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Risks of the BRRRR Strategy
It’s all the rage, and for good reason. I remember doing my first BRRRR strategy in 2004. I purchased a home in Arvada, Colorado with hard money to fix and flip. You would not believe it; the flip was a flop and I ended up with a problem. I was going over budget and was forced to scale back on my rehab. Like way back. I no longer had the confidence in the sale price and decided I would just keep that one as a rental. It was a nice big house in a desirable area, and I had a rent to own tenant in no time. Now to the problem. That darn hard money loan. Luckily, this was back when you could still state your income and since I had good credit, I was approved. I kept that house for over 10 years!
Little did I know at the time, but I just fell into the BRRRR strategy. I Bought a property, I Rehabbed it, I Rented it, I Refinanced it, and then I Repeated the process. I purchased that home with no money down and received option money and positive cash flow. The BRRRR term was yet to be coined, but I knew I was on to something.
The entire Pine Financial team talks about this strategy for a few reasons. First, we can help with the loan to get it done, but it also works extremely well. This is one of the best strategies when trying to purchase property with little or no down payment. Want more information about this strategy? I wrote a FREE report here. (See Below)
Although this is one of my favorite buying strategies, it does not come risk free. Here are three risks when using the BRRRR strategy:
- Different Opinion of Value: Outside of all the typical risks of owning rentals, the BRRRR risks all come down to your ability to refinance the private money or hard money loan. The easiest way to get tripped up on that is if your refinance appraisal comes in low. In my world we get an appraisal on the front of it with the appraiser’s opinion of what the property is worth after repairs. Also known as the ARV or after repaired value. The key word in here is – opinion. It is very possible that another appraiser will have a different opinion. This is even more likely if you are only doing minor repairs. It can be very difficult for an appraiser to understand a huge increase in value in a short period of time. Major repairs help with this. Although you are only rehabbing to rent, you still want to show that you did improve the property to justify the value.
The good news about the appraisal when you refinance is that you need to let the appraiser into the house. This means you can meet him or her at the property. I would strongly recommend you do that and bring with you, the appraisal done for your hard money loan, the lists of repairs made, any updated comps that support your value. With these documents, we have seen fantastic results, but you must understand this is always a risk. If the appraisal comes in low, you may need to cover the difference out of pocket, or worst case, sell.
The Initial Loan is Done Incorrectly: I have not seen this, but our preferred take out lenders have all told me this is common. If you are dealing with someone who does not understand this strategy, they could screw up the initial loan making it tough for you to refinance them. Some common mistakes are:
- How it is titled – The best loan right now for your refinance is a Fannie Mae loan. They have fantastic 30-year fixed rates and no title seasoning. Title seasoning just means, how long you must be on title or own the house before you can refinance it. Many banks or lenders have title seasoning guidelines. Fannie Mae does not. What they do have, however, is a guideline to not loan to an entity. This means they want you to own the house personally. It could be possible to quit claim deed the house from your entity into your personal name, but the loan process is much smoother if you buy in your personal name. After your loan is in place, it might be a good idea to quit claim the property into your entity at that point.
- Draws – I have heard of some lenders not holding back construction money. When a lender does this, you will get the full amount of the loan at closing. If the lender loaned money for repairs but did not list that correctly at closing, it will appear that you received cash back and the refinance lender will not make the loan. These are rate and term refinance loans, meaning they will only refinance debt that was used to purchase the property. If they pay off a loan that was used to put cash in your pocket, it is considered a cash out refinance and you will not qualify.
- Lien – This sounds simple, but the lien that the lender places on the title is a huge deal. The biggest issue is that they do in fact place a lien. This needs to show up in the title search and be disclosed on the closing disclosure, making it clear your refinance loan is being used to pay off purchase money debt. The lien also needs to match the amount of the payoff statement, and it is best to not modify that loan or increase it in any way after you buy the house. Any of these could create a problem separating a rate and term refinance from a cash out refinance.
Tight DTI: In 2004 I had a DTI issue. Debt to income. I was making money, but a lot of that money was not showing up on my taxes. These might be nonrefundable deposits that would be reported at a later date, money from the Army paying some of my expenses while in college or amortizing or depreciating assets. I also had a few roommates helping with my bills. If you looked at my tax returns and mortgage payments, I would not qualify for the loan. It was only because stated income loans were allowed that I qualified. Since we no longer have stated loans, we need to be extra careful here.
For Pine Financial, we require our client be pre-approved for the refinance before we loan them money IF they plan to refinance. That is not a requirement for flippers, but we want to help our clients succeed, so we pay attention to this small detail. After you are approved it would be a great idea to stress test that. What if rent is $100 less per month than you project? What about $200?
I hope I did not scare you. The point is not that, it is to keep you safe. If you have not experienced the BRRRR strategy, it is hard to understand the power behind it. If I were to give advice, it would be to explore this, but to also understand the risks going in. As a hard money lender, we have been involved in several hundred of these specific transactions and are happy to help guide you if you need a little hand-holding.
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