Trust Deed/Private Note Investing: 7 GUARANTEED Ways to Lose All of Your Money

Someone brings you a private real estate note opportunity. You have underwritten the borrower and the collateral and you like the deal – now it’s time to document and close the transaction. Do you know how to protect your money? Could your entire investment be at risk without you even knowing it? Here are some key questions to ask before risking your capital.

Do You Have Sufficient Title Insurance?
Always protect your investment with a title insurance policy issued by a large, institutional, AAA rated title insurer, but remember – title insurers are like any other insurance companies. They will issue policies that attempt to cover as little as possible – that’s just part of the insurance business. So you must review the title commitment and request appropriate endorsements and coverages on the policy. Does it have affirmative mechanic’s lien coverage? Creditor’s rights coverage? The insurer will probably give you the coverage – but if you don’t ask…

Is The Hazard Policy Sufficient?
It’s no surprise, but borrowers will usually buy the least amount of insurance possible to save on premiums – so make sure that prior to settlement the borrower names you as a “loss payee” and provides coverage in an amount sufficient to completely pay you off in the event of a catastrophic event. If you are lending on a rehab project, make the borrower obtain a builder’s risk policy, or insurance may not cover a loss. Also, when does the coverage expire? Does it cover you all the way to maturity date on your loan? What if the borrower doesn’t pay the insurance bill or the coverage expires? What do you do then? If you don’t carefully monitor and protect the insurance on the property, you are exposing yourself to a total loss of your investment.

Do Your Documents Properly Set Forth The Terms of The Deal and Are They Legally Compliant?
All too often, I see private lenders using “shelf” or boilerplate documents rather than having an attorney prepare them. After closing hundreds of hard money loans, I can tell you that each deal is slightly different, and often require adjustments to the standard documents or special disclosures in order to properly “lock down” the borrower and stay compliant with State or Federal law. Needless to say, I think it important to have an attorney draft your lending documents.

Are You Violating Any State Usury Laws?
Although not as much an issue with commercial deals as with residential deals, it is important to remain under the legally imposed caps on interest rates. If not, a Court could find your whole deal invalid. What then?

Do You Know How To Identify Fraud?
Even experienced investors fall victim to fraud. Just ask Bernie Madoff investors. Fraud comes in 2 forms, each equally as devastating: direct fraud – a con artist convinces you to put your money into a deal that doesn’t exist, or gets you to invest in a ponzie scheme, then runs away with your money; or indirect fraud – the borrower has committed some act of fraud to acquire the property and you, as lender, get caught up in the inevitable litigation. Fraud in real estate lending/investing is more rampant than you may realize, so protect yourself by: 1) working only with trusted and reputable parties; 2) if possible, always sending your money directly to the title company rather than the investor directly; and 3) if possible, always being the direct noteholder (vs. investing in a “mortgage pool,” where fraud is easier to perpetrate).

Does Your Borrower Have Authority To Borrower?
Sounds like a silly question, but it’s not. If you are lending to a company, a trust, an estate, or any other “non-person,” it is crucial that you have proof from the “non-signing” parties that the “signing” parties are authorized to act on behalf of the entity. You must also make sure the signing party is not violating any applicable restrictions, either in the documents or under the law, by entering into your deal. If you don’t do this, your security against the property (mortgage), as well as your note, could come under direct attack by Trustees, Beneficiaries, Heirs, etc., thus risking your capital investment.

Are Property Taxes Current And Are You Monitoring Them?
Municipal liens (water, taxes, etc.) usually take priority over your mortgage, so always make sure property taxes are current and up-to-date at the time of closing. After closing, follow-up with the County/City periodically to make sure taxes remain current. If you don’t, and the property gets sold at tax sale, you could lose your entire investment.

The next time you enter into a private note deal, make sure you know the answers to these questions, and if you need assistance documenting your deals, please feel free to contact me. I’d be happy to help.

Good luck and happy investing!

Jeffrey P. Shiller, Esq.

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