RIO 121 | Single Family Rentals

 

When done correctly, the BRRRR strategy can be a very profitable approach to investing in single-family rentals. You have to be very careful of some messy details, though, as Paul David Thompson illustrates in this case study. Paul gives us an example of a real-life investor who fell short of her expectations because of some lapses in implementing the strategy. He explains how some of these shortcomings can be prevented and teaches us how to use the BRRRR strategy to make the most out of our deals. This is the first of Paul’s new episode format called “Deal Diaries” where he will go over a few different case studies of real people and real deals in real situations and take lessons from them. Listen, learn, and stay tuned for more episodes!

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121. The BRRRR Strategy In Single Family Rentals

Deal Diary Case Study #1

I’m going to be doing a little experiment with a new episode format. I call them Deal Diaries. I’m going over a few different case studies of real people, no names included, but real deals in real situations and share with you what I do when meeting with clients, evaluating deals on my own, and talking to investors who asked to pick my brain. That happens quite a bit, “Paul, I need some help.” I enjoy doing so because it gives me an opportunity to sharpen the ax, make sure that I’m still on point and relevant in the marketplace. Fundamentally, I am a deal junkie. I love to evaluate investor’s situations and give advice on how I’d approach a problem. I’m going to do a series of three different scenarios and walk you through my process when talking to investors. I’ll be doing a single-family rental example. The next series will be a multifamily example. The deal that I do will be a note, deal diary. Let’s roll our sleeves up and talk about the single-family rental example.

First up, an investor who is relatively a beginner. This is her first real estate investment. She’s doing a single-family rental and she called me up asking about the BRRRR strategy. She bought a three-bedroom, two-bath house in my town from Auction.com for $86,000 and this is in a class B-plus, A-minus area. It’s a good house and a good neighborhood overall. It seems like a good opportunity. The rehab ended up costing her $30,000, which was a little bit over her budget. She thought it would take four weeks to do the rehab and it ended up taking seven weeks. It’s not a big surprise that the rehab went over budget and took longer than expected. I can relate. Haven’t we all been there before? She calls me up, asking about the nuances of the BRRRR strategy and keep in mind. This is after she bought the property.

The BRRRR Strategy

I wasn’t involved before the acquisition. I can’t help her with the frontend acquisition or evaluating a deal before she buys it. In this case, she’d already bought it. I wanted to help her figure out what her situation is. She’s already done a lot of research and study about the BRRRR strategy and that’s what she wanted to understand. She certainly had a lot of book knowledge about the subject, but she didn’t have any real-life experience. If you aren’t already familiar with the BRRRR strategy, it stands for Buy, Rehab, Rent, Refi and Repeat. You buy a distressed property, then you rehab it, fix it up, rent it to a long-term tenant and then you refinance it into conventional long-term debt. That’s backed by Fannie or Freddie on the secondary market with 30-year terms and a low-interest rate.

[bctt tweet=”Appraisals are not something you can negotiate or ask for discounts on. It’s one of the costs of borrowing cheap money from banks.” via=”no”]

As many of you know, this is a great strategy. The BRRRR strategy works at such a scale with the use of the opportunity to gain access to financing. You can read episode 21, where I discuss this strategy in great detail. I’ve referred to it as, “Buy and Refi, Eight Steps to Retirement.” In this episode, I’m using the BRRRR strategy as an example while doing a deal diary. If you want to know the details of the BRRRR strategy from my perspective, episode 21 is out there for you. You can watch a YouTube video on the topic for more details on that technique. The great benefit of the BRRRR strategy, if done perfectly, is you leave little or even zero money in the deal after the refinance. This was the intent of the investor that called me, but her rehab went a little more than she expected. It went several thousands of dollars more than she expected.

The ARV may not be high enough for her to do this deal and get all of her money back out. She didn’t share with me how she bought the property. If it was a loan or all her cash or from a HELOC, I’m not sure. She did say that her rehab was funded by her cash. Let’s assume for the sake of argument that she has an $86,000 HELOC on this property. If it’s borrowed money, then she’ll want to refi it out sooner or later to keep from paying that higher interest rate. As of our conversation, she had already spoken to her mortgage broker and the appraiser was scheduled to go out to do the appraisal. Here were her questions and maybe some common questions that you may have during the BRRRR strategy, especially if you’re on the newer side of doing things.

On Refinancing And Appraisals

She asked, “Can I tell the bank what I want the property to appraise for? How does the bank determine the property’s value? Does the bank send out an inspector to inspect the property themselves? What does the bank do to qualify the refinance?” To answer that, it depends on the bank, but regardless, they are going to do some underwriting whether they do it internally, send inspectors or rely on the appraisal. It depends on the individual bank, but no exceptions I can think of whether it is a bank that would not do a serious some degree of underwriting. They’re going to check and see if this is a good bank or a good loan for them to lend on. Most banks will require a formal appraiser from a third-party appraiser. The appraiser is selected by the bank and not by you, but you pay the appraiser. You’re responsible for the fee to pay the appraisal and it’s oftentimes rolled into your bank loan. That fee can cost somewhere between $600 to even as high as $1,000.

RIO 121 | Single Family Rentals

Single Family Rentals: The great benefit of the BRRRR strategy if done perfectly is that you leave very little or even zero money in the deal after the refinance.

 

Appraisals are not a small fee. This is usually not something you can negotiate or ask for discounts on. It is the rate that the appraisers charge. The bank will make you get an appraisal and the bank has a selection process of appraisers. You get whoever that they select. In most cases, you get who they select. It’s the cost of borrowing cheap money from banks. Banks do not send their inspector to walk through the property, especially when we’re talking about a refinance on a 30-year fixed note that’s backed by Fannie and Freddie. They’re relying on the appraisal for that. The report from the appraiser includes the property condition when evaluating. However, I have had local commercial bank officers drive by properties that I was asking to get a refi and I’ve even had them request to see inside the property before they would give me a loan. That’s not common, but I have run into that, so be aware.

I’m familiar with this area. I did a personal comp on it using a tool that I use called MyREIPro. It’s a subscription service that I have and does a variety of things. One of the functions that I like is it’s good at running comps. You could use Zillow in public data and be able to determine a comp yourself for properties that you run and I’ve talked about that in several episodes. I liked the way that this particular tool works. It makes it easy and fast for me. In this case, when I ran the comps, this property is worth about $130,000. She was hoping it was going to be worth $165,000. After looking around at the neighborhood and previous sales prices, I couldn’t find any evidence that was a viable sales price. It was overinflated. I don’t see where she’d be able to get that appraisal. I told her, “You can tell the bank and even the appraiser what you’re hoping to get within reason. A lot of appraisers will look for evidence to back up what you’re looking for.” In this case, I don’t see any way that $165,000 was going to be possible for this investor.

When it comes to appraisers, they all have their own personalities and temperaments and I’ve had some appraisers who want to discuss value at all. They would refuse to discuss value with me in any way until the report was complete. All they would do is talk about the logistics of gaining access to the property and then they would do their report. While I’ve had others who straight out asked me and, in this case, “What are you looking for in this property?” I say, “I’m looking for about this number.” They’ll say, “I’ll see what we can do. That might work.” What they’re doing when they say, “I’ll see what I can do,” are they know what their target is. They’re going to look for relevant comps nearby that could potentially back that up. With enough sales, they could potentially cherry-pick the highest values to help provide 3 to 4 good, reasonable, appropriate comps to back up the value that you’re looking for. They don’t have to. That is not our obligation from them to do that.

[bctt tweet=”Be very confident in your ARV on the front end when buying properties.” via=”no”]

An appraiser could find the three nearest houses of similar size sold within the last six months and completely ignore a fourth comp that is 0.1 miles further away and say, “These other three comps are closer and therefore a more relevant comp.” Quite a lot depends on the appraiser and you don’t get to pick and select in most cases, especially when you’re doing these Fannie and Freddie back loans, which is often what people are doing with the BRRRR strategy. I have had commercial bankers ask me, “Do you have an appraiser that you’d like to use?” I said, “As a matter of fact, I do.” A lot of this depends on which bank you’re using and which loan product that is being used. The last thing about appraisers and appraisals is you can dispute an appraisal if you get an appraisal back and the report isn’t what you think it should be. You can dispute it.

Always request to get the report for future use and see if that particular appraisal report is working for you. If it comes back and you think they missed a more relevant comp, you can point out what you think the more relevant comp is and ask them to relook at the appraisal and show them the evidence of why this one’s better. Your mileage will vary on that. Some will take it. Some won’t. It depends on the appraiser and how much they believe in your data. There’s a nearby property that’s the same configuration and it’s been completely rehabbed the same finishes that I have. One of the comps that you used was a property that is still has paneling and Formica on it and was sold to an investor as a rental. That’s the reason that has a lower value. That data can be compelling to an appraiser because it may be further away, but it may be a more relevant comp because of the finish inside.

Let’s get back to the actual deal here. Let’s assume this property comes back at $130,000 value from the appraiser. This investor has $86,000 acquisition into it, plus $30,000 of rehab. She’s all-in for $116,000 for a property that is now worth $130,000 per the appraiser, which isn’t necessarily a bad thing. It’s not a smoking hot deal, but she’s not losing money here. She has $14,000 of equity. It appraised for $130,000 and she’s into it for $116,000, could be worse. The property would rent for between $1,012. It’s a nice fresh rehab and we’ll give her the credit of saying that it will pull $1,100 to do our numbers here. After that, her goal and intent of owning the property are to own a long-term rental. She’s not getting what she was hoping for here because she wanted to pull all of her invested capital back out and do this again.

RIO 121 | Single Family Rentals

Single Family Rentals: You can definitely dispute an appraisal if you think the report isn’t what you think it should be.

 

In this case, we’re assuming she has an $86,000 HELOC and uses $30,000 of cash to do the rehab. She wants to pull the $86,000 and all of her $30,000 back out and we agree it’s worth $130,000. That’s what I got from pulling the comps and that’s what an appraiser is probably going to appraise it for if it’s a fair appraisal. It’s going to be within a few $1,000. We’re going to say it’s worth $130,000 for our use case. There are no other comps that would suggest that would bring the value up. What are her options? She’s in a bit of a pickle. She’s not in a place where she’s going to get the results that she was hoping for. Let’s do the numbers and figure out what our options are. Eighty percent of the appraised value of $130,000 is $104,000 and there is about $4,000 in transaction costs from the bank for the refi.

Let’s say that she can pull out around $100,000 out. She can easily pay back the $86,000 HELOC and she’s left with $14,000 of cash returned to her that she can put her back pocket. As a result, she’s into this property for $16,000. Let’s run the numbers and see what her cash on cash return is factoring in her 30-year mortgage of $104,000. Let’s say at 5% interest, which is probably a little high in the market, but I like to run my numbers a bit high to give her the benefit of the doubt. She’ll still yield $102 a month in free cashflow. I did a mortgage calculator both based on those terms and her payments would be $558 and less the income of $1,100 she would net $102 per month. What I’m doing there is I’m taking $102 times 12 to get her annual income of $1,224 and then I’m dividing that into her invested capital of $16,000. That would yield her a 7.6% return on her money.

Cash-on-cash alone can be somewhat deceiving. For example, if you put $1 into an investment and then you earned $2 back, you bought a property for a $100,000 and you borrowed $99,999 and you put $1 into it, and after all was said and done that year, you earned $2 back then you earned a 200% return on your money. You borrowed $99,999 to get a $2 return. Not a good strategy, but the cash on cash return alone looks like you got a 200% return on your money. I also like to look at the underlying performance of the house completely separate from financing. In this case, she bought the house for $116,000 and we reasonably expected to earn $1,100 a month in rent. Take the $1,100 times 0.6%, which I’m assuming that there’s 40% of expenses built into every month’s rent times 12. That gives you $7,920 of operating income per year, completely ignoring financing.

[bctt tweet=”Rehab costs will almost always exceed your estimates. Always factor in some buffer zone when estimating.” via=”no”]

That’s what you call the net operating income. You divide that into the amount of capital it took to acquire and fix up the property to get the rent to be $1,100 a month. That turns out to be about a 6.8% cap rate. That’s what the property operates if you bought it in all cash. I always like to start looking at the cap rate of a property when looking at the merits of a deal and the viability of an investment. If I bought this all in cash, would it be a good deal? This one, it’s so-so with financing. She can improve her return to about 7.6% with leveraged. On leverage, it’s at 6.8%. It’s an okay deal. Not a huge improvement, but she got a little bit from using leverage, another percentage point almost of extra return. You can also remember here that she’s buying it below market value. It’s worth $130,000 and she’s effectively buying it for $116,000. She has $14,000 of equity immediately because she was into it for only $116,000 but it’s worth $130,000. Plus, this property is in a good neighborhood.

Once you factor in the benefits of depreciation and the potential for rent to go up over time, this is not a bad investment. It’s not a home run. It’s not the home run she was looking for because investors who do this want to be able to pull money all their money back out. I know people who buy properties using the BRRRR strategy straight up, 20% down and 80% financing. They’ll do this deal all day. They’ll do it at a scale of twenty plus deals a year because this is good enough for them. It’s not a bad thing to do at all to invest $16,000 in this deal. Think about it, would you invest $16,000 to get a 6% or 7% return on your money and increase your net worth by $14,000? Effectively, what she’s done here is she put in $16,000. She’s going to be getting 6% or 7% return on that money plus some overtime, I suspect. As soon as she does it, she gets $14,000 in equity for that asset.

Case Study Takeaways

Not to mention the 6% to 7% income that she’s getting from the property would be effectively shielded by and tax-deferred for twenty years plus because of depreciation. If you think about it that way, you can see why people who have access to capital and don’t have a lot of time, this would be a good enough deal. The point of the BRRRR strategy is to repeat because if you are stranding capital in deals, you might as well put the 20% down and not worry about all of us. If you end up doing many deals like this one, you’ll end up trapping this money at this capital as equity in these deals. You’ll run out of available funds to do more deals. Ideally, you want to get all of your money back so you can recycle your capital and scale up and buy dozens of properties if you wish. What are the lessons learned in this scenario going forward?

RIO 121 | Single Family Rentals

Single Family Rentals: The point of the BRRRR strategy is to repeat because if you are stranding capital in deals, you’ll end up trapping your capital as equity and then you’ll run out of available funds to do more deals.

 

Number one, be confident in your ARV on the frontend when buying properties, the investor thought it might be worth $165,000 I’m not sure where she got that number from. The best I can tell is she was off by her values. I would suggest always get a realtor to do a CMA for you, a Comparative Market Analysis, or better yet, a BPO, which is usually a paid service of somewhere between $100 and $120. Could a broker’s price opinion factor in the condition of the property and with the rehab be? Ultimately, you could even hire an appraiser to do an appraisal for you to spend $600 to $1,000 to be confident that you’re already buying the property at a value that makes sense for you.

Second, getting a more detailed rehab estimate on the frontend. Probably the most common issue with investors is underestimating the rehab cost. I’ve done it a number of times myself. I always add 20% to whatever number that it is because I know there are always surprises and then I always double or even triple the timeline that it could be done. It’s going to take longer and cost more than you think and almost every case until you get to be extremely seasoned, you need to factor in some buffer zone for yourself as a newbie. Third, be confident in the rent rate. Property managers are the best resource to getting a good solid opinion of what a property can rent for, especially if you’re in a market you’re not real familiar with or in a neighborhood that you’re not already familiar with.

If you have rents nearby or properties nearby and you know what their rent for and you can tell yourself, but until then a property manager is the best place because that’s what they do all day. They rent the property. They know what the going rate is for a given property. Four, know how you’re going to refi on the backend and in this case, this investor knew this and had it squared away. She just was unfamiliar with the process. Having a mortgage broker in your pocket that knows exactly what you’re doing is extremely helpful. You’re not surprised at the end of the process and then not able to refi at all. You want to line up your mortgage broker and explain to them what you’re doing and make sure they have their heads around the situation. Lastly, have cash reserves. That’s ultimately what is going to save this investor. She’s going to be fine because she has cash reserves. What if this investor had borrowed the entire $116,000 and didn’t have any cash to fall back on? She’d be up a creek without a paddle.

[bctt tweet=”When you’re going to real estate investing, having cash and capital reserves for deals is imperative.” via=”no”]

Fortunately, this is not the case for this particular investor. She simply has stranded capital of about $16,000 after the refi and she’s not in desperation mode trying to raise an extra $16,000 to pay off the first loan. That would have been for $116,000 when she miscalculated and is only going to get a $100,000 back from the refi. I can’t stress that enough. When you’re going to real estate investing, having cash and capital reserves for these deals is imperative because you can get upside down quickly with these rehabs and you get in over your head if you’re trying to thread the needle too narrowly. You need a margin of error because there’s a lot of factors at play that you don’t always have control over and having those capital reserves or access to capital reserves to break glass in case of emergency, it’s going to help how you prepare yourself.

These are the discussions that I like to have what I’m coining the Deal Diaries. This is what we have in the mastermind group. We do it in quite a bit more detail with real deals using actual paperwork and we roll our sleeves up and figure things out. We do this with real investors. I’m also starting a community membership group where I’ll be hosting live Q&A’s. I’ll be doing deal case studies like this where we break down deals, develop business strategy and roll up our sleeves to create a specific action plan for the community members so they can grow their portfolio and improve their business.

If that is of interest to you, you can learn more about that by texting the word INVESTOR to 33777. If you’ve already done that in your on the investor list, look out for a questionnaire that I’ll be sending to you. I’m going to be asking the community some questions about the membership. I’m going to be asking you what your opinion is on this idea that I have. What do you think would be the most helpful? I’m looking to crowdsource advice. Get your advice on what would be most helpful for you. Until then, thank you for sharing this time with me as you lead a life completely of your design and connect to those who are closest to you.

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