Summary:
Investing in deeds of trust and mortgages is an excellent option for those who want consistent cash flow and to keep up with inflation
Investors need a fundamental understanding of the process and the inherent benefits vs risks
Investors will most likely develop a relationship with a knowledgeable mortgage broker specializing in procuring loans from the public, processing, underwriting, and delivering them to the public with a material disclosure package so that the public can make an informed decision.
Article:
Promissory notes secured by deeds of trust or mortgages are securities. Deeds of trust and mortgage instruments are securities. These contracts represent evidence of indebtedness. Ownership is a security defined under the Federal Securities Act of 1933
Acquiring a comprehensive understanding of the legal framework is not just necessary; it's crucial. This knowledge empowers you to make professional investment decisions, providing the confidence and control to navigate the industry's complexities easily.
The definition of security under federal law is as follows:
Property given or pledged to guarantee the performance of an obligation.
An instrument that functions as proof of a security interest in a public or private body.
Parties in a loan transaction:
The borrower and private-party lender are not just integral but fundamental principals in a loan transaction. The borrower's signing of a promissory note, a promise to pay, and the recording of the security instrument, a deed of trust, at the county recorder's office are public notices of the charging lien against the property, underscoring their value in the process.
The note and deed of trust are contracts between the borrower and private-party lenders. After the loan closing, the investors/lenders or their servicing agents will retain the executed and recorded documents as evidence of the investment.
Promissory notes and deeds of trust (or mortgages) are considered personal rather than real property.
Deeds of trust and mortgage investments are securities requiring federal or state registration unless there are applicable exemptions from registration:
Each state in the U.S. has its own securities laws and regulations, known as Blue Sky laws. These are designed to establish safeguards against investor fraud and provide security to all involved, giving you a strong sense of reassurance and security.
What does securities registration mean?
Registration is when a company files the required documents with the Securities and Exchange Commission (SEC). This process involves approving disclosures and other information related to the offering and usually leads to quarterly and annual reporting requirements.
Unregistered securities have fewer protections than registered securities. Companies can only sell unregistered shares to a limited number of qualified or high-income and high-net-worth investors.
Securities overview:
Federal and state securities exemptions from registration are common and available.
Federal Exemptions:
Federal exemptions for privately funded loan transactions and loan-pooled investors are referenced in Regulation D, Rule 506 section 4(a)(2), Rule 506(b), Regulation A, and Rules 147 and 147A. Information about these regulations can be found at:
https://www.investor.gov/introduction-investing/investing-basics/glossary/regulation-d-offerings
https://www.sec.gov/education/smallbusiness/exemptofferings/rega
https://www.sec.gov/education/smallbusiness/exemptofferings/intrastateofferings
Definitions and exemptions are on the www.sec.gov website.
State securities exemptions:
Each state has its own securities laws and exemptions.
Understanding your state's relevant securities statutes, such as California's Corporate Codes, can provide security and protection. This knowledge is crucial for those involved with loans and investors in any state.
California Corporate Codes relating to securities are 25000-31516
The California Corporate Securities Law of 1968 regulates all offerings and sales of securities in California. All securities offered or sold must be qualified by the Department of Financial Protection and Innovation Commissioner or exempted from qualification and registration by a specific law or corporate rule. The Department of Financial Protection and Innovation Commissioner plays a crucial role in qualifying securities, ensuring that all offerings and sales comply with the state's securities laws.
25100 (p) is referred to as a whole note exemption, one note purchased by one party
(p)This is a promissory note secured by a lien on real property, which is neither a series of notes of equal priority secured by interests in the same real property nor a note in which beneficial interests are sold to more than one person or entity.
25102 for state offerings exemption
25102 (e)
Under Section 25102 (e, f), an exemption from the qualification requirement for issuer transactions is available for any offer of sale of evidence of indebtedness, a partnership, a joint venture, and a specific participating interest in railroad rolling stock or other equipment, if the transaction does not involve a public offering.
California state exemptions for fractional trust deeds are 25102(e), 25102(f), and 25102.5. These exemptions cover multiple investors who invest in real estate loan transactions. 25102(e) and 25102.5 allow a maximum of 10 investors. Both exemptions, 25102 (e) and 25102.5, contemplate lending on California properties with California-based investors. Family members are considered part of the same household.
25102.5 is referred to as the fractional note exemption.
California rules are promulgated in the Business & Professions Code 10237-10238, 10232.3, 10232.4, 10232.5, Civil Code 2941.9, and many others.
To make sure you understand these requirements fully, it's essential to consult a real estate or securities lawyer specialist who can guide you and provide the support you need.
25102(f) private offering exemption.
The Corporations code sets forth an exemption from the qualification requirement for transactions where (1) the sale is to 35 or fewer persons, (2) each purchaser has a preexisting relationship with the securities issuer, (3) each purchaser represents the purchase is for the person s account, (4) the offer or sale is not accomplished through advertising, and (5) the issuer files a notice with the Department of Corporations, within 15 dates from of the issuance. Corporate commissioner's rule 260.102.14 provides instructions for filing the notice and paying a fee. Failure to file the notice on time negates the exemption.
25102 (f) allows up to 35 unaccredited investors, with no limitation for accredited investors with conditions. 25102 (f) does not require California investors or California properties for a particular loan request. Could you talk with counsel?
260.102.12 of The Corporate Commissioner's Rules:
There are three instances when a 25102 (f) exemption may be helpful.
When a trust deed requires more than ten investors
When an occasional (accredited investor) out-of-state party invests in a trust deed on a California property
When a California real estate lender makes a loan on an out-of-state property
25113 provides a path to eligibility for qualification through a permit process. Under this section, an issuer may apply for a permit to operate and provide the accompanying documentation as required by the commissioner. These permits are usually renewable annually.
I'd like to point out that seeking advice from a qualified securities attorney is crucial in applying appropriate securities exemptions and ensuring regulatory compliance. This will provide you with a sense of security and guidance in the complex landscape of securities compliance.
California Corporate Commissioners rule 25206.
A broker licensed by the Real Estate Commissioner is exempt from the provisionsof Section 25210(broker-dealers) when engaged in transactions in any interest in any general or limited partnership, joint venture, unincorporated association, or similar organization (but not a corporation) owned beneficially by no more than 100 persons and formed for the sole purpose of, and engaged solely in, investment in or gain from an interest in real property, including, but not limited to a sale, exchange, trade, or development. One person shall own an interest held by a husband and wife for this section.
California Code of Regulations, Section 260.204.1
An exemption from the provisions of Section 25210 of the Codeis hereby granted, as is necessary and appropriate in the public interest and for the protection of investors, to any person who is a real estate broker as defined in Section 10131of the Business and Professions Code, duly licensed to engage in the business of a real estate broker in this state, and whose business as a broker-dealer, in addition to any transactions within Section 25206 of the Code, is limited to any or all of the following:
Transactions in a series of notes secured by interests in the same real property, or undivided interests in a note secured by real property, according to qualification under Section 25110, Section 25120, or Section 25130 of the Code or according to the exemption contained in Section25102(e), Section 25102(if) or Section 25102.5, other than an offering which is made under a registration under the Securities Act of 1933 or a Regulation A exemption under that Act ( 17 CFR 230.231 et seq.).
California is highly regulated, with other laws passed and pending future legislative bills that diminish property ownership rights and lessen prospective benefits. Real property ownership rights and benefits continue to be eroded.
There are hundreds of code sections about licensing, fiduciary obligations, operation of real estate and mortgage companies, and disclosure requirements for both borrowers and trust deed investors. I omitted the extensive list of all the code sections because the number is significant. Therein lies the continuous employment of lending consultants, expert witnesses, real estate lawyers, and securities lawyers.
Disclosure requirements for trust deed Investors:
A California mortgage broker soliciting an investor to purchase all or a fractional share of a trust deed must provide a lender/purchaser disclosure statement before taking funds.
A lender/purchaser, disclosure statement 851-C, revised 7/2018
https://www.dre.ca.gov/files/pdf/forms/re851c.pdf
A lender purchaser disclosure statement for the multi-lender form is 851-A, revised 7/2018
https://www.dre.ca.gov/files/pdf/forms/re851a.pdf
A lender-purchaser disclosure statement for the sale of an existing note
https://www.dre.ca.gov/files/pdf/forms/re851b.pdf
Investor disclosures are in 10232.3 &10232.5 of the California Business and Professions Code.
Business and Professions Codes 10232.3 and 10232.5 outline the disclosure requirements the funding lender must adhere to for a real estate licensee. I am familiar with these requirements since I co-sponsored Senate Bill SB 1554 in 1998 and wrote a portion of the language that resulted in the code's adoption.
The purpose is to provide the investors with written disclosures to make them aware of the material facts and risks and to enable them to make an informed investment decision.
Sections 10232.3 and 10232.5 outline required investor disclosures.
Address or other means of identification of the real property that is to be the security for the borrower's obligation.
The estimated fair market value of the securing property as determined by an independent appraisal, a copy provided to the lender. However, a lender may waive the requirement of an independent assessment in writing on a case-by-case basis, in which case, the real estate broker shall provide the broker's reported estimated fair market value of the securing property, which shall include the objective data upon which the broker's estimate is based. A broker can issue a broker's opinion of value.
Age, size, type of construction, and a description of improvements to the property, if contained in the appraisal or as represented to the broker by the prospective borrower.
Borrower(s): Identity, occupation, employment, income, and credit data are represented to the broker.
Terms of the loan transaction.
Liens and encumbrances: pertinent information concerning all liens and encumbrances against the securing property and, to the extent of actual knowledge of the broker, relevant information about other loans that the borrower expects or anticipates will result in a lien recorded against the collateral property securing the promissory note, created in favor of the prospective lender. As used in this paragraph, actual knowledge concerning any anticipated loans means knowledge gained by the broker through arranging the subject loan or other loans on behalf of the borrower.
Title insurance: The broker shall provide the prospective lender with the option to purchase a title insurance policy or endorse an existing title insurance policy covering the securing property.
Written loan application (signed).
Credit report.
Loan servicing provisions include the disposition of the late charge and prepayment penalty fees paid by the borrower.
Industry standards and best practices may expand investor disclosures. Here are recommended guidelines on data accumulation.
Individuals/entities: The borrower may be one or more individuals or an entity such as a family trust, limited liability company, or corporation. The procuring loan broker should be able to articulate who the borrower is and provide a brief background.
Collateral property: Describe the property, its uses, and the address. Describe the tenancy, income stream, and vacancy if the property is income-producing. Describe the condition of the property and its strengths and weaknesses. Will the property be improved because of this loan?
Purpose of loan: What is the intended use of the loan proceeds? What other debts are to be paid as part of the loan? How much net proceeds will the borrower receive? What will the net proceeds be used for? Will most of the loan proceeds be used for consumer or business purposes?
Some lenders operate under a pooled limited liability format with a California Finance Lenders license. Others operate under a Bureau of Real Estate broker's license. Some real estate brokers also create pools using one of the various federal and state securities exemptions.
Three questions arise:
Does the entity or the security issuer have a fiduciary obligation to the investors?
Is the entity required to follow real estate law?
Does the entity or issuer waive or disregard reasonable and prudent underwriting processes without violating fiduciary rules or breaking the law?
Private-party investors:
Private-party investors may purchase 100% of a loan, co-invest fractionally with a small group as tenants-in-common, or form a pooled entity with other investors. They include individuals, family trusts, corporations, IRAs, and pension plans.
Most investors invest with multiple ownership methods (holding titles), such as a family trust for a portion and an IRA custodian for a portion. I have noticed various titles for couples who establish a family trust for themselves and their descendants and invest in each. Multiple family members living in the same home are considered one investor for ten or fewer investors.
The entire trust deed investment percentage represents the investor's beneficial interest portion of ownership. For example, if the trust deed investment is for $1,000,000 and the investor purchased $200,000, they would own a 20% undivided interest as tenants-in-common. A $100,000 investor would hold a 10% undivided interest as tenants-in-common with other investors.
Private-party Investors who desire to invest in trust deeds with their available capital understand that they are securing their investment by accepting a signed promissory note from a borrower and a signed and notarized recorded deed of trust on the security property. Investors' names are affixed on a recorded trust deed as beneficiaries. Investors will also assume there is a title insurance policy with their names connected as beneficiaries.
Trust deed investments usually provide for receiving monthly interest payments from the borrower and are distributed to the investors. The annualized yields are comparatively reasonable. Investor distributions are generally a tiny fraction less due to being charged a servicing fee.
I think interested parties should seek loan broker professionals who understand required regulatory compliance, best practices in process and underwriting, and correct documentation. Lastly, interested parties should seek someone with an experienced track record as their agent and source of trust deed investments.