Smoke & Mirrors is a classic technique of creating a magical illusion that makes something appear to hover in an otherwise empty space. It is also used to call attention to something intended to disguise or draw attention away from a factual narrative and create an illusion of truth.
The reason for this article is that I received a solicitation recently from a mortgage broker to invest in a trust deed. His representations were full of smoke & mirrors. His email was a request to invest in a first mortgage on a commercial owner-occupied property. The borrowers owned the property in their personal names and ran a day care center located on the property. The new loan request was for $465,000. The appraisal for the real property only was $775,000 represented by the broker as “after repair value” (ARV). No upgrades or associated costs were disclosed as part of the transaction.
The appraiser stated that there was an addition made to the building in 2010 which was not reflected on public records. No effort was made to verify whether there were building permits or that the construction was legal. The broker stated that the real estate and business value combined was $1,200,000. The lender will only encumber the real estate, not the business. The broker stated that the borrowers would personally guarantee the loan, however, an individual who owns a property in their personal name cannot personally guarantee the loan. The broker represented that the borrower’s exit strategy was an SBA loan. The real cliff hanger came when through a public records inquiry I discovered that the property was in foreclosure due to lack of timely payments. This is an example of smoke and mirrors because an unsophisticated investor might not be able to identify the misleading and intentionally withheld material facts.
A broker selling a trust deed to the open public has an absolute fiduciary obligation to engage in an in-depth inquiry about the material facts of the proposed loan transaction. Upon completing the inquiry and writing up a disclosure package the broker is absolutely bound by federal and state law to disclose material facts which are discovered.
A material fact which is miscalculated, falsely interpreted, or intentionally left out of the relevant disclosures may result in a dramatically different risk/reward decision for a prospective trust deed investor. A broker who misrepresents or fails to disclose may be guilty of negligent misrepresentation, fraud, or constructive fraud.
A trust deed is defined as a security instrument by both federal and state securities laws. Any evidence of indebtedness is a security. California Corporations Code 25400 and 25401 cover fraudulent and prohibited practices in the sale of securities. Under California real estate law it is covered under 10176 of the Business and Professions Code.
Each state in the USA has its own real estate and securities regulations which may be like California’s or may be different.
Relevant questions that need to be factually verified are as follows.
- Is the borrower the actual fee owner and title holder of the real property?
- Does the borrower acting individually or on behalf of an entity have the authority to encumber? An entity may be a limited liability company, corporation, partnership, trust, or others.
- Did the borrower execute a promissory note and deed of trust (mortgage instrument) to convey the security interest in the subject property as security for a lender to hold until full payment and return of capital is received?
- Did the issuer/broker obtain the required regulatory disclosures from the borrower including a mortgage loan disclosure document.
- If the borrower is an entity, is all the documentation in order to prove up ownership and authority given to a person to act of behalf of the entity.
- Does the borrower have the capacity to make reasonable financially prudent decisions?
- Has there been an assessment about the borrower’s credit worthiness, and ability to make the monthly debt service payments? This includes net cash flow from income property and the borrower’s personal financial strength.
- Has the borrower demonstrated a reasonable exit strategy to pay off the debt in the future?
- Has the borrower disclosed the use of proceeds from the proposed loan?
- Has a title search been performed to determine all liens and encumbrances recorded or affecting the subject property? Can title be delivered free of liens and encumbrances except for the ones accepted by the lender.
- Was an independent appraisal done by a licensed, certified, and qualified expert using the comparable sales method, income approach (for income property), and replacement cost approach? If the property was income producing was there a rent survey?
- Was the appraisal accomplished by a certified appraiser qualified to perform both an “as-is” and an “as-completed” or “future” or “prospective” valuation in compliance with the Uniform Standards of Professional Appraisal Practice (USPAP)? “As-Is” and “As-Completed” valuations are required when the proceeds of the loan are going to pay for modification and improvements of the property where the after-repair value would be significantly greater.
- Was the valuation for real property only, excluding the business valuation and contributory personal property? Properties may contain an ongoing concern or profit-making business owned by the property owner. The business ownership is personal not real property. The valuation should be on the real property only and exclude any business value or personal property.
- Does the issuer/broker and subsequent investor/beneficiaries who purchased all or fractional portions of a trust deed investment have the right to rely upon the value conclusions and supporting data written and presented by the designated appraiser?
- Are there anticipated future property upgrades, modifications or improvements required in order to arrive at a conclusive appraised value?
- Does the value conclusion include considerations for the viability of property modifications in the entitlement process? Can the owner get an approved building permit based upon zoning and building regulations?
- Has some work already begun to alter or improve the property? If so, mechanics lien law becomes important. The lender will want to make sure that all tradesmen have been paid and provided lien releases prior to the recording. The title insurer will also require this. What modifications have been completed and paid for? What has been completed and not payed for? What has not been completed and not paid for?
- Does the owner/borrower have a significant financial risk to lose money if they default on the loan obligation? Does the owner have real capital, sometimes referred to as skin-in-the-game?
- Was the trust deed investment a disguised strategy by the issuer/broker to get the interested investor to put up all or most of the required capital thereby assuming the position of “high-risk” “high-reward”?
A trust deed investor usually will assume that someone else like the owner/developer is the provider of the “speculative capital” and would be willing to invest in a trust deed for less yield and correspondingly less risk. The trust deed investor will usually consider, based upon the material disclosures, that he/she has 30%, 40%, or more protective equity. If the borrower/owner defaults on the loan obligation, they will lose their protective equity with a successful foreclosure.
What would happen if an issuer/broker of the trust deed disclosed that the loan to value was 60% “after-repair-value,” rather than “as-is”? The trust deed investor may assume that that means 40% protective equity at the beginning of the investment. But what if the issuer/broker failed to disclose that the property was purchased at about 100% loan-to-value prior to any fix up or improvements using the trust deed investment capital? The real “as-is-value” would reflect 100% of TD invested capital and the trust deed investor assumes a much higher risk than anticipated. Remember that the property may need to be improved which requires time and additional capital from some source.
There may be a massive difference between the actual investor risk disclosed in a trust deed offering and subsequent investment by an unaware investor, based upon non-disclosed and/or withheld material facts of the issuer/broker. Most issuer/brokers are highly professional and will disclose all material facts known to them. A few are not.
Prospective trust deed investors should seek out proven professionals to work with to develop a long-term productive relationship.
Business and Private Money Finance Consultant
Cell 949 533 8315
This article is intended for educational purposes only and is not a solicitation.
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