Feb 26, 2019
Weigh Your Options - Investing in Nonconventional Lending
Non-conventional lending is an immensely popular area for Self-Directed IRA investors. The availability of real estate security along with higher than average returns has attracted many IRA investors into the space.
There are so many different types of investment opportunities in non-conventional lending. But they ultimately boil down to two main categories: Direct Investments and Indirect Investments. These typically take the form of Trust Deed Investments vs. Fund Invesments.
Both present immense value and have their benefits. I’m here to outline the pros and cons of both.
Pros and Cons of Trust Deed Invesments
- What are the advantages of Trust Deed Investments?
- Direct Control of the Asset. Trust Deed Investments results in the IRA investor becoming the lender(s) of record. Meaning it owns (wholly or fractionally depending on the transaction) the promissory note and deed of trust. Why is this important? Control over the outcome and enforcement of the loan’s terms.
- Selection of the Asset. Because Trust Deed Investments are direct investments, investors are able to pick and choose what they invest in as opposed to a diversified pool where they have no decision-making authority. This goes to the same point as above, it grants the investor control over the decision to invest.
- Direct investments typically present higher liquidity because they are shorter- term, and the loans could be sold to note purchasers.
- What are the disadvantages of a Trust Deed investment?:
- Diversification can be challenging because of the direct nature of the investment.
- IRAs may not be able to obtain all of the income derived due to prohibited transactions rules. For example, origination fees often cannot be paid directly to the IRA because of these prohibited transactions rules.
- Direct Nature of the investment may result in less return than expected. If the loan is paid off in 6 months instead of the expected 12 months – the “lender” will not have received the full annualized return on their capital invested.
- Because the investor owns the loan directly, they are also subject to any litigation brought by the borrower.
Pros and Cons of Mortgage Funds
- What are the advantages of a Mortgage Fund?
- Funds are pools of mortgages that allow investors to own a proportionate share based on their investment. The sponsor can diversify the portfolio with residential and commercial loans in various markets granting the investor a diversified investment in a lending business.
- Reduced Involvement. Simply put, it allows the experts or the specialists to make the lending decisions and allows the investor to earn returns on a more passive investment.
- Annualized Return. Mortgage funds deliver annualized returns and because they are pools of loans, the investor’s capital is working for the full year, as opposed to trust deeds which requires the investor to find the deals to fund.
- What are the disadvantages of a Mortgage Fund?
- Management Fees. Funds, unlike trust deeds, often charge management fees to investors. This is to manage the investments and the labor associated with loan origination. It is important to note that trust deed investments often are also charged servicing fees by loan servicers/brokers.
- Tax Efficiency. Funds can incur leverage. While this increases yield, for IRA investors this can be troublesome because it can trigger Unrelated Business Taxable Income for the IRA investor. UBTI can be avoided by investing in Mortgage REITS, securitized notes, or other exempt vehicles.
- Limited Liquidity. Most mortgage funds require a minimum of a 1-year investment, if not longer. In addition, because they are often privately offered, the investments cannot freely be sold. For these reasons, they are often longer-term investments.
When deciding to partake in any investment opportunity, it is important to understand all of the pros and cons associated with your decisions. Conduct due diligence by enlisting the help of a trusted advisor and knowledgeable attorney in this space.
Kevin Kim, Esq., is a partner in the Corporate & Securities practice at Geraci LLP, a full-service law, media, and consulting firm at the forefront of the ever-changing non-conventional lending space that caters to non-conventional lenders worldwide.
*Mainstar's role as custodian of self-directed accounts is nondiscretionary and/or administrative in nature. This information is for educational purposes only, and should not be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments. Mainstar encourages individuals to consult a financial or legal professional when making investment decisions.