The following is an excerpt from an article I wrote that was published in an Orange County Magazine in May of 2005.

“What happens when the buying stops”?

Cheap money and the mortgage industry 100% financing, stated income no document loans (loans extended without reviewing the borrower’s assets or ability to pay) have fueled the real estate industry these past four years. Dangerous lending practices and even more dangerous borrowing practices have been the norm recently. Want proof? The Mortgage Bankers Association reports that 2/3 of all mortgages are adjustable rate loans and the “Sub-Prime” lenders market share has more than doubled the past two years with loans that can best be described as short term adjustable rate structures, most the “No Doc” loan variety and many with pre-payment penalties and high margins which could be disastrous to these marginal borrowers when interest rates rise.

In discussing this with other industry professionals, many have stated that if their customers were forced to qualify for their loan requests their borrowers would be unable to get a loan period.

A 1% increase in interest rates will do more damage than you can imagine and a 2% increase may be an all out disaster. I know many people feel that we will have a “Soft Landing” because housing, unlike the stock market, is a staple required by every family. Perhaps …but if the mortgage industry is forced to change the current easy money practices then who will be able to afford to buy a home at these current prices? The average income has certainly not kept pace with the increase in home values. I have been wrong before BUT if the secondary markets decide that they will no longer accept these high risk loans……then look out below.

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In June of 2007 the housing industry has had 9 consecutive months of declining sales and prices are no longer increasing at the rates that made a housing purchase a no-brainer as many borrowers have painfully began to experience. Should you invest your assets or self directed IRA funds in mortgage backed securities or are these investments now too risky?

While loans issued by Mortgage Pools usually carry high interest rates and do have an element of risk due to the fact that many borrowers are either in financial difficulty or the property is a non-conforming property with other considerations making financing difficult, it does not mean that these are no longer a viable investment.

The primary difference between these types of high risk loans and the type of loans secured by a Mortgage Pool is the loan to Value and fixed rate loans with no future payment shock. Since most Mortgage Pools have investor funds and self directed IRA funds involved, the security rarely exceeds 65-70% Loan to Value. Should the loan default there should be sufficient equity to cover the loan ensuring the investors and their self directed IRA funds are safe from capital loss.

Reasons for using professional management in any investment vehicle are numerous. Unless you are experienced and know what you are doing then investing in a mortgage pool to obtain high returns on diverse and comparatively secure mortgage backed loans is something to consider.

Keith Webb
CEO

Trust Deed investing is the loaning of money with real estate as collateral. In California, most loans against Real Estate are called “Trust Deeds,” after the name of the legal instrument used to pledge their security. Anyone can successfully invest in trust deeds. This contrasts with most other investments where extensive study and years of experience may be necessary before you can invest with confidence. Trust Deeds are safer than most other investments of comparable yield because the risks are identifiable, as well as the procedures necessary to counter them. Many investors, especially retired people, also enjoy the relatively minor effort needed to manage the investment once their money is in place.

The typical trust deed investor is a person looking for a competitive return on their investment. The interest rate the borrower pays is generally higher than the borrower would pay at a bank. The investor in turn, receives a higher return on his investment. Additionally, the money you loan is secured by the borrowers’ equity in their real estate. The security, the good return, plus the monthly cash flow, make trust deeds and excellent investment vehicle.

Like any investment, there are risks involved in trust deed investing. Investing without understanding the consequences, knowing what may need to be done or spent to protect your investment, or without a well thought out strategy is risky. Understanding the risks and how to mitigate them will ensure your long term success in trust deed investments.

Most private money trust deed investments are conducted through loan brokers, who either arrange new real estate loans, or who broker the sale of existing loans. If truly an expert in the business, the broker brings vast knowledge about the origination and administration of trust deed investing. One of the most important requirements in trust deed investing is the knowledge, experience and integrity of the loan broker through whom the transactions may be made or arranged. One possible indicator of a good broker is his membership in professional trade organizations such as CMA (California Mortgage Association). Membership in a professional association requires a vigorous educational program designed to keep the broker apprised of every nuance of the law.

Mortgage Pools are good choices for investors who have lower risk tolerances but still want the security and return potential of investing in trust deeds. Mortgage Pools function like Mutual Funds whereby an investor purchases shares of the LLC. The investment capital then used to purchases a number of different Trust Deed investments. The goal of any mortgage pool is to obtain a favorable rate of return for the investors, while providing them with a predictable and consistent monthly cash flow or growth

Mortgage Pool Highlights

Private lending on deeds of trust is both an art and a science. There is a formula as well as a philosophy designed to originate well underwritten and well secured non-bankable loans of institutional quality. The philosophy when evaluating and underwriting a potential loan opportunity is based on what is commonly referred to as The Three C’s: 1) Capacity, “Can they pay?” 2) Character, “Will they pay?” 3) Collateral, “If they don’t pay, where do we stand?”

1) Capacity, “Can they pay?”
This seems like a no-brainer. Verifying whether the borrower has the ability to pay goes way beyond what they state on their application. Even for the ‘stated income’ loans, a borrower must have a verifiable position that merits the stated income (for example, a gas station attendant that makes $10K a month does not make sense) and provide bank statements or assets that support that income. It is unethical and in violation of the law to lend money to borrowers who knowingly can not make the payments as stated. Making sure the borrower understands the terms of the loan, the repayment plan (most loans are not longer than a 6 year term, with the average being 3-5 years for non-residential loans), and the consequences of non-payment are critical to the success of any given deed of trust.

2) Character, “Will they pay?”
Sometimes borrowers show they have the capacity to pay, that doesn’t always mean they will pay. The borrowers’ character and desire to pay are based on their past performance in handling credit. A three bureau merge credit report provides payment history on existing loans, including the number of late payments, any open or outstanding liens for taxes, and credit references to verify the borrowers’ character and desire to pay. Lending on private money trust deeds is typically not a stellar credit proposition. Most borrowers who are looking to private money lenders as a source of funds do not have perfect credit. Reliance on the credit report as the last word on a lending decision is not prudent, but it is potentially a good indicator of future behavior. A letter of explanation regarding the issues highlighted by the credit report is a helpful tool in assessing creditworthiness of a borrower but is by no means the final word.

3) Collateral, “If they don’t pay, where do we stand?”
Worst Case Scenario – the borrower can’t or won’t pay…now what? The collateral is the backbone and security of all our loans. All private money lending is equity based. As such, the market value of the property is critical in the decision making process. Prudent private lenders stick to 65% Loan-To-Value (LTV), requiring at least 35% protective equity in the property. The protective equity is the difference between the market value of the property and the indebtedness secured by the property. The lower the LTV and the greater the equity, the more incentive for the borrowers to protect the equity in the property and protect the investment of the lender. Verification of the market value of a property requires an appraisal, preferably completed by an independent appraiser. Many investors prefer to lend only on properties located in their “back yard,” allowing them to visit each property and personally meet each borrower.

The goal of any investor or pool is to build a loan servicing portfolio comprised of well underwritten and well secured real estate loans. As a lender, you don’t want to become a collector of property. Collections of interest and fees are the best way to make money lending money. Looking to achieve maximum security through increased levels of protective equity is a sound lending strategy.

Laura Riffel
President

Throughout much of our website, we reference Self Directed IRAs as a method of investing in our mortgage pool and expanding your investment options. I thought a brief Question and Answer blog might be a good way to start the education process. While this may appear as a new concept in retirement investments, Self Directed IRAs have been around since the inception of Individual Retirement Accounts. Hopefully you will find this blog insightful.

1) What is ERISA?
The Employee Retirement Income Security Act (ERISA) passed the responsibility of retirement savings from the employer to the employee. IRAs were created in 1975 to provide individuals a chance to direct where their retirement funds were invested. Rather than distinguishing which investments are allowed, the IRS code instead identifies which investments are not permitted under these laws.

Only two types of investments are excluded under ERISA and IRS Codes:
• Life Insurance Contracts
• Collectibles such as works of art, rugs, jewelry, etc.

IRS Code Sec. 401 IRC 408(a) (3)

2) Why haven’t I heard about this?
Once ERISA was passed, the securities markets were responsible for bringing the IRA and 401(k) to the mass market. The banks and brokerage houses created a misconception that buying stocks, bonds and mutual funds was all that was allowed through retirement products such as an IRA. This is 100% false! Banks and brokerage houses have a vested interest in having you invest in stocks, bonds and mutual funds - not real estate, businesses and other non-traditional investments.

3) What kind of retirement funds am I able to use?
It is possible to use funds from most types of retirement accounts:
• Traditional IRA
• Roth IRA
• SEP IRA
• Keogh
• 401(k)
• 403(b)
• And many more!

It must be noted that most employer sponsored plans such as a 401(k) will not let you roll your account into a new vehicle while you are still employed. However, some employers will allow you to roll a portion of your funds. The only way to be completely sure whether your funds are eligible for a rollover is by contacting your current 401(k) provider.

4) How many people have self directed IRA accounts?
The self directed industry is growing at a rapid pace and is expected to see upwards of $2 trillion enter the market over the next two years. Some of the latest numbers show over 45 million IRA holders in the U.S. and less than 4% of those funds are held in non-traditional assets. This number is expected to increase significantly over the next 5 years as more and more individuals and their financial advisors attain a greater awareness of self-directed IRAs.

5) Are there limits to the investments I can make?
Yes. As discussed previously, you cannot invest in Collectibles or Life Insurance Contracts. In addition, there are certain transactions in which you cannot participate when using IRA funds. These are referred to as “prohibited transactions”. Prohibited Transactions are defined in IRC 4975(c)(1) and IRS Publication 590. They were established to maintain that everything the IRA engages in is for the exclusive benefit of the retirement plan. Professionals often refer to these as “self-dealing” transactions. Self-dealing occurs when an IRA owner uses their individual retirement funds for their personal benefit rather than to benefit the IRA. As an IRA owner, if you violate these rules, your entire IRA could loose its tax-deferred or tax-free status. It is very important that you work with competent professionals to help avoid violating these rules.

6) Specifically, what are prohibited transactions?
IRC 4975(c) (1), identifies prohibited transactions to include any direct or indirect:

• Selling, exchanging, or leasing, any property between a plan and a disqualified person. For example, your IRA cannot buy property you currently own from you.
• Lending money or other extension of credit between a plan and a disqualified person. For example, you cannot personally guarantee a loan for a real estate purchase by your IRA.
• Furnishing goods, services, or facilities between a plan and a disqualified person. For example, you cannot use personal furniture to furnish your IRAs rental property.
• Transferring or using by or for the benefit of, a disqualified person the income or assets of a plan. For example, your IRA cannot buy a vacation property you or your family intends to use.
• Dealing with income or assets of a plan by a disqualified person who is a fiduciary acting in his own interest or for his own account. For example, you should not loan money to your CPA.
• Receiving any consideration for his or her personal account by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. For example, you cannot pay yourself income from profits generated from your IRAs rental property.
If you participate in a transaction which does not fit SPECIFICALLY within these guidelines, the Department of Labor or the IRS will analyze the specific facts and circumstances in order to decide whether you have engaged in a prohibited transaction.

7) Who are disqualified parties?
Many of the prohibited transactions are the result of a very simple equation:
Plan (or plan asset) + Disqualified person = Prohibited Transaction
A plan is defined to include tax-qualified plans, IRAs and other tax favored arrangements. For the complete definition you can reference IRC 4975(e) (1). A disqualified person (IRC 4975(e) (2)) is defined as:

• The IRA owner
• The IRA owner’s spouse
• Ancestors (Mom, Dad, Grandparents)
• Lineal Descendents (daughters, sons, grandchildren)
• Spouses of Lineal Descendents (son or daughter-in-law)
• Investment advisors
• Fiduciaries - those providing services to the plan
• Any business entity i.e., LLC, Corp, Trust or Partnership in which any of the disqualified persons mentioned above has a 50% or greater interest.

8 ) Why are these rules considered to be complex?
These rules exist to ensure that your IRA does not engage in any investment activity other than for the exclusive benefit of the IRA. There are many types of investments which violate this law. For example, buying a house and then letting your mother rent it would potentially create a conflict of interests. If your mother, who was making rent payments, all of a sudden could not - you would be conflicted from evicting her and finding a more reliable tenant. You would then have a conflict of interest between your relationship with your mother and what is in the best interest of your IRA. These rules were put in place to help avoid these sort scenarios.

9) If my brother in not a disqualified party, then can I buy a house and let him rent it from me?
Theoretically yes. Your brother is not a disqualified person. However just like the scenario mentioned above, if he occupied a rental property owned by your IRA and could not make the payments, you could run afoul of the exclusive benefit rule. This could cause your IRA to have participated in a prohibited transaction. It is important that you treat every investment the same - to benefit your IRA and only the IRA.

10) What is the consequence of a prohibited transaction?
If an IRA holder is found to have engaged in a prohibited transaction with IRA funds, it will result in a distribution of the IRA. The taxes and penalties are severe and are applicable to all of the IRA’s assets on the first day of the year in which the prohibited transaction occurred.

11) How do I make sure that I am following the rules?
As mentioned previously, the IRS does not identify what investments or transactions you can make in your IRA. They instead state which investments are prohibited and what makes certain transactions prohibited. Identifying, interpreting and following these rules can be complicated, but not impossible. Utilizing specially trained professionals (such as Pensco Trust) can help you follow Internal Revenue guidelines and steer clear of prohibited transactions.

12) My CPA and Financial Advisers say this is illegal. Why?
It may be they are influenced by self interest or they are simply uninformed. Often times an individual will ask their CPA, Attorney or Financial Planner for advice and in turn are told: “That’s illegal.” “You can’t do that.” “It is very risky.” Attorneys stick to their core competencies and rarely deviate from them: Tax preparers are taught to do just that - prepare taxes. Your financial advisor’s company or agency may either be disinterested in this type of business or have not been educated regarding this type of investing format: A stock broker makes money when they sell stocks, bonds and mutual funds - not real estate or other types of investments..

13) What is a self directed IRA custodian?
The Custodian is a bank or savings and loan association, as defined in IRC 408(n), or any other entity that has the approval of the IRS to act as Custodian. In order to have a self-directed IRA, it needs to be held with a Custodian who will allow investments into non-traditional investments. There are very few of these types of custodians.

14) Why are there not more of these custodians across the country?
There are very few non-traditional IRA custodians simply because the business is not as profitable as it is for the brokerage houses. It requires many more hours to complete a real estate transaction than to purchase stocks over an electronic system. Traditional banks do not compete because it does not fit within their business objectives. They make money by leveraging the dollars you have sitting in their accounts.

15) Is my money safe?
A custodian must be a registered Trust Company. For one to register as a Trust Company the institution must meet stringent state requirements and have adequate reserves. Your money is kept in a separate account for your benefit and not subject to creditors of the custodian. While your money should be out working and not sitting with the custodian, in the event of a loan payoff your account may hold substantial funds at any one time. Finding a custodian that is also a FDIC insured institution is one way to address the issue of potential loss at the hands of a custodian. Pensco Trust is the only custodian we are aware of who is FDIC insured for each retirement account up to $250,000 per account.

16) How do I setup a self directed IRA?
It is a fairly simple process, but it takes some time. Go to Pensco Trust for a comprehensive look at how to get started. They also have customer service representative available to answer questions during business hours.

I will continue to answer questions in blogs as they come in to me. Our goal is to provide an educational resource to expand your horizons with regards to investment opportunities, not only in your IRA and retirement accounts, but in all things real estate related.

Laura Riffel
President