Comparing Investing in Individual Deeds of Trusts with Investing in Funds
Written By: Edward Brown
Wednesday, August 21, 2019
More often than not, individual deeds of trust [DOTs] provide a higher coupon than mortgage pool funds [Funds], but there are some specific downsides to choosing individual DOTs instead of Funds. First, choosing the right DOT takes due diligence and a certain amount of expertise in many cases. Investing in extremely conservative DOTs that have LTVs at lower than 25 may not need a PhD in economics, but the yields on these types of DOTs are usually much lower than one can earn in a Fund; thus, one has to start looking at less conservative assets in order to produce the desired yield.
Another advantage to investing in individual DOTs is that the investor can pick and choose which DOT to in invest in compared to having the manager of a Fund choose which mortgage fits the desired yield. This is really not much different than an investor choosing to invest in specific stocks instead of investing in a mutual fund; for some reason, however, the public seems to be more at ease in trusting a mutual fund manager than a Fund manager. Could this be because mutual funds are regulated under the Investment Act of 1940? Could it be the >
There are some advantages for investing in a Fund [as compared to an individual DOT] that may outweigh the negatives. For one, there is diversification in a Fund, so the risk is spread amongst many DOTs. Unless the Fund experiences a major disaster, distributions to the investor should be uninterrupted. With an individual DOT, a default usually means months or possibly a year or longer [as in the case of a bankruptcy by a borrower]. If foreclosure proceedings are necessary, the Fund will usually handle them without the need for the investor to get involved or have to come up with money to pay the trustee or other costs, such as an attorney. In the case of an individual DOT, the investor/lender has to front these costs. If regular distributions are a must, a Fund is a more conservative route.
Although individual DOTs usually earn a higher interest rate than a Fund [about 1-1.5 on average], Funds may offer the advantage of offering a reinvestment program whereby the interest can compound, usually adding about 35 basis points, whereas an individual DOT has to take the monthly distribution with no ability to reinvest. The gap between interest rates of Funds and DOTs gets even narrower [for most investors] when considering the income tax issue because of the new QBID [Qualified Business Income Tax Deduction] introduced in 2018. Congress decided to allow Funds the benefit of reducing the income that has to be reported on an investorrsquo;s tax return [subject to certain income limits]. Investing in individual DOTs does not allow for this tax benefit. This 20 reduction in reporting can have a significant impact on the after tax rate of return of a Fund compared to an individual DOT. For example, if a Fund is paying 7, and an individual DOT is paying 8.5, the after tax return [presuming a 40 tax bracket] of the Fund is 4.76 whereas the DOTrsquo;s after tax return is 4.80. This 4 basis point difference is not significant, especially if one were to reinvest the distributions in a Fund.
The most important factor nowadays [at least in California] is the continuity of a investing in a Fund compared to investing in individual DOTs due to the downtime experienced in many investorrsquo;s portfolio when a loan gets paid off. In these circumstances, the investor usually calls his broker for another DOT to invest in and may be told that there are no good loans to look at for the moment. The investor is asked to be patient or may be forced to look at less quality DOTs. There is tremendous pressure in the market right now for loans to fund, as there is significant capital looking for a home. This competition for loans has driven down interest rates that an investor can earn on a DOT as well as adding to the length of time to reinvest capital that has been returned due to payoffs from borrowers. When one looks at the time value of money, this delay in redeploying capital can significantly lower the net, after tax, rate of return desired by investors. Money that is not deployed in new DOTs sitting idle in low earning bank accounts bring the net yield down for the investor. For example, if an investor desires an 8 return on an individual DOT, having money sit idle for three months at 1 produces a pre-tax return for the year of 6.25. Money sitting idle for four months lowers the net yield to 5.67. In addition, in many cases, Funds snap up the better quality DOTs, leaving the less quality loans available for individual investors. The main reason for this is that Funds want to produce steady, uninterrupted returns for their investors. They usually desire to avoid loans that have a more likely default rate, even if the yield could be higher by taking on a bit more risk. Some investors lower their quality investing standards in order to keep their money working; thus, investors have to carefully consider whether the benefits of investing in individual DOTs outweighs the benefits of investing in a Fund.
nbsp;Edward Brown is an investment expert and host of the radio show, ldquo;The Best of Investing.rdquo; He is in the Investor >
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