Real Estate 008: BRRRR method of investing

In my previous posts, I have discussed different strategies to meet your real estate investing goals. I have recently come across a method that has been popularized by Brandon Turner at BiggerPockets.com but has existed and been used by savvy real estate investors who want to start investing using little to no money down. So what is it? The BRRRR method - stands for Buy, Rehab, Rent, Refinance, and Repeat. Lets take a closer look at each step below:

1. Buy

They say you make money in real estate in three ways: 1) buy 2) sell 3) cash flow. Knowing your numbers used in your BRRRR strategy is just as important as wholesaling, flipping, or buy and hold rentals. The main focus of the BRRRR strategy is to pull out all your money (in some cases, you may be able to pull out more than what you've put in) and end up with a cash flowing property with some equity. A general rule of thumb is to look for a purchase price that is 75% of the after repair value of the property.

For example: A home that has an after repair value of $150,000 * 75% (cash out refinance) - $25,000 est. rehab costs = $87,500 maximum purchase price.

If you are able to purchase below $87,500 or perform a quality rehab for under $25,000, then you will end up with more equity/less cash out of pocket. Note that the above calculation is a simple illustration and there are usually refinancing costs involved with the lender.

2. Rehab

The rehab budget is always an area of discussion among investors for many reasons. Here are my thoughts on the dollar amount on spent rehab and value add upgrades:

• There is a key distinction between primary residence (Owner Occupied) and rental properties (Leased). Simply put, renters may not need, nor would they pay the extra $25-50/month in rent to have all the bells and whistles that you would want for yourself. Granted, if there are two homes in a neighborhood with all things being equal and 1 has granite countertops/backsplash and the other has none, it may be more appealing and rent out faster. However, you have to decide for yourself, at what cost? For me, I am mostly focused on replacing key CapEx items with little useful life to reduce deferred maintenance as well as making the house livable and suitable for the market/neighborhood (an A class neighborhood will definitely have different upgrades than a C class neighborhood).

• You also have to decide what value add upgrades - new kitchen/new bath/new flooring will being the most return on investment. This is a great conversation with your property manager and rehab crew as they will have the most insight into the neighborhood and experience dealing with tenants.

3. Rent

The next key step is renting out the property after it has been properly rehabbed. Whether you decide to buy and hold or sell the property as "turn-key" alternative, renting the property will help you obtain refinancing with the lender. You can advertise and rent out the property by yourself, or I would personally recommend using a property manager who typically charge 8-12% of the rental income. Their marketing efforts, tenant screening, and maintenance handling should be well worth their fees. Make sure to received referrals from active investors in the market and interview multiple property managers. Remember, a good PM can make a good deal into a solid deal, whereas a bad PM can turn a solid deal into a horrible deal.

4. Refinance

You have crunched the numbers, bought/rehabbed/rented the property, so now you are ready to refinance and pull out your cash (downpayment + rehab costs). Depending on the lender, there will be different seasoning requirements. A traditional refinance may require a 12 month period for which you will have to maintain the property then request a refinance. However, there are many portfolio lenders who have 6 month seasoning requirements or some who can start the refinance process the day after closing (zero seasoning). The lender will order their own appraiser to go to the property and draft an appraisal. 

In the example mentioned earlier, lets look at two scenarios with the same expected ARV of $150,000.

Example 1: Purchase price of $50,000 (bought distressed/foreclosed/divorce/REO) and put in $25,000 amount of repairs for an all in cost of $75,000. The bank appraises it for $140,000. You request a cash out refinance and the bank gives you $105,000 (75% of the appraised value). Now you can fully pay off the $50,000 loan and $25,000 rehab costs (if you used private financing or hard money lender) and have $30,000 in excess cash + 25% in equity.

Example 2: Purchase price of $75,000 (normal sale) and put in $20,000 worth of repairs for an all in cost of $95,000. The bank appraises it for $135,000. The bank does not allow for refinances greater than your all in cost. In this case, you will get back $95,000 to pay off the $75,000 purchase and $20,000 in rehab, and the remaining amount will be left in equity ($135-95K = $40K/135K = 30%).

5. Repeat

The above examples are cases of success stories in which you were able to cash out your initial investment and maintain equity of 25% or greater in the home. Now you will rinse and repeat the process and scale your rental portfolio!

Few thoughts on BRRRR vs. TurnKey/buying off MLS

Although I have bought my first rental property from a turnkey company, I eventually want to try the BRRRR method for a couple reasons: 

• Ability to cash out refinance and retain equity in the home

• Control over the type/quality/amount of rehab

• Ability to retain your "seed" capital for other investments (typical buy will lock up 20-25% cash each time you by, thereby significantly lowering your buying power)

• Allows for faster scaling of your rental portfolio

• Higher return on investment (more of other people's money = higher ROI)

However, there are also a couple reasons why I do not want to jump on the BRRRR bandwagon just yet:

• More risk is placed on the project owner overall (you are buying/rehabbing/renting/refinancing)

• Risk of appraisal coming in lower than expected (not being able to break even)

• Risk of rehab delays (A turnkey is already rehabbed and tenanted)

• Longer process than buying turnkey/MLS

• Risk of being unable to cash out refinance

  • Seasoning requirements

The BRRRR method has been a very popular method for investors to increase their return on investment as well as overall net worth due to the fact that they are leveraging other people's money and if done correctly, able to repeat the process over and over. However, if it was so easy, why doesn't everyone do it? As mentioned in the reasons above, the BRRRR takes careful planning, finding the right deals, using the right team, and comes with its own set of headaches as things can go wrong during the process. What is your strategy? I would love to hear your thoughts on BRRRR vs buying turnkey/MLS.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 007: Rental Property Criteria

Now that you have identified a market, its important to start developing a criteria (again, a ship with no clear direction is sailing towards nowhere) and analyzing properties.

So how does an investor analyze properties? Below are some metrics that I use to evaluate rental properties. Remember to subscribe to my blog to receive updates as well as gain access to my free cash flow calculator and rental property criteria.

1. Cash on Cash (Used when financing a property)

To calculate the cash on cash return percentage, I take the net monthly income after all mortgage, insurance, property taxes, property management fees, vacancy and maintenance expenses are included, and annualize the amount. That amount is divided by your total cash invested into the property.

Below is a property analysis using real numbers of a sample investment in the midwest, USA.

Net Cash flow of $174.13 * 12 months = $2,089.56 divided by total out of pocket cash $13,600 down payment + $3,400 estimated costing cost 5% = $17,000.00

• Cash on Cash %: Net Annualized Cash Flow / Total Cash Invested

• 12.29% (rounded): $2,089.56/$17,000.00

2. Cap Rate (Used when paying all cash)

The Cap Rate is used to make comparisons between similar rental properties. By taking the Net Annualized Cash flow / Purchase Price, you arrive at the Cap Rate of a rental property. This method is more meaningful when an investor pays for a property all cash thereby calculating their annual return on their lump sum of money. Please refer to the picture above that illustrates the Cap Rate calculation on this property

• Cap Rate %: Net Annualized Cash Flow (no mortgage) / Purchase Price

• 8.30% (rounded): $5,643.96/$68,000.00

3. Rent to Value Ratio

Another quick measure of relative costs of buying and renting across different markets is the rent to value ratio. As mentioned in my previous post of cyclical and linear markets, I have generally observed that cyclical markets tend to have a lower rent to value ratio, meaning you will make less by renting out of property relative to its purchase price, compared to linear markets with a higher rent to value ratio meaning its a better market for investors looking to cash flow on their investment properties. The rent to value ratio is calculated simply by taking the gross rent divided by the purchase price of the property

• RTV %: Gross Monthly Rent / Purchase Price

• 1.21% (rounded): $825/$68,000

4. Debt Coverage Ratio

The debt coverage ratio is not often used by all investors, but I like to use it to gauge the cash flow that is generated to pay my mortgage on the property. It is calculated by taking the Net Annualized Cash Flow / Total Debt Service owed to the lender. A debt coverage ratio of less than 1% means that the buyer will not be able to pay the current mortgage without using their own funds (i.e. negative cash flow). A ratio greater than 1% means that the buyer can use cash flow from the investment property to pay the mortgage.

• Debt Coverage Ratio %: Net Annualized Cash Flow (no mortgage) / Annualized Mortgage Payment

• 1.59% (rounded): $470.33 * 12 months / $296.20 * 12 months

So what do I look for when analyzing rental properties?

Great question. As I mentioned previously, I am a buy and hold investor primarily focusing on single family homes in strong working class (blue collar) neighborhoods for positive cash flow. Note that this criteria is quite fluid and used as a basis to narrow down my search from a pool of 50+ properties at any given time. Note: these are my "rules of thumb" as of writing date, and can change any time.

• When Financing a property: Net monthly cash flow (after all expenses)> $200 per unit

  • Assumptions used: 5% closing costs, 8% vacancy reserves, 8% maintenance reserves

• Neighborhood Rating: B- or above (Note that each investor may rate neighborhood's differently). For example, some investors rate A/B/C based on ratio of owners/renters, crime stats, schools, other statistics and demographics.

• Property Type: Single Family 3 bedroom 1 bath (or more), ideally with a Garage in markets such as Kansas City, where there is heavy snow and hail. Note: Some markets (i.e. Memphis), it is common to have a carport instead of a garage. Further, 2 bedroom homes are more difficult to lease. 3 bedroom houses are most common, thereby increasing the tenant candidate pool.

• Size of home: Ideally 1,000 - 1650 sq ft. Not too large, nor too small. Note: I do this on purposes as the extra sq ft. of ~800 (ex: 2,400 sq ft. homes) do not necessarily correlate to the same ratio of increased rent. Also, replacing a roof/flooring on a 2,400 sq ft. home is significantly higher than a 1,200 sq. ft. home.

• Low Crime Areas

• No HOA fees. The HOA fees are unpredictable and can kill your projected cash flow.

• Cash on Cash: 12-15% or higher (Depends on market, type of property, location, etc.)

• Rehab including updates to CapEx items 5 years life or less (Water Heater, HVAC, etc.) 10 years life or less (roof). Note: The amount of rehab (after reviewing scope of work) may result in a lower or higher maintenance reserve from base of 8%.

• Rent to Value Ratio: At least 1% or higher, ideally 1.30% or higher

Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 006: Finding the Right Market

In my previous posts, I have discussed why I personally like to invest in real estate and talked about how to get educated before diving in. If you have decided that real estate investing may be right for your financial goals, next up would be finding the right market.

Before even zoning in on one market or another, there are key terms that you must understand: Cyclical and Linear type markets.

Cyclical markets are markets that have large fluctuations in housing prices during a bear and bull market. Its the high risk, high rewards market primarily found on the coastal regions: West (Seattle, Oregon, San Francisco, Los Angeles, San Diego) and East (New York, Boston, New Jersey). Investors in these markets will not likely target cash flow as rent to value ratios using the 1% test will be hard to find (ex: $500,000 home in Los Angeles will not rent for $5,000, it may rent for $2,500-3,000, which is a 0.5-0.6% rent to value ratio). Instead, investors in these markets will play the appreciation game, hoping for large gains in housing prices sometimes 15-30% greater than houses in the MidWest, or linear markets. 

Linear markets, on the other hand, are markets that do not typically see large fluctuations in housing during a housing boom, but do not significantly drop during the recession/correction like the Coastal Markets of California, San Francisco, and New York. These markets are primarily centered in the MidWest (Kansas City, Memphis, Texas, Alabama, Ohio, Indianapolis). Although they may not appreciate as much as cyclical markets, they will be able to have higher rent to value ratios and provide better cash on cash returns for an investor. 

There are many ways to analyze a market, but here are some of the criteria that I look for when researching a new market.

Location Location Location

You may have heard the "L" word more than once. I think this is true still to this day. There is a reason why companies such as Costco, Starbucks, and McDonalds spend hundreds of thousands of dollars analyzing data and the demographics of a neighborhood before opening a location. They know that good location is the key to success. Investors in neighborhoods have realized the "Starbucks effect" has fueled home appreciation in past years. Although it is impossible to guess if these specific areas will appreciate and develop better than other areas without these retailers, but you can make reasonable assumptions and mitigate risk. There are several factors that impact location: Population, Jobs, and Crime.

1. Population

There are many online resources for you to research data in a given market. I personally use www.neighborhoodscout.com, www.bestplaces.net and www.city-data.com to see trends in population growth and demographics (i.e. population by age, gender, marital and education status). Simply put, if a market is seeing negative population growth, it means people are moving out, and housing demand will drop, thereby resulting in lower rental rates and more vacancy. Furthermore, if there is a trend of an aging population or less families, it may also result in renters downsizing sq ft of their home and decreasing demand of standard 3-5 bedroom single family homes that may traditionally be rented to larger families.

2. Job Quantity and Economic Diversity

When looking at jobs in a given market, it is important to not only look at the number of jobs available, projected growth, but also economic diversity. Take a look at Detroit Michigan, for example, which heavily relied on success of the auto manufacturing industry that dominated the area. When those industries suffered and jobs were cut, housing demand and rental prices dropped more than other markets as people looked to move out to other states. States such as Kansas City, MO or Indianapolis, IN that had a well-balanced economy such as retail, manufacturing, transportation, healthcare, and education, suffered less dips in housing and rental prices. 

Do some research on the web to see if there are fortune 500 company presence in the market, are there contracts signed to open new fulfillment centers, new HQ by Amazon? In real estate, its not insider trading, its using information to make good judgment and decisions and capitalizing on trends and forecasts. More jobs also mean more people with steady income to pay rent and other bills.

3. Crime Stats

This is an obvious one, but something that investors may overlook when blinded by a "discounted" purchase price or home that they have fell in love with. Generally speaking, investors with properties in higher crime areas, may be starting off with higher returns on paper due to lower purchase price, and other factors, however, in the long run, you may end up with a lower quality tenant pool, more occurences of vandalism, and even loss of equity because home prices are negatively being affected. I personally use Trulia's crime heat map: https://www.trulia.com/real_estate/Los_Angeles-California/crime/ (Example of Los Angeles) and perform a detailed review of the property neighborhood and crime statistics, along with felons/sex offenders who may be present. This will also affect rent prices down the road.

Crime Stats are related to neighborhood class: A, B, C, but its also made up of other factors such as ratio of owners/renters and good school districts. With that being said, Crime stats should be carefully evaluated to make sure that you are not taking in too much undue risk.

4. County and City Taxes

Taxes are also an important part of your return on investment calculation. Depending on the region, there are different tax rates applied to your property. For example, there are regions in Memphis, TN that charge both a county and city tax: $685 and $550, and there are zip codes 10 minutes away that may only have county taxes $685. In this example, there is a huge difference of $550/year or $46/month per unit that can change a good investment into a homerun.

On the other hand, there are situations where your property may share the same street, but different zip codes that end up costing hundreds in additional taxes. For example, I was analyzing two rental properties in Kansas City and noticed the same company remodeled it, same age, number of rooms, sq ft, but one was $2K cheaper. Taking a deeper look, I realized that one had property taxes of $1,400 while the other had $450 because the county lines were drawn on the same street. Its important to factor in these information when calculating your pro-formas.

Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!