Real Estate News

The Pitfalls of Fractionalized Deeds of Trust


Written By: Edward Brown
Monday, November 30, 2020

Many investors like the alternative lending space where they can invest in mortgages, otherwise known as, Trust Deed investing, whereby they become the lender on real estate. The two major ways to invest in these mortgages is either in some kind of pooled investment [a Fund], similar to a mutual fund or owning the deed of trust on a specific piece of real estate, similar to owning an individual stock.

In the case of investing in a Fund, the investor invests in the Fund, and the manager chooses which loans to make to borrowers. In the situation of owning an individual deed of trust, the investor chooses which specific loan to invest in and is recorded on title. It is the latter that is the focus of this article, and specifically fractionalized deeds of trust where the investor shares ownership in the investment with on or more other parties.

Most note brokers [in California; other states may vary] are licensed to fractionalize a deed of trust [notes] with up to 10 owners [beneficiaries]. Other brokers have licenses from the Department of Corporations to have more than 10 beneficiaries. The reason brokers fractionalize notes isnbsp;usually because they are too big for one investor. A 40,000 note may be able to find a home with one investor, but a 700,000 note may need more than one investor in order to be funded. Each investor receives a recorded deed of trust [for their protection as evidence for their loan]. When the borrower pays the loan off, each investor is required to reconvey their interest in the loan [notarized signature] in a timely manner [California requires this be done within 21 days of the request]. The reconveyances are deposited in escrow, and each lender is paid off in escrow as well.

If everything goes smoothly, no one complains; however, what happens if things dont go according to plan? What if a lender is unavailable to sign off in a timely manner? What if a lender refuses to sign? What happens if the borrower defaults on a fractionalized loan? What happens if you have a minority interest [less than 50 ownership] in a fractionalized loan? These are just a few instances where a fractionalized lender faces challenges, and these challenges can be monumental.

First, lets look at a simple situation where a 900,000 loan has been fractionalized into 9 different lenders [each having 100,000 ownership in the loan] and 8 of the 9 lenders signs the reconveyance paperwork in a timely manner but one chooses not to sign [in time, or not at all]. Why would the lone lender choose not sign? What if the loan was very well secured and the note was yielding a higher than market rate of interest? A nave lender may think that they can enjoy the higher interest for longer than allowed [not signing in a timely manner]. This situation is not as far fetched as one might think. In the 1990s, first deed of trust notes yielding 12 were not uncommon. When rates dropped dramatically, borrowers were quick to refinance. One investor tells the story of how a 12, 1.2M loan was trying to be refinanced by the borrower at 9 with a new lender. The fractionalized note had 5 owners. 4 of the 5 had their reconveyances notarized and delivered to the escrow company in a timely manner. The last investor had 500,000 in the note and did not want to lose his 12 rate; he was under the misconception that he could just keep coming up with excuses as to why he was not able to get to a notary [he was a busy surgeon]. After more than a month went by, the borrower sued all of the lenders for the difference in the rates [3] plus attorney fees. Although thenbsp;lone holdout was ultimately responsible, all of the other lenders had to defend themselves, which put undue burdens upon the innocent 4 lenders.

Next, lets look at a situation where a majority [over 50] lender chooses to extend a loan when it matures, and a minority lender does not. Unless the minority lender requests a partition action so as to separate himself from the majority lender, the majority lender is in control of the fate of that loan.

Dealing with foreclosures by the lenders introduces an enti>

Thus, foreclosing may not even be possible if the note holders cannot agree to their destiny or come up with the funds needed to file the paperwork to foreclose [which can be many thousands, depending on the size of the loan].

Other issues arise even if foreclosure has been started; one lender tells the story of how the borrower stopped making payments to both the 1st and 2nd mortgage. This particular lender was one of many in the 2nd mortgage. The 1st started the foreclosure process. Nobody in the 2nd mortgage wanted to cure the 1st. There was an offer by an independent 3rd party to purchase the property for the 100,000 over the1st mortgage, which would have been given to the 2nd [which would have paid its loan down but not off]. There were 25 beneficiaries on the 2nd DOT. 24 of them chose to allow the salenbsp;and take the 100,000, which would have amounted to a short sale; however, the one lone holdout, who represented only 4 of the 2nd, refused to sign off on the sale. His reasoning? He stated that he believed that, at the foreclosure sale, someone would bid the property up more than 100,000 over the 1st. Not only was this illogical [based upon the value of the property], but it went against his previously signed documents stating that he would go along with the majority, opening himself up to a lawsuit by the other lenders. The title company refused to give title insurance to the potential buyer, and the sale never went through. At the trustee sale, one bidder bid just over the 1sts credit bid, and the 2nd walked away with zero.nbsp;

Many individual trust deed investors believe they are protected from many perils if they own over 50 of the note, as most states have a rule that the majority holder makes the rules; however, title companies are not bound by such laws. If they refuse to give title insurance, any prudent would-be buyer of the property will walk away.

Another issue is that an investor in a note does not have to come up with his fair share of the money it takes to file foreclosure, and there is no provision that states that other investors who come up with more money get a preference, so it is difficult to maneuver a foreclosure unless each person comes up with his percentage required.

Other not infrequent situations come up where the borrower wants to do a loan workout or re-write the note. Unless all parties agree, everything is at a standstill. Some unethical fractionalize note holders will sometimes hold this over on the rest of the note holders by demanding a larger share than they are entitled to or demand that the other investors buy them out.

For these reasons, many investors have turned to Funds where the Fund manager handles the foreclosure paperwork, pays the fees, and sees the entire process through.

The takeaway here is that one needs to be extremely careful if one wants to invest in a fractionalized note not only do you want to own more than 50 of the note, but make sure you know every other owner and have like minds, which, in todays world, is more than a daunting task.


nbsp;nbsp;Edwardnbsp;Brownnbsp;is in the Investor >

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