A second Trust Deed is also called a second mortgage and maybe referred to as mezzanine financing due to its subordination to a senior debt, but in the realm of private lending usually does not have an equity stake in the asset. A second position Trust Deed is recorded after the first position Trust Deed and is second in all considerations such as payoff and payments to investors. This significantly increases the risk of the investment for the investor.
These loans are sometimes attractive due to the higher interest rate charged to the borrower and passed on the investor. In many cases the second Trust Deed is offered as being ‘as secured’ as the first Trust Deed by the value of the asset with an opportunity to get a higher yield. This is where PITFALL #4 becomes very important. A potential investor in this type of loan would be encouraged to inquire in detail about the use of the funds for the borrower or a ‘why’ the borrowers are interested in acquiring this financing as it is very expensive and may over-encumber the property for collateral. In many cases the ‘why’ exposes a borrower or situational risk factor(s) that may influence the investors’ decision about the loan.
Compared to a first Trust Deed; second Trust Deed carries its own additional risks and considerations for the investors such as if the borrower defaults the investors must be able and willing to cover the first position debt (and all property costs) to protect the second position debt. In the case of most renegotiations or foreclosure action the second position debt is at the greatest risk of principle loss. However; the lack of true current equity in the property will wipe out investors principle almost assuredly. In the event a borrower defaults on the second Trust Deed, (stops making payments) the investors to recoup the principle invested the Trust Deed must pay to foreclose on the borrower and cover the entire first Trust Deed to control the property so that they are allowed to attempt to sell it to recoup the principle invested.
Investors may wish to limit the amount of capital they contribute to this type of loan, the additional yield may not adequately compensate for the lending risks. When accessing the investment of a second Trust Deed the loan to value and the qualifications of the borrowers becomes even more important. An investor may look for additional collateral, equity in the underlying business and additional personal guarantees from the borrowers.