Don't trust first trust deeds.
Tuesday, March 24th, 2014
Investors have become concerned with the volatility in the stock market, which is why I have advised many times to look at your portfolio on Jan. 1 and then Dec. 31 — everything in between is just a bunch of noise.
I have seen many sales pitches that scare people into "safe" investments. When the stock market was high, investors would generally put their money into bonds and maybe get a 4 to 6 percent yield. With rates at lows not seen since our parents’ generation, investors are looking for alternative ways to invest their money and get some type of yield.
As always, there are salespeople out there willing to scare you into their "safe" investment. It is far easier for them to sell you what you think you need rather than spend more time trying to educate you on how investing really works.
The latest “safe” investments that salespeople are pitching are first trust deeds. I reviewed one for a potential client and will share what I discovered. I know other plans will have some differences, but the overall concept will be the same.
The sales pitch starts off with the coming fixed-income catastrophe along with the forgotten history of bonds. Now that the sales pitch has scared the potential investors with pages and pages of how bad all other investments are, they are now set up for the solution, which is trust deeds.
The sales pitch begins to whet your appetite by talking about fixed-income investments paying 7 to 10 percent annual interest. The sales pitch focuses on how safe your money is because it is a first trust deed and the loan to value is about 50 percent.
This all sounds pretty good, but let’s think about what is really going on.
First off, they are saying the loan to value is 50 percent. While that sounds pretty attractive, I would have to ask whether the person who is on this first trust deed has 50 percent of the money to put down. I find it hard to believe the investor cannot get a loan at the bank.
I'm sure the salesperson will come up with all kinds of excuses why it is more beneficial to do the trust deeds than get a bank loan.
You are being told that you will receive between 7 and 10 percent, but no one is doing this free. Someone somewhere down the line had to do the research and legal paperwork. So what this means is the person paying on that first trust deed either paid a large fee to get it done or perhaps is paying a higher interest rate.
These are not jumbo loans. Currently, people buying a home can get a mortgage from the bank at about 4 percent. There may be other fees and buy-down provisions, but the bottom line is the homeowner is paying roughly half the interest rate by going to the bank versus the trust deed route.
So I would be confident in saying that the person who is using this first trust deed to whom you are loaning money is probably not creditworthy at all.
The salesperson will also tell you not to worry because your loan to value is 50 to 60 percent, so your money is safe. However, when that person can't pay the mortgage, that inflated appraised value now comes to light.
Think about this: If that person defaults on the loan, he has legal rights, which means he can't be kicked out of the home the first time he misses a payment. The homeowner could miss a number of payments, putting the loan in default, and in the meantime let the maintenance and upkeep of the home decline dramatically.
Eventually, that person will have to leave that home — probably not in the best of shape — and the owner of the trust deed will have to take a legal route, and lawyers can be rather expensive.
Once the legal stuff is taken care of and you've paid for repairs, the house then must be sold. It could take months to sell that house and in the meantime, the investor is not collecting any interest from the house or the first trust deed, which is now gone because you have become the owner of the house.
Then you must pay for upkeep and maintenance while you are trying to sell this house. And just like attorneys, real estate agents don't work free, either. They charge a sales commission and I'm sure they are not going to give you a break because they know you're in a bind, so be prepared to pay a 6 percent commission. There also will be other fees for selling the house.
I noticed in the sales pitch that these houses are not in San Diego. They were in Texas, Wyoming, Wisconsin, Illinois and North Carolina, just to name a few. You have no opportunity to see this property to verify what it really looks like. Also, the appraised value could be much higher than the true value of the home.
So put it all together and understand: You cannot see this supposedly safe investment, you're depending on someone else appraising this property and the person you're loaning money to cannot get a loan at the bank for 4 percent or so because they are not creditworthy.
I would approximate that if that person defaulted on the first trust deed, you would not receive any interest checks for 6 to 12 months, and when you got your check for the principal after fees, you may only get 50 cents to 70 cents on the dollar.
I have been managing money for more than 30 years and I have seen programs very similar to this in which investors lost all their money on these real estate deals that are sold by people calling themselves investment advisers. They are nothing more than salespeople.
While people complain and say stocks are too risky, they are highly regulated by many entities, including the Securities and Exchange Commission. If an investor goes to a good adviser who understands fundamental analysis, that adviser can pull out some good companies that traded publicly and may be well known.
The stock will fluctuate but if the adviser has done his or her homework and has invested in different companies in different industries and has not overpaid, and you are patient and can wait 18 to maybe 36 months, you could have a good return.
The thing you must do is not get emotional and panic when the market goes down on a temporary basis. Remember: You didn't buy the stock market. You bought a small piece of a large company based on strong fundamentals.
Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!
Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.
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