If you have read my posts on maintaining financial independence then you know that I prioritize cash flow over high-growth prospects in my investment strategy. I value total return (appreciation in your investment + dividends) but I believe your investment portfolio and your financial independence status needs to be able to weather economic/market downturns by including investments that generate stable cash flow.
The Stock Market is at All-Time Highs
One way to generate cash flow is through dividend yielding stocks. A good dividend portfolio can have a weighted dividend yield of 4% or more and its part of my investment strategy. On a $100,000 investment, that is dividends of $4,000 per year. However, the S&P 500 Index has seen tremendous growth over the last ten years. After the Great Recession of 2008, the S&P 500 Index hit a low of 889 points in February 2009. Ten years later it has gone to over 3,100 points. The most recent growth cycle is longer than any growth cycle seen by the S&P 500 Index. Therefore, it may not make sense to add a lot of dividend stocks to your portfolio at this time.
Bond Yields are Really Low Right Now
Bond yields remain near historical lows and therefore offer limited income potential. As of the end of the year 2019, the 10 year Treasury bond yield is a little over 2%. On a $100,000 investment, that is only $2,000 per year in interest payments.
Real Estate Trust Deeds Can Be the Answer to Increasing Your Passive Income
Another alternative to these types of investments is investing in real estate trust deeds or mortgages. Trust deed investing provides you the ability to loan money to a real estate investor, earn interest on the loaned money, and have your investment protected by the underlying real estate. I have seen interest rates as high as 10% with these types of loans and I am currently invested in trust deeds that charge interest rates of 7%-8%. On a $100,000 investment, I receive over $7,000 per year in interest payments.
Why do people seek money from trust deed investors? Sometimes banks are less likely to lend money to certain investors for certain projects or the investor needs to obtain very quick financing in connection with the transaction and a traditional bank cannot move quickly enough. A trust deed investor essentially steps in to play the role of the bank! I have had this type of investment in my investment portfolio for over 20 years and I will highlight the three different ways that you can invest in trust deeds.
How to Invest in Real Estate Trust Deeds
Own a trust deed on a single residential property and service the loan on your own:
My first experience with investing in trust deeds involved loaning $100,000 to a borrower involved in a single real estate project. I personally found the borrower and loaned the money to him using an escrow and title company to close the transaction. I also personally collected the interest payments from the borrower. I earned a 10% interest on the loan and did not have to pay management fees to anyone. There were times when I had to spend some extra effort to make sure the borrower paid me in a timely manner but at the end of the day I received about $20,000 in interest payments over two years before the borrower paid the loan off in full.
Own a trust deed on a single residential property but use a third party to service the loan
I have also used a third party hard money lender to identify, originate, and then assign me the note and deed of trust secured by a residential property. The loan had a 10% annual interest rate but I had to pay a 1% management fee to the hard money lender to service the loan (basically, to collect the interest payments) so my annual yield after fees was 9%. I had this loan as part of my investment portfolio for years and it was a solid investment for me. It was ultimately paid-off in full by the borrower.
Invest in a fund that holds and services trust deeds
I currently own positions in two private funds that loan money on larger commercial properties and the funds service the loans. These funds invest in a few hundred properties and manage over $1 billion in loans, making this a more diversified investment than the prior two options. After management fees, I receive monthly payments that equal approximately 7% in annual yield. I have held these investments for over three years and my payments come in like clockwork. I do not need to do anything for these investments and my financial adviser reviews the quality of the underlying loans on a monthly basis to make sure that I continue to have a very limited risk of losing any principal if the real estate market sees a significant downturn.
Not All Trust Deeds are Created Equally
If you decide to invest in trust deeds, please consider the following:
Your Trust Deed should be secured by real property and should be in first position
There will be times when a borrower defaults on a loan and the investor’s protection is to foreclose on the real estate securing the loan in order to get back any unpaid interest and principal. Sometimes there are multiple loans on a property and the order in which these investors gets paid back depends on the position of your trust deed relative to the position of the trust deeds of any other investors. I always invest in trust deeds that hold a first position so that I get paid back first if there is a default and subsequent foreclosure.
Your Loan-to-Value ratio needs to be 80% or below (based on a real appraisal)
Since real estate is the security that protects your investment, you need to make sure that the real estate has enough value to pay you back if there is ever a default by the borrower. I personally have always invested in loans where the loan amount is no more than 75% of the appraised value of the real estate. The funds I currently invest in do not issue loans greater than 60% of the value of the securing real estate which should protect investors if the underlying real estate declines in value. Make sure that the real estate protecting your investment is worth enough to pay you back in full if there is ever a default by the borrower.
Diversification is important when investing in trust deeds
I much prefer investing in trust deeds through funds that hold a large number of loans and trust deeds because if one loan has an issue I still receive monthly payments on the other loans and the risk to the money I invested in is very small. Some of these funds have minimum investment requirements so it is not an option for everyone but it is the investment approach I prefer to take when it comes to investment in trust deeds. Otherwise, you can invest a fractional interest in many individual trust deeds with other investors to try to diversify your risk yourself.
A downside to trust deeds is the investor does not participate in the upside of any real estate appreciation
When I first heard about trust deeds I thought I would back up the money truck and place all of my savings into this type of investment. However, a real downside is that your return is fixed and you do not participate in the upside of increasing real estate values. Trust deeds are great for passive income but the total return you will see with this investment is limited by the contract.
I believe trust deeds can be a great part of a person’s investment portfolio – trust deeds can diversify your portfolio and create a good source of cash flow. Do some more diligence on this type of investment before jumping in and make sure to consult with a professional in the event of a default by a borrower as there are many laws regulating the foreclosure process, but I wanted to point out this great investment option for you to consider as part of your portfolio.