By Jim Freeman, CFP®
A private trust deed is simply a loan made against a real estate investor's property. In other words, it is a private mortgage. Trust deeds and mortgages have slight differences, but for this discussion it's fine to think of them as very similar.
Over 10 years ago, we sat with a prospective client reviewing his portfolio and discussing his financial planning goals and objectives. When we got to one of holdings he said he really liked this investment and wanted us to take a closer look at it. He saw no reason why he shouldn't put all of his money into it. The investment was a private trust deed fund.
We told him, on the contrary, that most likely we'd be advising him to take all of his money out of it.
We explained that we had reviewed many investments of this type for our clients in the past and had not recommended a single one for their use. We further explained that the past trust deed investments we reviewed had the following negative characteristics:
Surprisingly, after a detailed review of this investment, we found that this particular trust deed investment defied our negative expectations. It seemed like the quintessential diamond in the rough as it seemed to exhibit the following characteristics:
Next we interviewed the principals of the firm as well as their employees. We were impressed, and to make a long story short we told our client we liked his investment and that he should keep it. In fact, we liked it so much we began incorporating it into our other clients' portfolios and have been using it successfully for over 12 years now. During that time it performed very well and weathered several downturns.
Due to the new 2018 tax law changes this investment changed its legal structure to a REIT and now 20% of the distributions received are free from Federal income taxes. Not all first trust deed investments qualify as REITs, but this one does.
There are several pearls of wisdom that can be gleaned from this story about trust deed investments, and about investing in general.
The most pertinent takeaway is the extremely high importance of conducting thorough due diligence every single time you commit your money to an investment. As we described, our skeptical view turned out to be incorrect. Many times it goes the other way, where overly optimistic attitudes can be proven wrong. We've seen that as well.
It may seem basic, but don't let your emotions or any preconceived notions bias your investment strategy. This can be hard to do as even the best of us are subject to our emotions as humans.
Also, realize how drastically investments of a particular type can vary from one to the next. As you heard in this case, trust deed investments can make excellent investments - but they can also be much, much riskier than you realize.
If you are ever presented with such an investment opportunity, be careful and make sure you thoroughly understand all aspects of the investment, the management team running it and the amount of risk that is being taken to generate the advertised returns. And remember, if the returns seem too good to be true, they probably are.
The diamonds in the rough are out there, but they don't come along without a great deal of time, effort, and objective consideration.
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