Dan Harkey
Deed of Trusts and Mortgage Investments
Real estate lending encompasses both real estate and securities laws.
A) Deeds of trust and mortgage instruments are securities:
Promissory notes secured by deeds of trust or mortgages are security instruments. These contracts represent evidence of indebtedness. Ownership is a security under the Federal Securities Act of 1933.
- The definition of security under federal law is as follows:
a) Property given or pledged to guarantee the performance of an obligation.
b) An instrument that functions as proof of a security interest in a public or private body.
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- Parties in a loan transaction:
Borrowers and private-party lenders are the principals in a transaction. A borrower will sign a promise to pay called a promissory note and the security instrument called a deed of trust. The deed of trust is an instrument recorded at the county recorder’s office, which becomes a matter of public notice of the charging lien against the property.
The note and deed of trust are contracts between the borrower and private-party lenders. After the loan closing, the investors/lenders, or the servicing agents of the investors, 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.
B) Deeds of trust and mortgage investments are securities requiring federal or state registrations unless there are applicable exemptions from registration.
Each state in the U.S. has its own securities laws and regulations. State statutes, known as Blue Sky laws, are designed to establish safeguards against fraud for investors. Each state passed separate securities laws to protect the public from fraudulent schemes as far back as 1911 in Kansas. The term “blue sky law” originated in the early 1900s, gaining widespread use when a Kansas Supreme Court justice declared his desire to protect investors from speculative ventures that had “no more basis than so many feet of ‘blue sky.’”
- What does securities registration mean?
Registration occurs when a company files the required documents with the Securities and Exchange Commission (SEC). The extensive process involves approving disclosures and other information related to the offering. There will usually be 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), and 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.
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- State securities exemptions:
Each state has its own securities laws and exemptions.
I am using California as an example because that is my state of origin. However, those involved with loans and investors in other states should identify their dominion’s relevant state securities statutes.
- California Corporate Codes relating to securities are 25000-31516
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. Securities references include 10CCR, Chapter 3, Sections 260.115 and 260.204.1, California Corporate Securities rules 25206, 25100 (p), 25102, (e) (f) (n), and 25102.5 which refers to the multi-lender rules.
a) 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.
b) 25102 for state offerings exemption
c) 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 certain 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, which 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 as one in the same household.
d) 25102.5is 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.
Under the 25102 (e) and 25102.5 exemptions, ten private investors can co-invest into a single trust deed as tenants-in-common. The difference between 25102 (e) and 25102.5 is that “e” requires disclosure documents in the form of an offering circular, subscription agreements, and a suitability questionnaire. 25102.5 provides a framework for suitability and investor disclosures within 10237-10238 of the Business & Professions code. Interested parties should consult a real estate or securities lawyer specialist
e) 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 own 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 investors, with conditions. 25102 (f) does not require California investors or California properties for a particular loan request. Discuss with counsel.
There are three instances when a 25102 (f) exemption may be helpful. (1) when a trust deed requires more than ten investors, (2) when an occasional (accredited investor) out of state party invests in a trust deed on a California property, (3) when a California real estate lender makes a loan on an out of state property.
(f) 25113 provides a path to eligibility for qualification by a permit process. An issuer may apply for a permit to operate under this section and provide the accompanying documentation as required by the commissioner. These permits are usually renewable annually. Caution: Applying appropriate securities exemptions and actions to remain in regulatory compliance is most likely accomplished by consultation with a qualified securities attorney. The above is a general but not all-inclusive overview of securities compliance.
2) 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. An interest held by a husband and wife shall be owned by one person for this section.
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3) California Code of Regulations, Section 260.204.1
An exemption from the provisions of Section 25210 of the Code is 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:
- (d) 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 processionary 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 abundantly 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.
C) 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 highly familiar with these requirements since I co-sponsored Senate Bill SB 1554 in 1998 and wrote a portion of the language that resulted in adopting the code.
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.
Section 10232.5 outlines required investor disclosures.
- Address or other means of identification of the real property that is to be the security for the borrower’s obligation.
- 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 has the option of issuing 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 as 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 an endorsement of an existing title insurance policy covering the securing property.
- Written loan application (signed) loan application.
- Credit report.
- Loan servicing provisions: including 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 and its uses, along with 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 the majority 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: (1) does the entity or the security issuer have a fiduciary obligation to the investors? (2) is the entity required to follow real estate law? (3) can the entity or issuer wave or disregard reasonable and prudent underwriting processes without violating fiduciary or breaking the law?
D) Private-party investors:
Private-party investors may invest by purchasing 100% of a loan, co-invest fractionally, with a small group as tenants-in-common, or in a pooled entity format with other investors. Private-party investors 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 investors or less.
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.
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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, 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.
Interested parties should seek loan broker professionals who understand required regulatory compliance, best practices process & underwriting, and correct documentation. Lastly, interested parties should seek someone with an experienced track record as their agent and source of trust deed investments.
Thank You,
Dan Harkey.
Dan Harkey
Dan Harkey is a contributing author to Weekly Real Estate News and is a Business & Financial Consultant. He can be contacted at 949-533-8315 or [email protected].
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