active income, instead of the lower capital gains tax rate assessed against real estate appreciation.

• Borrower default. If the borrower stops making payments, your investment is dead until you foreclose, negotiate, or settle. 

• Real estate could lose value. If you do foreclose, there’s a chance that a market downcycle could leave you with property worth less than the note, if loan to value is too high.  

Trust Deed Investing During Inflation

So how do trust deeds stand up to inflation? As with all things financial, there’s good news and there’s not-so-good news; which way the scale tips depends on the deal itself, as well as a variety of external economic factors beyond our control and impossible to predict. 

Here’s what to look for in the trust deed investing space … 

NOT SO GOOD NEWS — Debt Balances Become Less Valuable

Broadly speaking, in real estate inflation of the currency is generally good for real borrowers and not so good  for lenders. 

Why? Because inflation causes the property to become more valuable and command a higher rent. But the debt balance and monthly payments usually stay the same. 

Mortgage notes are not indexed to inflation. If the currency inflates 8% (as it did severely times already this year), the lender can’t kick a mortgage payment up from $1,000 to $1,080 or a debt balance from $100,000 to $108,000. 

No, the lender is stuck with the original balance and payment … and due to the decreased purchasing power of the dollar, both are less valuable than they were before. 

GOOD NEWS — Yields and Valuations Go Up

First things first — if inflation pushes the price of real estate up, that means you have better debt security and therefore less risk. If you do end up foreclosing, there’s little chance that you will wind up seizing property that is worth less than the debt.

Second, to combat inflation the Fed has increased bank-to-bank overnight interest rates twice already this year — first 25 basis points, then another 50 basis points — and we’re expecting several more interest rate hikes. This has the effect of decreasing the supply of money in circulation and cooling down the economy.

Scarce money puts upward pressure on all interest rates. Long story short — trust deed investors may have some very high interest rates to look forward to, which means higher yields. With enough yield, trust deeds and still beat inflation — even hyperinflation.

Now is not the time to swing for the fences. Note investors will beat your average….investor during inflation, if they keep their heads on straight.  – John Reid

Mitigating the Risk of Trust Deed Investing

Since the economic landscape is not all good news for notes, trust deed investors need to double down on risk management and risk mitigation. Here’s how to go about it.

Be conservative. 

Now is not the time to swing for the fences. Note investors will beat your average stock or bond investor during inflation, if they keep their heads on straight.

Here are some rules of thumb for conservative trust deed investors:

• No more than 65% LTV (loan to value). Don’t pay more than 65% of the property’s market value for the right to foreclose that property. The face value of the note (i.e. the total repayment balance) can be higher than 65%, as long as you buy it at a discount. 

• 10-year loan with 5-year call option clause. With this kind of note, the borrower has to pay the note in full at the 10-year maturity date … but there’s a second maturity date, for the call option clause. This clause gives the lender the right to declare the entire loan due in full. This makes it easier to foreclose if the borrower defaults. We have never exercised this clause if the borrower has substantially paid as agreed (or close to it).

Be prepared to foreclose as a last resort.

“Secured by real estate” only has teeth if you’re willing to bite. The lien is there for your protection. The borrower agreed to the terms of the loan; if they are past the point of salvation, you have to be ready to foreclose for the sake of your own financial wellbeing. 

However, there are several recourse strategies to consider before moving to foreclosure, and it rarely does come to that point. We recommend progressive escalation when it comes to nonperforming loans. Be open in your willingness to workout the loan to keep the payments coming. REID Lending Partners can help.

Invest retirement funds. 

Trust deed notes are a perfect investment vehicle for retirement funds. The IRS requires that IRA and 401(k) investments be held passively, and notes fit the bill perfectly. 

In tax-sheltered retirement accounts, your yield is shielded from that higher ordinary income tax rate, substantially accelerating the growth of your wealth. 

How to Invest in Trust Deed Notes

Ready to get started? Here’s how to invest in trust deed notes:

Originate Loans

Use your personal savings, family funds, business funds, or retirement funds to lend money to borrowers who want to buy or refinance real estate. An attorney can draw up a promissory note and deed of trust which can be filed with the county, making it official. 

Find Great Deals on Existing Loans

Network with banks, lenders, note brokers, and other investors to find great deals on existing notes. Often you can buy non-performing notes at a discount. If you strike a deal with the borrower to restart payments, the yield on the note will skyrocket. Alternatively, instead of buying the note in full you can buy partial ownership of a note, or you can buy the right to collect payments on a note for a period of time.

Don’t Go It Alone

Whether you’re new to the game, or an experienced real estate note  investor whose time is valuable, there’s no need to do it all yourself. REID Lending Partners pairs qualified investors with high-yield trust deed investment opportunities.