Are you a new real estate investor? Or do you already have your own rental portfolio but are considering a new investing approach?
If you’re a real estate investor in any capacity, chances are you’ve heard people argue about what’s a better investing approach: BRRR or fix & flip.
In the following article, we’ll dig into the nuts and bolts of both of these investing approaches to provide you the information necessary to make an informed decision about what makes the most sense for you.
What is BRRR in Real Estate Investing?
“BRRR” is an abbreviation, not a word, and it stands for: buy, renovate, rent, and refinance. These are the key steps to this process, and it’s worth discussing each element in turn:
⦁ Buy: The first step is to buy a property that meets your specific needs (more on your needs later). Typically, it’s a property that’s undervalued relative to the local market or, for some other reason, just not moving.
⦁ Renovate: When you find a good deal on a property, there’s likely a reason why you got such a good deal, and that’s usually because the place needs some work. This leads directly into the next step: renovating the property to A) add value, and B) create a living space that a potential tenant would like to rent.
⦁ Rent: The property renovation leads directly into the third part of the BRRR method: rent. Having taken the initial property and renovated it, you can now find a high-quality tenant to rent your place. This is how you take a property with potential and turn it into an income-generating one. If your goal is to buy one property, you can certainly stop here. However, the beauty of the BRRR method is that it allows you to continue building your portfolio, which leads into the final step.
⦁ Refinance: Having renovated and rented your new property, you’ve taken two critical steps in the eyes of lenders. First, you’ve added value to the property during the renovation process. Second, by finding a high-quality tenant, you’ve turned the property into an income-generating property, demonstrating that these rents can cover monthly mortgage payments. So now you take the last step: you appraise the new property (in theory, at a significantly higher value than your acquisition price) and refinance it. You should be able to use the increased valuation to cash-out both your initial down payment and the additional renovation costs.
Really, there should be a fourth “R” in BRRR for “repeat.” With the cash pulled out in the refinance, you can do it all over again with a new property.
Advantages of the BRRR Approach
Four primary advantages exist to the BRRR approach: long-term wealth building, cash flow, replication, and tax deferral. Actually, you don’t need to have lots of cash to use BRRR strategy. Instead, you can use BRRR strategy with little of your own money.
⦁ Long-term wealth building: Having someone pay your mortgage is one of the best ways to build long-term wealth. Every month, as a portion of a rent payment goes to loan principal, your equity in the property increases. This is amplified by the appreciating nature of residential real estate and, in the case of the BRRR method, the fact that you can build a portfolio of numerous properties that take advantage of this leverage.
⦁ Cash flow: When you have tenants in your properties, you have the added benefit of the cash flow from their monthly rent payments. While you need to cover costs first, a well-structured BRRR deal will ensure that your property is cash-flow positive, leaving a little extra in your pocket at the end of the month. And that’s the goal, right?
⦁ Replication: As stated above, the ability to replicate the BRRR process over and over is a tremendous benefit. With each completed cycle, you more thoroughly understand and solidify procedures, making each subsequent deal more effective and, by extension, profitable.
⦁ Tax deferral: Less often discussed but just as beneficial, BRRR allows investors to defer taxes, leaving more money for current investments. When you sell an investment property, it’s a taxable transaction, and you will need to pay Uncle Sam a portion of your proceeds in the form of capital gains taxes. By holding a property, you can defer this tax as long as you’d like.
What are the Drawbacks of BRRR?
As with any investment strategy, the BRRR method also has its disadvantages, with the following being the major ones: access to credit, understanding of renovation costs, market risk, and maintenance costs.
⦁ Access to credit: The third “R” in BRRR—refinance—necessitates relationships with reliable lenders. And, not all lenders are willing to provide cash-out refinances for investment properties. Consequently, before undertaking the BRRR process, potential investors should confirm lender terms and eligibility for investment property cash-out refinances. Here at The Investor's Edge, we have lending partners who will work with our borrowers to refinance.
⦁ Understanding of renovation costs: Unfortunately, watching a few TV shows does not make someone a renovation expert. Outside of the initial acquisition, renovation costs are the largest costs a BRRR investor will face—and can make or break a deal’s profitability. Therefore, it’s critical that investors have realistic renovation budgets and the associated contractor bids to support those budgets.
⦁ Market risk: The BRRR process is based upon an increase in valuation from acquisition to renovated/rented property. If property values plummet during this period, investors lose the ability to take out their initial down payment and renovation costs during the refinancing process.
⦁ Maintenance costs: When you hold a property for an extended period of time, you also need to deal with the associated wear-and-tear. Between roofs, HVAC systems, water heaters, and every other thing in a house that can break or need to be replaced, maintenance and upkeep costs can add up over the life of a property.
What is a Fix & Flip?
Put simply, flipping a house means buying a property with an intent to sell it at a higher price a short time later (typically less than a year). While certain HGTV shows have made flipping seem like an easy process, there are definitely certain skills a potential investor needs to master before diving into this process.
If you have these skills—or know someone who does—flipping may make sense for your real estate investing needs. Though deals will differ, there are three main steps to a flip:
⦁ Buy an undervalued property, likely in need of repair: With an understanding of the local market, a savvy investor can tell A) that a property is undervalued relative to its neighborhood, and B) what work needs to be done to increase its value. Using this experience and analysis, a house flipper will find a property to buy that has upside value potential, often through short sales or foreclosures.
⦁ Renovate, or “fix,” the property: Next, the house flipper needs to take this property in need of some TLC and complete the necessary renovations, either personally or by hiring a contractor (recommended). This added value is critical to the next step.
⦁ Sell the property for more than the purchase price: With the property renovated and looking good to potential buyers, the flipper puts it on the market without ever having lived there or leased it. In theory, the house sells for more than the acquisition, renovation, and holding costs to provide the investor a solid profit.
Advantages of the Fix & Flip Approach
For the right investor in the right market, flipping can have tremendous profit potential. Specifically, this investing technique has the following advantages:
⦁ Quick return of capital: Real estate investing can be a great way to build long-term wealth, but it’s not always viewed as an investment strategy with a quick return of capital. With flipping, however, investors can put money into a deal and have those funds back within a year, plus a nice profit margin if done correctly.
⦁ Potential for significant profit: If the purchase price is right, the renovation budget is accurate and adhered to, and the market continues to grow, a house flip can return a huge profit for an investor.
⦁ Opportunity to raise seed money for other investments: In investing, getting the initial seed money is often the largest obstacle. For investors with a long-term investment goal—but lacking the initial capital to make it happen—house flipping can be an effective way to quickly generate seed money.
What are the Drawbacks of a Fix & Flip?
If no potential downside existed to the fix & flip technique, everyone would be getting rich (and have their own TV show, too!), right? Wrong. Like all investment strategies, flipping has its own unique set of disadvantages, and any potential investor would be wise to understand the following major ones:
⦁ High market risks: More so even than the BRRR approach, a profitable flip is contingent upon the right housing market. If a market plummets—or just doesn’t appreciate as expected—during the renovation period of a flip, an investor can be either A) stuck with an unsellable property, or B) need to sell a property at a loss.
⦁ Holding costs: Related to the above, holding costs can be high for a fix & flip period during the renovation period. Remember, during this time (and with flipping in general) there’s no cash coming in from renters. Therefore, all holding costs (interest, property taxes, utilities, landscaping, etc) need to be paid by the investor. These outlays can quickly cut into profit if the project goes longer than anticipated.
⦁ Transaction costs: Next, due to the short-term resale nature of a flip, investors need to factor transaction costs into their profit projections. Specifically, capital gains taxes, realtor commissions, and local filing fees are all costs associated with a property sale. If not properly accounted for, these costs can turn a profitable deal into an unprofitable one at the drop of a hat.
BRRR vs Fix & Flip, Which one is Right for You?
Armed with the above background information about both the BRRR and flip approaches, potential real estate investors have a foundation to make a decision. But before actually deciding which route to pursue, investors need to define their unique situation.
Most importantly, real estate investors need to ask the following questions:
What is my long-term financial goal?
This question should be the first thing any investor asks. Beginning to invest in real estate without an associated long-term financial goal is equivalent to getting in the car, pulling out of your driveway, and then thinking about where you should go—it just doesn’t make sense.
Once an investor decides his or her long-term goal, crafting the most effective real estate investing strategy becomes the logical next step.
For example, an investor seeking financial independence as early as possible may consider the BRRR approach, as the cash flow from these properties will eventually cover living expenses, thus providing that level of independence.
On the other hand, some investors enjoy the pursuit of larger and larger projects, taking satisfaction in the challenge of this growth. For these people, the fix & flip approach may make sense, as it’s a way to build seed capital for future projects.
What is my risk tolerance for investing?
Next, investors need to honestly reflect on their personal risk tolerance. House flipping is not for the faint of heart. During the entire process, investors have the looming stress of not meeting budget or asking price and coming out of the deal at a loss.
Though the BRRR approach is certainly not risk free, there’s not such an immediate dependence on the market. For instance, if the market goes down prior to a refinance, the investor still has a renter paying the mortgage.
How much time am I willing to contribute to my real estate pursuits?
Regardless of whether an investor decides on the BRRR or fix & flip approach, time is a finite resource. Do you have a full-time job and want to do this on the side, or are you planning on 100 percent committing to real estate?
Whatever the decision, analyzing deals, renovating properties, finding tenants, and all other tasks related to real estate investing take time out of your day. It’s important to define how much of your time you’re willing to sacrifice.
This time commitment will dictate the deals you’re willing to do and how much you’re willing to outsource to contractors and other real estate professionals (which has the inherent tradeoff of cutting into your bottom line).
What is my current level of expertise?
This is another critical self-reflection question. Have you replaced a few light bulbs in your day and now consider yourself a master electrician? Bottom line, you don’t want to bite off more than you can chew.
If you’re an amateur carpenter, maybe you can handle installing new kitchen cabinets. If you know how to install light fixtures, maybe you can save yourself the costs of hiring someone else to do that work.
But, whatever you decide, recognize two key realities. First, when you do something yourself, the opportunity cost of that work is what you no longer have the time to do.
Second, there are many jobs that require a licensed contractor and permits to do legally. Getting yourself into legal trouble is definitely not the way to begin a real estate investing career, so do your research to find out what is and isn’t allowed in your market.
Choosing your Real Estate Investment Methods
After considering the above background information and questions, it’s time to make a decision and dive into your first deal. However, it’s important to remember that the BRRR and flip methods aren’t mutually exclusive for an investor.
Every deal—and our situation in life when we assess a given deal—is unique. Early on in your investing career, it may make sense to knock out a couple of fix & flip transactions to build some capital.
Later on, you may transition to focus more on long-term wealth building and cash flow, in which case building a portfolio of rental properties with the BRRR approach may suit your needs.
Whatever decision you ultimately make, the most important element is actually taking action. The best idea unexecuted is never more than an idea.
Furthermore, taking action is an education in and of itself. It’s important to read and research before diving head first into a real estate deal, but at the end of the day, some things need to be done to be learned. If you view every real estate deal—and the associated mistakes you make—as learning experiences, real estate investing becomes a way to learn and grow.
Next Steps: Financing for your Investing
So what’s next? You’ve done your research and made a decision – what now?
In any deal, financing is king. Without financing, a great opportunity cannot be pursued. As such, it’s critical to establish solid relationships with lenders.
Join us on our next webinar to see how all this works.