A mortgage fund is an investment that pools money from multiple investors to purchase mortgages (also known as trust deeds). This differs from investing in individual trust deeds, in which the investor is secured on a single mortgage. In this article, we are going to explore the various benefits of a mortgage fund and why a fund can be a better option than investing in individual trust deeds.
The biggest advantage of a mortgage fund is that it is comprised of a diversified over a pool of mortgages. If one of the mortgages from the fund is paid off, or the borrower defaults on the payments, you continue to earn income from the other mortgages in the portfolio. If the loan is paid off, the manager simply replaces that trust deed with a new one.
For trust deed investors, because you are invested in a single loan, your income is dependent on that one loan. If a loan is paid off or the borrower defaults on the payment, your income stream stops. In the case that the loan is paid off, it is then up to the investor to replace the trust deed with a new one.
The next advantage is liquidity. When you invest in a mortgage fund, you can decide on the size of your investment and the timing. If you are looking to withdraw your investment, you have the option to submit your request to the fund manager and have it returned (keep in mind most funds have restrictions on how investor capital is returned).
With a trust deed, your investment will be dependent upon the size of the loan (or your ownership interest in the loan) and when it closes. If there is a delay in the closing, or the closing is cancelled, the income you would be earning is negatively impacted. Also, the only way to liquidate your investment in a trust deed is when the loan is paid off, or to sell it to another investor. Because there is a small secondary market to purchase trust deeds, you will most likely need to sell the trust deed at a loss.
Another advantage is the ability to earn compounded interest by reinvesting your distributions. Because most trust deeds are structured such that the borrower makes monthly payments, you as the investor receive a monthly distribution. Those funds are deposited into your account and earn little to no interest until such time as you reinvest the proceeds.
In a mortgage fund, you have the option to reinvest your proceeds and earn income on those distributions the following month. Let’s consider the following, if a mortgage fund earned an 8.5% return over the course of a year and the investor elected to take their distributions, their annualized return would be 8.5%. Compare that with an investor who elected to reinvest their distribution. Their return with the same investment over the same period of time would be 8.84%. That is why most investors elect to reinvest their distributions and may make withdrawals only when they need the funds.
Many fund managers have elected to structure the mortgage fund as a real estate investment trust (also known as a REIT). The advantage of structuring the mortgage fund as a REIT is that investors are eligible to receive the 20% Qualified Business Income Tax Deduction (also known as QBIT) regardless of their income. Trust Deed investors on the other hand that use non-retirement funds are subject to ordinary income tax on 100% of the distributions.
It is important to keep in mind that investors using their retirement funds through a self-directed IRA (also known as a SDRIA), may or may not be subject to Unrelated Debt Financed Income (also known as UDFI). Because most mortgage funds use leverage to manage the inflow and outflow of investor capital or loans, investors using retirement funds may unknowingly be subject to tax on the distributions from the fund because some of the income was generated a result of the leverage. By having the income from the fund flow through the REIT, fund managers can eliminate the UDFI.
At the end of the day, most investors don’t want to spend the time to identify, underwrite, and service a portfolio of trust deeds. The process can be very time consuming, from engaging trust deed brokers, reviewing potential investment opportunities, collecting payments from borrowers, and balancing available cash with available trust deeds.
Additionally, individual trust deeds subject the investor to litigation. If you fail to follow ever changing and complex state or federal regulations regarding real estate loans, you could be subjected to government and civil penalties. And should you have to deal with a defaulted loan, the time and resources to enforce your foreclosure will most likely cost more than the income generated on the investment.
The one biggest disadvantage of investing in a mortgage fund is that the investor gives up control of which trust deed to invest in. This is a common complaint, especially with trust deed investors that have been investing for a long time or are very specific on their requirements. These investors have the time to review each trust deed offering and build a portfolio of trust deeds that matches their risk tolerance.
However, this approach is probably not the right option for most. Investing in trust deeds is complicated, and knowing how to approach each investment based upon the risks in the market can be very difficult. That is why investors are advised to invest in trust deeds through a professional with the experience, knowledge, and current data to invest properly.
Investing in mortgages can be very lucrative for investors seeking consistent monthly income, the security of real estate, and the ability to invest locally. However, investing in trust deeds can be very complicated which is why most investors elect to invest in a mortgage fund. The mortgage fund offers various advantages including diversification, liquidity, compounded interest, tax advantages, and is generally a more passive investment approach to investing in mortgages.
If you are interested in investing in a mortgage fund, check out our article on What is a Mortgage Fund.
Brock VandenBerg has been investing in trust deeds for over 15 years. Mr. VandenBerg has funded over 850 loans totaling over $350MM over that period. He started in the industry investing in trust deeds using his own capital and then soon brokered trust deeds to outside investors. He successfully grew the trust deed portfolio to over $55 million with over 150 individual investors. In early 2021, Mr. VandenBerg launched his first mortgage fund because of the inefficiencies he found in building and managing a portfolio of trust deeds. Currently, Mr. VandenBerg manages over $35 million in TaliMar Income Fund I, a mortgage fund focused on funding residential and small balance bridge loans in the Southern California market.