Property Value and Equity Level
The most important element of Trust Deed investing is the property value (or equity level). The property value is critical to your decision to lend your funds or purchase a promissory note because there is a possibility that the only way to recover your investment is through the sale of the property. Therefore, the market value of the property should be correctly estimated and the total loan-to-value ratio properly analyzed as illustrated below.
The Market Value of a property is not necessarily the sale price, cost to build, or the value in use to a specific owner or business. A market value requires consideration of comparable sales and other market data by competent professional. The market value conclusion may be presented in a number of different ways. One method is an having an appraisal done, another would be the tax assessed value, and yet another method is an average price of comparable sales in the area. Although each of these methods is unique, each should be given equal weight and used in conjunction with each other to form the best overall average value.
Loan to Value Ratio
The total loans against a property, including your potential loan, divided by the market value of the property determines the Loan-to-Value ratio. For example, if a borrower has a first mortgage (first deed of trust) in the amount of $25,000.00 and is requesting an increase of $40,000.00 and no other liens will be placed against the property, which is valued at $100,000.00, the loan to value ratio is $25k + $40k / $100k, which equals 65% in this case. The lower the loan to value ratio and the greater the borrowers equity (borrowers equity is the difference between the the total amount of all loans against the property and the value, in this case $35k), the more incentive for the borrower to protect the equity in the property, meaning they would have a better chance and more motivation to sell or refinance the property if they are unable to perform on the note. If the property is over-encumbered (the total loans or other liens exceed the reasonable loan to value or market value), the property will provide little or no security for your investment.
A note about equity...the borrower's equity is not the same as protective equity. The borrower's equity is the difference between the market value of the property and the total indebtedness secured by the property. The protective equity is the difference between the market value of the property and the total indebtedness of loans senior to yours plus your loan (if you are in first position then you are the senior), but does not include loans junior to yours (loans in second, third, fourth position). For this reason we tend to stay away from 2nd mortgages unless there is a unique circumstance or an appropriate protective equity level.