BRRR: A Cool Strategy for Hot Markets
Buy, Rehab, Rent, Refinance... It's an acronym that's been floating in real estate communities for over a decade, maybe more. I don't know who first came up with it, might be Brandon Turner since he'd base every webinar on it back when he still worked for BiggerPockets. Back in 2014 few people aside from him talked about it publicly but it is a strategy that's been used by experienced investors for ages.
Buy
The idea is to buy the property at a steep discount, usually by thoroughly researching the market you're buying in, identifying motivated sellers, and giving them lowball offers for their property until some of them agree to sell. Why would someone take a lowball offer, you may ask? Traditionally real estate isn't as liquid as other assets. The all-cash offers with waived contingencies we're seeing now aren't the norm, they're merely a side-effect of people wanting to put their money to use as they realize the Fed has been lying to them about inflation.
Traditionally, to sell a home on MLS, the seller would need to fix up all the deferred maintenance, make the home presentable, and host multiple open houses, where hundreds of strangers roam around his/her home for weeks. After which, the seller would need to agree to multiple contingencies (inspection, financing, etc.), wait 2-3 months for the buyer to secure financing, and share 6% of the sale commissions with the agents. And this is assuming he/she gets an offer quickly. Up until COVID-19, it would take 60+ days on average to get an offer.
Even now, lenders will often refuse to finance a distressed home. Conventional lenders require that you're able to move in within 60 days of closing, and most won't finance a home with structural issues, severe mold, damaged roof, issues with electric circuitry or plumbing. FHA and first-time homebuyer loans are even stricter. Just last week I visited a house in New Hampshire that was sold for $200k below ARV because of a leaky roof and severe mold damage, and that's in a hot market. That's a deep discount for an investor willing to pay cash and take on the risk of dealing with mold.
In general, in order to buy the property at a discount, one of the following has to be true:
- Something is wrong with the property
- Something is wrong with the location
- Seller needs to sell ASAP
1 and 3 are great (as long as you're well-equipped to solve that problem), 2 is usually not (see my earlier post on importance of location in real estate). You don't want to buy in a war zone just because it's cheap. With that said, one of the best ways to make money in real estate is to identify gentrification waves before others do (I heard there is an app for that). When you buy in a gentrifying area early on, others will often dismiss it as a bad area until it's too late, and FOMO in several years later.
Rehab
After you buy your discounted property, you probably want to rehab it (after all, the current property condition is probably the reason for the steep discount you got). You should already know your rehab cost before you buy (that's what inspections are for). If you don't factor in repairs correctly, your deal may turn out to be a money pit. A common rule of thumb among rehabbers (that admittedly no longer works in many markets post-COVID and never worked in hot markets even before) is that your purchase price AND rehab cost should at most be 70% of the ARV. That means if you plan to sell the house for $700k, your purchase price combined with repairs should not exceed $490k (good luck finding that in Boston).
This doesn't mean that BRRR doesn't work anymore, you just need to be more creative. Developers here will often buy triplexes and do a condo-conversion to meet the 70% rule that way. Others will buy a single-family home on a lot that's grandfathered in for a duplex, demolish the original structure and build 2 luxury townhomes each selling over $1 million (a popular strategy in Newton).
As old options cease to work, new opportunities arise. Multiple Boston suburbs have voted to allow denser housing. Most states have now allowed ADUs. That doesn't mean that you have to do new construction as your first real estate deal, but you should understand that if the area doesn't pencil in, there may be other ways to achieve value, including buying multi-family.
I should also note that to a buy-and-hold investor, the 70% rule is less relevant. As a landlord, you want to get your property rent-ready quickly and your cashflow to exceed your expenses. Getting the property at a steep discount is what allows you to buy your next rental sooner, but if searching for that discount results in you not buying your first property at all, that could be an even bigger setback.
Real estate is uniquely positioned to benefit from the power of compounding. A bad deal doesn't set you as far back as it first seems, especially in an inflationary environment. Sitting on the sidelines, however, does.
Rent
Rent is your revenue, without rent your property can quickly become a money pit since debt service is expensive. I highly recommend you play with the Napkin Analysis tool to understand income and expenses before you buy your first home. Here in Boston, the average triplex now costs over $1.2 million, resulting in $8000+ monthly mortgage payment. A vacant property can quickly wipe out your W-2 income. But don't rush to fill your property up at the expense of doing due diligence, the only thing worse than a vacancy is a bad tenant, especially in Boston where the lawmakers are oblivious to landlord rights. Remember what I said earlier about the 3 ways to get a discount on the property. Don't let a problem tenant turn you into a motivated seller.
Refinance
Ok, you got your property rehabbed and rented. Maybe you paid cash for it, maybe you got a bridge loan, maybe you bought it with a conventional mortgage. If you made significant improvements to the property, you probably want to refinance it. You obviously want to refinance out of a bridge loan (which typically has high interest rate and comes due after a year), but why refinance in the other 2 cases?
If you paid cash, that equity sitting in your property could instead be used to buy another one. It's the same concept I've explained in my earlier blog post, in real estate you build money with leverage. Even if you already have a conventional mortgage on the property, it's a good idea to refinance every few years in an appreciating market or after significant improvements to the property that bring the value up. Many people are reluctant to do so because they're married to their low interest rate, and while low rate is nothing to scoff at, sometimes the opportunity cost outweighs the benefit of low rate.
Let's say you're netting $2000/month on your triplex. If you can pull out $300k by increasing your monthly payment by $1500, you're still cashflow-positive on property 1, and can use $300k to acquire another $1 million property. As long as the new property cashflows more than $1500/month after expenses, you come out ahead.
The Snowball
The main benefit of the BRRR strategy is the snowball effect, which is why some people add another R at the end (which stands for Repeat). While the second property seems to add little value year 1, after year 5 the effect is compounded. You now have 2 properties generating income, 2 properties appreciating annually, and 2 properties where you can raise rents in response to inflation. After year 5, you can refinance your properties again, this time pulling money out from both of them to reinvest into an even larger property.
It's not hard to see how this growth becomes exponential, and is in fact how most real estate investors made their money. Real estate investing initially seems like a cumbersome and slow process, but the sooner you systematize it, the faster you will grow your wealth.