Can Mortgage Brokers Be a Pitfall of Trust Deed/Mortgage Investing?

Most Trust Deed investing for individual investors is facilitated through a Mortgage Broker.  For the borrower; the Mortgage Broker advertises that he has money to lend and negotiates the terms of the loan, is to conduct due diligence on the borrower and the property.  For the investor; the Mortgage Broker advertises that he has investment opportunities for the money of investors in properties.  Simply put; the Mortgage Broker is simply acting as a middleman between those that have the money and those that want the money.

A successful Trust Deed Broker is typically every effective at marketing and sales as they must consistently cater to two groups at all times; the borrower and the investors to create a transaction so they can earn their fees.  However in most cases; at the core; they are not true Real Estate guys. The interest in the transaction usually begins and ends when they collect the upfront loan origination.

Investors and Brokers – Conflict of Interest

There are two fundamental conflicts of interest between the investors and the typical private money Mortgage Broker arrangement.

First conflict of interest; is that typically all of the Mortgage Broker’s income is collected upfront as the loan closes in the form of underwriting fees and loan origination.  The Investors are paid after the Broker over time from the Borrower in the form of the monthly interest installments.

Second conflict of interest between the investors and the Broker is that the Borrower is the one that pays the Brokers fee(s), therefore the Borrower is the primary customer of the Broker.

The Mortgage Brokers gets typically 10% of the loan amount upfront to make the loan in addition to underwriting and other fees…on a $500,000.00 that is at least $50,000.00 in income that day from the Borrower to the Broker.  The investor is disadvantaged by this method of compensation.  The borrower gets the money and the investors hope that they get their payments, if the property is managed effectively and that the exit strategy is successful.  If any thing goes wrong the Mortgage Brokers got paid upfront and usually has no experience managing or developing Real Estate which really doesn’t matter anyway as they are not in control of the property until after the investors pay the attorney fees to foreclose on the Borrower.

The Information Channel –

Having a middleman (Broker) between the investor and the borrower with misaligned interests is full of opportunity for misunderstandings and outright deception.  The Broker wants to protect the borrower – because the borrower is directly paying the Broker the origination fees and (they will come back for more money) and keep the investors generally happy so that they will re-invest in new loans.  It is in the best interest of the borrower and the Broker to not convey any potentially negative information to the investor.  The competiting interests often times does not give the investors the clarity they deserve and in most cases the first time the investors learn of a problem with the borrower or the real estate is when a payment is missed.

Control of the Asset –

Trust Deed investors typically invest for the passive income, so investors are not looking for direct control of the Real Estate.  However, the investor never had access to the borrower and the Broker has no control or direct influence on the Real Estate after the closing of the loan.  In the event anything goes wrong, it is a long process to get the security of the principle invested.  Foreclosures can be expensive to investors and tie up the invested capital for prolonged periods of time.

Brokers are deal guys –

In many cases Trust Deed investors are relying almost completely on the Broker to perform all the due diligence and supply them with unbiased information to make an informed decision on the merits of the investment.  The monetary conflict is born by the commission structure; the Broker has found a willing and (maybe) able borrower…the Broker in incentivised to “shine up the apple” to sell the deal to the investors to get the loan to close.  Additionally, the Mortgage Broker in most cases has limited experience in actually hands on property management, rehab, construction and sales.  It is reasonable to expect that from time to time the sophisticated borrowers can “shine up the apple” for the Broker as well.  In some cases of failed lending the borrower ‘sells’ the Broker, the Broker ‘sells’ the investor to get the commission.

The investor is not alone in this area of being potentially ‘sold’ a story by the Broker.  The Broker is directly incintivized to commit to funding the total amount of the loan amount even if the Broker does not presently have access to the remaining funds. More on that in PITFALL #3.  If the Broker is unsuccessful in raising the remaining amount the borrower is left with a partial project (partial loan) and a loan to repay and the investors are relying on incomplete collateral to secure their principle.

In the event that the property must be managed by someone other than the initial borrower, recent history has shown that the Broker will not be able to help the investors due to the lack of knowledge, experience and manpower to effectively turn the asset around to protect the investor’s principle.

Private investing through a middleman creates risk for all parties; the developer and the lender and is ultimately more expensive and in the most common situation creates a huge fundamental conflict of interest between the Broker and the Lender (you).

Solution –

The solutions are relatively easy for these three issues.

First, remove one of the monetary conflicts of interest, require that the Mortgage Broker get paid WITH the investors or AFTER the loan is successfully paid off and the investors are whole. This simple alignment of interest will create a total shift in the perspective of the Broker and investors relationship.

Second, investors should verify that the Broker has the ability, experience, desire and staffing to take over the property effectively in the event of Borrower default.

Third, investors should get reasonable direct information from the borrower.  Investors should communicate directly with those that produce any third party reports to validate the information.