Private-Party Investors in Real Estate Lending: Technical Read Dan J. Harkey

Most people think trust deed investing is “about the property.” It isn’t. It’s about owning a secure, professional financial instrument—a promissory note—secured by real estate. That note, coupled with a deed of trust or mortgage, is personal property and is often legally treated as a security. If you invest in notes as a private-party lender (or buy them in the secondary market), the difference isn’t academic—it governs your rights, duties, risks, returns, and compliance.

“Trust deed investing is not a real estate purchase—it’s a purchase of a financial claim on real estate.”

What You Actually Own: Paper, Not Property

When a private investor funds or acquires a promissory note and its related security instrument (deed of trust or mortgage), they are buying contractual rights—not land. Those rights include receiving interest, enforcing late charges, collecting principal at maturity, and invoking remedies if the Borrower defaults.

Promissory Note—Your Evidence of Indebtedness

The promissory note specifies the principal, interest rate, payment schedule, maturity date, default interest, late fees, prepayment terms, and remedies. It is the investor’s evidence of indebtedness—the central asset in the transaction. If it’s poorly drafted, ambiguous, or non-enforceable, the collateral won’t save you. Proper structuring ensures clarity and confidence in your investment.

Deed of Trust or Mortgage—Your Security Instrument

The security instrument (deed of trust or mortgage) secures the note by creating a lien on the real property. It defines priority, lien position, the power of sale (in nonjudicial foreclosure states), and the covenants the Borrower must maintain (e.g., taxes current, insurance coverage, no waste). It doesn’t give you ownership of the property—it gives you a security interest.

“The note is the asset; the property is the collateral. Confusing the two is the first mistake new investors make.”

Personal Property—Not Real Property

Even though your note is secured by a house, apartment, or commercial building, the note and security instrument themselves are personal property (intangible) rather than real property (land and fixtures). Practically, this means:

Transferability: Notes can be assigned relatively easily compared to selling real estate.
Valuation: The value of a note is driven by Borrower performance, loan terms, and collateral quality, not market comps alone.
Governance: Disputes and enforcement fall under contract and commercial Law, alongside state real property statutes for foreclosure.

This distinction sets the stage for the securities overlay.

Why Trust Deed and Mortgage Notes Are Often Securities

Under the Securities Act of 1933, instruments that serve as “evidence of indebtedness” are generally considered securities, affecting how private investors must handle disclosures and compliance. Recognizing that trust deeds and mortgage notes may be securities emphasizes the need for legal guidance when raising or investing funds.

Key takeaway: You are not only a lender—you may be a purchaser of a security. That has consequences for how deals are sourced, offered, documented, fractionalized, and serviced.

“The moment you sell or buy a note, you’ve stepped into securities Law—whether you realize it or not.”

How the Law Frames It

Security includes, among other things, any note and any evidence of indebtedness.
A security instrument (deed of trust or mortgage) pledges property to guarantee performance.
Offering notes to multiple investors, fractionalizing a single note into interests, marketing yields publicly, or compensating third parties to raise capital all elevate securities compliance.

Practical implication: If you’re funding one loan with your own capital, you may be outside registration, but anti-fraud rules and truthful disclosure still apply. If you’re raising money, pooling, or selling interests, consult a securities attorney on exemptions (e.g., Reg D 506(b)/(c)), investor qualifications, and offering documents. Following proper procedures protects your reputation and investment security.

Active vs. Passive Investors—Know Your Lane

Active Investors

You behave like a private bank. You may:

Source deals, set terms, and underwrite risk.
Directly review creditworthiness, income, assets, title, lien priority, and collateral.
Oversee servicing, manage modifications, extensions, and foreclosures.
Demand and verify insurance, tax payments, and property condition.

Passive Investors

You rely on:

Licensed brokers and originators for sourcing.
Loan servicers for payment collection, notices, and escrows.
Fund managers or syndicators for structuring and compliance.

The more passive you are, the more securities compliance matters you face, as relying on others’ efforts to generate returns makes understanding legal obligations essential for protecting your investments.

Structuring the Investment: Core Terms That Drive Yield and Risk

To price risk and protect principal, negotiate and verify:

Lien Position: First vs. second (or junior) lien. Firsts offer stronger recovery; juniors demand higher yield.
Loan-to-Value (LTV): A conservative LTV (often 55–70% for private loans) increases the margin of safety.
Rate & Points: Higher rates reflect collateral risk, Borrower profile, loan purpose, and exit strategy. Points compensate for origination and risk.
Term & Amortization: Shorter terms with interest-only payments are standard in private loans. Verify balloon feasibility.
Protective Provisions: Default interest, late fees, due-on-transfer, impounds for taxes/insurance, assignment-of-rents (for income property), and consent to receiver appointment.
Covenants: Maintenance, no waste, required permits, leasing restrictions, or performance milestones for construction/rehab.
Guaranties: Personal or entity guaranties where appropriate.
Prepayment: Yield maintenance or minimum interest clauses to protect target returns.

“Senior lien + low LTV + clean title beats a high coupon with messy documents every time.”

Diligence: The Five-Pillar Framework

· Borrower & Sponsor

o Credit, liquidity, income stability, experience, track record.

o Verify source of repayment (income, sale, refinance).

o For investors/flippers: scope of work, cost breakdown, timeline, permits.

· Collateral & Market

o Third-party appraisal or evaluation; adjust for condition, location, market absorption, and use restrictions.

o For income property: rent roll, leases, estoppels, operating History, DSCR.

· Title & Lien Priority

o Preliminary title report/commitment: identify liens, judgments, easements, taxes, CC&Rs.

o Confirm recording sequence, subordinations, and intercreditor terms.

· Legal & Documentation

o State-specific note and deed-of-trust/mortgage forms.

o Required consumer vs. business-purpose disclosures.

o Cross-default provisions, collateral assignments (rents), UCC filings for personal property where relevant.

· Servicing & Enforcement

o Who collects payments? How are late notices, NOD/NOS (where applicable), and escrows handled?

o Default playbook: workouts, forbearance, modifications, deed-in-lieu, foreclosure, receiver.

Pricing Notes: Yield, Discount, and Seasoning

If buying an existing note:

Coupon vs. Yield: Your yield-to-maturity changes if you buy at a discount/premium.
Seasoning: A track record of on-time payments typically improves price and reduces perceived risk.
Defects: Documentation errors, missing assignments/allonges, broken chains of title, or unenforceable terms reduce value.
Extension Risk: Balloons often extend; price for the probability of modification vs. refinance.
Exit Liquidity: Secondary market appetite varies with rate cycles and collateral.

Rule of thumb: Buy quality or buy a discount big enough to fix quality.

Compliance: Where Deals Live or Die

Even single-investor loans can expose lenders to legal liability if compliance is ignored. As complexity increases—fractional interests, funds, syndications, general solicitation—so does the need for securities counsel. Consider:

Federal Exemptions:

Reg D 506(b): No general solicitation; accredited and limited sophisticated investors; PPM recommended.
Reg D 506(c): General solicitation allowed; verification of accredited status required.

State “Blue Sky” Laws: Notice filings, fees, and state-level exemptions may apply.
Broker Licensing: Who is arranging or selling the investment? Compensation may trigger licensing.
Advertising / General Solicitation: Website claims, social posts, or email blasts can reclassify your offering overnight.
Anti-Fraud: Full, fair, and non-misleading disclosure of risks, fees, conflicts, and performance.

Shareable: “In private lending, compliance is not paperwork—it’s investor protection made visible.”

Disclaimer: This article is for educational purposes and not legal or investment advice. Consult qualified counsel for your specific facts, state rules, and transaction structure.

Risk Management: Before the Check Clears

Over-Collateralization vs. Reality: Don’t assume appraisals are infallible; adjust for condition, permits, market liquidity, and absorption.
Title Insurance: Lender’s policy with endorsements (ALTA where applicable) to protect lien priority and access.
Insurance Controls: Require hazard, liability, and, where relevant, builders risk or rent loss coverage—name the lender as loss payee.
Construction Controls: Use fund control/escrow, draw inspections, lien waivers, and contingency budgets; no advance funding without verified progress.
Covenant Testing: For income property, set minimum DSCR thresholds and periodic reporting.
Default Triggers & Timelines: Pre-define actions for 30/60/90+ days past due; begin protective steps early.

Servicing Excellence: How Income Becomes “Boring”—in a Good Way

Automation & Reporting: ACH/lockbox, standardized late notices, interest statements, and year-end tax forms.
Escrows: Taxes and insurance impounds reduce surprises and protect collateral.
Communication Protocols: Document conversations, promises, and workout terms—assume a judge may one day read your file.
Vendor Bench: Appraisers, brokers’ price opinions (BPOs), inspectors, attorneys, foreclosure trustees, and receivers—pre-vetted and on-call.

Goal: Make performance predictable so the investment behaves like a fixed-income instrument, not an adventure.

Default & Recovery: From First Missed Payment to Exit

· Early Intervention: Clarify whether the default is temporary (cash flow timing) or structural (project failure).

· Forbearance vs. Modification: Short-term relief may protect value; document consideration and reinstatement terms.

· Deed-in-Lieu: Efficient if liens are clean; ensure title review to avoid inheriting hidden problems.

· Foreclosure: Judicial vs. nonjudicial varies by state; timelines, rights of redemption, and deficiency judgments differ.

· Receivership (Income Property): Stabilizes operations, protects rents, and preserves collateral pending foreclosure.

· REO Disposition: If you take title, treat it like a separate project—budget, repairs, marketing, broker selection, time-to-sale.

Recovery math: Protect the basis first, then interest. Avoid “extend and pretend” unless the extension is tied to provable performance.

Ethics & Investor Reputation: The Long Game

Trust deed investing is a small community. A reputation for fair dealing, clear disclosure, realistic pricing, and decisive action is a durable edge. It reduces your cost of capital, improves deal flow, and gets borrowers to call you first when they have a good project—because they trust you to close and perform.

Shareable: “Great private lenders don’t just price risk—they manage it, disclose it, and act on it.”

Practical Scenarios: How Pros Think

Scenario 1: The Tempting Junior

A second-position loan at 12% on a property with a first at 50% LTV; your second takes the total LTV to 72%. Looks fine on paper—but the first has aggressive default provisions and a rent lockbox. In a downturn, your junior may see a slight recovery. Decision: Require intercreditor protections or reprice for loss severity.

Scenario 2: The Balloon Extension

An interest-only bridge loan matures in 12 months, with a Borrower plan to refinance. By month 10, rates rise, and the take-out is shaky. Decision: If the project’s cash flows and collateral strengthen, consider an extension fee and a step-up rate; otherwise, begin protective filings early to preserve rights.

Scenario 3: The Fractional Note Offer

A sponsor wants to split a single note across 12 passive investors. Attractive yield, glossy deck, public webinar. Decision: This is likely a securities offering. Require counsel-reviewed exemption (e.g., Reg D 506(b)/(c)), investor qualification, and complete risk disclosures—or pass.

Frequently Asked Questions

Is a promissory note secured by real estate considered real estate?
No. The note and deed of trust/mortgage are personal property (intangible assets).

Is a note a security?
Often, yes, because it is evidence of indebtedness. Exemptions may apply, but anti-fraud rules always apply.

Can I sell interests in my note to friends?
Not without considering securities laws. Fractionalization may require an exemption, investor qualifications, and proper documents.

Are second liens a bad idea?
Not inherently—but they require higher yield and careful analysis of the senior loan terms, default behavior, and exit scenarios.

What’s the single best protection?
Conservative LTV with first-lien priority, clean title, and tight documents—plus disciplined servicing.

Checklists You Can Use

Pre-Funding Checklist (Abbreviated)

☐ Borrower: identity, credit, liquidity, track record
☐ Purpose: business vs. consumer, scope, timeline, exit
☐ Collateral: appraisal/BPO, condition, permits, market
☐ Title: lien position, encumbrances, taxes, judgments
☐ Docs: state-compliant note, deed of trust/mortgage, guaranties
☐ Insurance: evidence, coverage limits, loss payee
☐ Compliance: exemptions, disclosures, licensing, advertising
☐ Servicing: payment method, impounds, notices, default plan

Ongoing Monitoring

☐ Payment performance & late triggers
☐ Taxes and insurance current
☐ Construction draws tied to inspections
☐ Financial reporting (for income property)
☐ Market changes impacting exit/refi

Conclusion: Treat It Like Fixed Income—Manage It Like a Business

Private-party lending through promissory notes and trust deeds occupies a powerful niche: income secured by collateral, governed by contract, and shaped by securities Law. The investors who win don’t chase the highest coupon—they underwrite rigorously, document precisely, comply faithfully, and service professionally.

When you approach trust deed investing as ownership of a financial instrument—not a real estate proxy—you clarify your strategy, protect your downside, and build repeatable results. That’s how private capital becomes a durable, compounding advantage in real estate finance.