Countless real estate investing strategies exist. But, from a long-term wealth building perspective, I firmly believe that the BRRR strategy represents one of the best options for investors. As such, I’ll use this article to argue why, after rehabbing a house, you should be refinancing a BRRR.
BRRR stands for buy, rehab, rent, and refinance. And, by completing this final step, investors create three ways to profit on a deal: loan amortization, property appreciation, and tenant cash flow. But, before refinancing, BRRR investors should consider a few key lender questions.
I’ll dive into the BRRR overview and these lender questions in the rest of the article. Specifically, I’ll cover the following topics:
- BRRR Overview and Key Players
- BRRR Profit Paths
- The Importance of Refinancing a BRRR
- Questions to Ask a Lender before BRRR Refinancing
- Final Thoughts
BRRR Overview and Key Players
Prior to diving into the refinance-specific part of the BRRR strategy, new investors should have a solid grasp of both A) the strategy, in general, and B) the key players necessary to successfully execute that strategy:
BRRR stands for buy, renovate, rent, and refinance, and it’s a frequently-used strategy of real estate investors looking to build a portfolio of rental properties. The overall goal of the BRRR strategy is to get into rental properties with as little of your own cash as possible. The less cash you contribute, the higher your return on investment. Best case scenario, you contribute nothing and have infinite returns!
Here’s a more detailed look at each element of a BRRR deal:
Similar to fix & flip deals, BRRR investors purchase distressed properties – typically at a significant discount. Most of these properties don’t qualify for traditional financing, that is, your standard 30-year residential mortgage. Consequently, motivated sellers who want to convert their equity into cash need to find other buyers, as people looking for primary residences can’t finance these properties.
Enter real estate investors as problem solvers. Unlike primary homebuyers, BRRR investors use either cash or hard money loans to finance the purchase and renovation of a property. When approving a mortgage, traditional lenders look to A) the condition of the underlying property for collateral purposes, and B) the borrower’s entire financial picture. On the other hand, hard money lenders look solely at the “hard asset” – the property – when approving loans. More precisely, these lenders look at what the property will look like in the future.
When you apply for a hard money loan to buy and renovate a distressed property, the lender completes two types of appraisals. First, they determine the “as-is” value of the property to ensure the purchase price is reasonable. Second, lenders hire appraisers to determine the after-repair value, or ARV, of the property. These specialized appraisers look at the contractor renovation bids and local area homes with similar renovation work to determine what the property will be worth after the renovation.
Hard money loans hinge on this ARV number. While every lender varies, Do Hard Money will issue loans at 70% loan-to-value (LTV) based on ARV. For example, say a property has an ARV of $300,000, meaning that the appraiser believes this property will be worth that much following the renovation. With this ARV, we’d lend $210,000 ($300,000 ARV x 70% LTV).
But, these loans function more like acquisition/construction loans in that borrowers don’t receive the full lump sum at closing. Instead, hard money lenders issue loan funds in accordance with predetermined draws. Generally, you’ll receive an initial amount to purchase the property. Then, the lender will release funds to pay the contractors as work progresses. This provides a level of protection to hard money lenders, as they don’t lend out more money than costs put into renovating the property.
This hard money loan amount also plays a critical role for investors analyzing potential BRRR deals. With particularly good deals, investors can complete the purchase and renovation with 100% financing. Continuing the above example, if you can find a $300,000 ARV property to purchase and renovate for $210,000 (the hard money loan amount) or less, you can complete the deal with no contributed capital. Put simply, you can end up owning a rental property without investing any of your own cash.
This is one of the primary goals of BRRR investing: to find deals that require little to no up-front capital. In addition to significantly increasing your ROI on individual deals, this also provides you the flexibility to keep investing in new properties.
Once you close on the purchase, the renovation work begins. During the deal analysis of the BRRR buy phase, you’ll work with a general contractor (GC) to develop a detailed scope of work. This will include a line-by-line accounting for all work the contractor will complete – and the associated prices. In addition to making sure that you and the GC are on the same page, this document also serves as an outstanding project management tool, allowing you to tangibly measure renovation progress.
As an investor, you likely have too much on your plate to supervise every step of the rehab period. But, I recommend that you go to the property at least once a week, as you’ll want to make sure that the work is progressing as scheduled. At these weekly meetings, I suggest walking the property with your GC and always asking two questions:
- What did you do last week, by scope of work line item?
- What are you doing this week, by scope of work line item?
These questions A) let you track the progress and make sure you hit milestones, and B) let you submit loan draw requests to pay your GC accordingly.
Occasionally, a contractor falls significantly behind schedule. When this happens, I recommend holding a status of rehab work meeting. In this meeting, you discuss a plan for the contractor to catch back up on the work. If not possible, I bring in a back-up contractor to finish the work. However, I will definitely provide some time liberties if a delay is documented by third parties (e.g. a city delaying permit issuance).
In many respects, this BRRR renovation period parallels the rehab work in a fix & flip deal. However, investors should recognize one major difference: they must account for the wear and tear tenants put on rental properties.
When you sell a fix & flip, you don’t need to worry about this. But, with a BRRR property, investors absolutely do not want materials breaking every year or so. Instead, investors need to use far more durable materials during the renovation. Ideally, you can find a happy medium between cost, style, and durability. The home needs to look nice enough to appeal to potential tenants while A) holding up to their wear and tear, and B) not breaking the renovation budget.
Following the renovation period, BRRR investors rent the property out to high-quality, long-term tenants. Unlike fix & flip investors who profit on the sale of the renovated property, these investors instead seek cash flow and loan amortization via quality tenants.
Additionally, renting a property proves critical to the next step in the BRRR strategy: refinancing. Traditional lenders require that borrowers meet certain debt-to-income (DTI) criteria. Conceptually, DTI represents the percentage of every dollar of income you use to make monthly debt payments, including the future mortgage. Mathematically, you solve for DTI by dividing all of your monthly debt payments by your monthly gross (pre-tax) income.
While lenders vary, many require a DTI of 40% or lower to qualify for a mortgage on an investment property. Without these new rent payments offsetting the future mortgage, many investors will not meet this DTI requirement.
After renting their property to long-term tenants, BRRR investors need to refinance their short-term, high-interest hard money loan into a long-term mortgage – often referred to as take-out financing. Of note, this refinance qualifies as a rate and term one. Investors use the proceeds from the take-out financing to pay off the hard money loan, in effect extending the term and changing the interest rate from one loan to another. Very few lenders will provide a cash-out refinance in this situation.
If BRRR investors fail to refinance their hard money loans into long-term mortgages, they face two bad options: 1) continue paying the high interest rate of a short-term loan, or 2) change strategies and sell the property. This begs the question, how can investors refinance a BRRR property?
If investors ask this question during a BRRR deal, they’ve already set themselves up for failure. Instead, before beginning a deal, BRRR investors need to get pre-approved for the eventual permanent, or take-out, loan. They need to find a lender who will provide this sort of refinance loan on an investment property, apply for pre-approval, and then purchase the property with a hard money loan.
This sequencing is the result of credit requirements. With hard money lenders, credit scores and income qualifications largely don’t matter. These lenders only concern themselves with the “hard asset,” the property – and its after-rehab value. As a result, hard money loans are often easier to qualify for than traditional mortgages.
On the other hand, traditional lenders do care about credit scores, income requirements, and other personal financial information. This means that, of the two loans, the long-term financing proves far more difficult to receive. Due to this reality, BRRR investors will want to confirm that they’ve secured their long-term financing before jumping into a deal. If not, they can face an unpleasant surprise during the refinance period of the BRRR deal.
From a loan amount perspective, most lenders will provide 75% to 80% LTV take-out financing on investment properties. If you have analyzed the deal correctly, this long-term mortgage will completely pay off your hard money loan balance.
Let’s continue the above example of the $300,000 ARV property and the $210,000 hard money loan. First, it’s important to note that ARV is an estimate, meaning that the actual market value following the renovation may differ. But, assume the market value also equals $300,000. With 75% LTV, you could borrow $225,000 – $15,000 more than the hard money loan. Therefore, if interest payments are less than $15,000 on the hard money loan, the take-out financing will completely pay off the balance. However, if interest payments exceed $15,000, you’ll need to contribute cash to pay the difference between the hard money loan balance and the total take-out financing.
As the above overview should make clear, investors need to connect with three key players to make a BRRR deal happen:
- Hard money lender: This is the initial key to financing a BRRR deal. Your hard money lender will extend you the short-term credit necessary to A) buy, and B) rehab a property. As with most aspects of real estate, establishing a relationship with a reliable hard money lender will make loan approval a far smoother process.
- Take-out financing lender: Usually a loan broker, mortgage company, or local credit union, your take-out – or permanent – financing lender is the final key to a BRRR deal. This lender allows you to convert your short-term, high-interest hard money loan into a long-term, low-interest mortgage. In the process, you gain the profit benefit of loan amortization.
- General contractor: A reliable general contractor is integral to hard money approval. Before approving any loans, your hard money lender will require a detailed contractor bid. By establishing a relationship with a reliable contractor, you’ll develop a seamless process for both underwriting potential deals and getting the financing for those deals approved.
BRRR Profit Paths
I mentioned it above, but I firmly believe that the BRRR strategy provides one of the best ways for investors to build wealth. In particular, this strategy provides three distinct profit paths, each of which contributes to your overall wealth:
- Cash flow from rents: With a properly analyzed deal, investors will collect excess cash flow from a rental property every month.
- Loan amortization: When tenants pay rent, they also pay your mortgage. With an amortizing loan like a mortgage, a portion of every payment reduces your loan balance. As your loan balance decreases, your equity – or ownership – in the property increases, building your overall wealth.
- Property appreciation: BRRR investors also benefit from long-term property appreciation. While home values may fluctuate in the short-term, if you hold for an extended period, you’ll likely benefit from property appreciation, or increases in value.
Why You Should Be Refinancing a BRRR
However, investors won’t reap any of the above profit paths until they refinance their hard money loan into a long-term mortgage. Due to their short-term, riskier nature, hard money loans have far higher interest rates than take-out financing. These high interest rates are acceptable for the purchase and rehab period, as they enable investors to purchase distressed properties. But, with these sort of rates, investors:
- Will likely not receive any cash flow from tenants, as most rents will go to debt service.
- Will not receive the benefits of loan amortization, as most hard money loans do not amortize – they just accrue interest or require actual interest payments.
- Will have the benefits of property appreciation offset, as hard money loan interest will likely outpace that of appreciation.
- Will not recover their initial capital investments, meaning that they cannot use those funds for additional deals.
Bottom line, the refinance portion of a BRRR deal is absolutely critical to deal success. Until you refinance your hard money loan, you: A) at best, tread water financially, not actually making a profit; or B) at worst, continue to sink yourself into debt as the hard money interest owed increases.
With an outstanding BRRR deal, your refinance proceeds will allow you to recover 100% of your contributed capital. This creates a situation with infinite returns, and investors should absolutely strive for this goal. But, even if you don’t recover all of your capital, you’re still getting a return on investment once you complete your refinance.
Questions to Ask a Lender before BRRR Refinancing
As you pursue a BRRR deal, you’ll want to ask potential hard money and take-out financing lenders some key questions:
Hard Money Lender Questions
- Will you finance the purchase, closing, and rehab costs? (Some lenders will not cover closing costs, meaning you’ll need to set cash aside for these costs).
- What loan-to-value (LTV) will you provide based on a property’s ARV? (This varies by lender, but at Do Hard Money, we’ll lend 70% of appraised ARV).
Take-out Financing Lender Questions
- Do you have a seasoning requirement? (This is a period of time a lender requires you to own a home before you can refinance it. A three-month period is perfectly acceptable, whereas a year-long seasoning requirement will seriously cut into a deal’s budget, as you’ll need to pay hard money loan interest that entire time).
- What LTV will you offer, and is it based on purchase price or post-rehab value? (Most lenders will offer 80% LTV, and you’ll want to confirm this is based on current market value – not purchase price).
NOTE: If you place a tenant and then fail to get take-out financing, you’ll be in trouble financially (and potentially legally). For this reason, make sure you have take-out lender pre-approval before a BRRR deal. A quality hard money lender will require this pre-approval, as well, but it’s important enough to reiterate here. At DHM we’ll certainly help you through this process and make sure everything is set up correctly.
BRRR deals provide investors an incredible path to building wealth. But, until you complete the final “R” – refinancing – you won’t take advantage of the strategy’s three profit paths.
At The Investor's Edge, we understand that doing a BRRR deal can seem like a daunting challenge to new investors. We’d love to help!
If you would like to learn more about managing a BRRR, sign up for our free webinar.