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Risk & Reward

For over 12 years Capital Alliance has originated trust deeds that generate high returns (typically between 11% and 12%), consistent monthly cash flow distributions (over 140 consecutive months as of March 2008), while preserving investors' capital, which is secured by a substantial equity position in the real estate collateral.

The reward that comes from an investment relates to how well the underlying asset performs and how successfully risk, endemic to any investment, is managed. In the case of trust deeds, the goal of maximizing the reward (return on investment) is supported by ensuring that:

• The property which collateralizes the deed (loan) is properly valued;
• There's sufficient equity in the property to provide the incentive for the borrower to meet the monthly loan payments, and to withstand a reduction in property value;
• The borrower can demonstrate the ability to make loan payments; and
• Title to the property and trust deed has been properly vetted and is in good stead.

The goal of minimizing risk works hand-in-glove with maximizing reward, and is primarily related to property value, lien position and legal action.

Property's Market Value

An accurate assessment of the market value of the property that collateralizes the trust deed is critical to an investor's decision to purchase it because there is the possibility that the only way to recover the investment is through the sale of the property.

The market value is generally presented in the form of an appraisal report which considers comparable sales and other relevant data by one of our stable of competent professional appraisers. The appraised value is the appraiser's final estimate of market value.

Loan-to-Value

As is well known today, real estate values do not always rise—there are periods of devaluation. An erosion or loss of protective equity can affect the trust deed investment.

If protective equity is lost, then loss of principal in the trust deed could occur. This is why the loan-to-value ("LTV") and protective equity are so important. The LTV ratio is the total loans against the property divided by the market value of the property.

For example, if a borrower has a first deed of trust outstanding in the amount of $100,000 and is requesting a second deed of trust in the amount of $50,000 and no other liens will be placed against the property, which is valued at $300,000, the LTV is 50% ($100,000 + $50,000 divided by $300,000 = 50%).

The more equity the borrower has in the collateral, the less likely it is that the borrower will default. A Federal Reserve study conclusively demonstrates that "The current equity status of the property is a key determinant of whether a delinquent mortgage will prepay or will default."

The Federal Reserve's bottom line: "Borrowers with substantial equity will prepay rather than default or foreclose." With an equity position of 25% (a Loan-to-Value ("LTV") of 75%), this study shows the probability of default is less than 2%. An equity position of 30% is even safer.

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Loan-to-Value and equity in a property are inversely related

The lower the LTV, the higher will be the borrower's equity position in the collateral, and the greater the borrower's equity—and, most importantly—the greater will be the borrower's incentive to protect his equity in the property (i.e., sell or refinance the property if unable to make payments under the trust deed promissory note), or for a third-party bidder to purchase the property at a foreclosure sale.

If the total loans or other liens exceed a reasonable LTV or exceed the market value, the property will provide little or no security for the trust deed investor. Sufficient equity should be maintained in the property to allow for the fees, costs, and expenses that are incurred in foreclosing, even though this situation is of low probability.

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Lien Position

Lien position is about the ranking of priority of liens against a property that collateralizes two or more loans. The first lien position gets paid first.

In the case where a junior (anything other than first lien position) trust deed is owned, and a foreclosure action is initiated by a senior trust deed, this could threaten the security of all other lien positions in the deed.

It is important that these filing actions are monitored regularly since at such time a senior trust deed initiates a Trustee Sale (auction), a junior trust deed could potentially incur a loss should the property not be sold at a price sufficient to pay off all lien positions.

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Legal Action

A legal action (Action of Notice) recorded against the property, or one that has identified the property in an action, could threaten its negotiability. This could encumber the title, potentially preventing a trust deed holder (investor) from selling the property or proceeding with a foreclosure action.

In short, a legal action, as well as legal proceedings in general, ties up the property and all parties involved with the property until such time the legal action has been resolved, rescinded or cancelled. Consequently, the Escrow [C] proceedings and Title Report [D] are of paramount importance.

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How We Mitigate Risk

Capital Alliance takes several steps and precautions to minimize risk and to protect investors' capital. From the initial stages of making a loan for one of our Funds or a trust deed investor, we verify that each property has sufficient protective equity. This is achieved by having the property appraised or by establishing value with comparable sales.

Our underwriting rules mandate that the maximum LTV on residential real estate is 75% (minimum equity position of 25%), and that the borrower's income and ability to pay debt servicing is verified—these are the two most significant predictors of future solvency in a trust deed investment.

We further mitigate risk by regularly monitoring all pertinent criteria, including whether all loan payment histories check with public records. This is done monthly to determine if any foreclosure actions have been initiated.

If a foreclosure action has been started by a senior lien holder, we can take preemptive actions to protect our investor's position in the collateral.

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