Risks of the BRRRR strategy
It’s trendy, and for good reason. I remember my first BRRRR strategy in 2004. I bought a house in Arvada, Colorado with hard money to fix up and flip. You wouldn’t believe it; the flip was a flop and i ended up with a problem. I was running over budget and had to cut back on my rehab. As way back. I no longer had confidence in the sale price and decided to keep that price 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 damn hard money loan. Fortunately, this was when he was still able to report his 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 for the BRRRR strategy. I bought a property, rehabbed it, rented it, refinanced it, and then repeated the process. I bought that house with no down payment and received the option money and positive cash flow. The term BRRRR hadn’t been coined yet, but he knew he was right.
The entire Pine Financial team talks about this strategy for several reasons. First, we can help with the loan to do it, but it also works very well. This is one of the best strategies when it comes to buying a property with little or no down payment. Do you want more information about this strategy? I wrote a FREE report here. (See below)
Although this is one of my favorite buying strategies, it is not without risk. 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 come down to your ability to refinance private money or hard money lending. The easiest way to go wrong is if your refinance appraisal is low. In my world, we get an appraisal on the front with the appraiser’s opinion of the value of the property after repairs. Also known as ARV or after repaired value. The key word here is – opinion. It is quite 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 large increase in value in a short period of time. Major repairs help with this. Even though you’re just rehabbing to rent, you still want to show that you improved the property to justify the value.
The good news about 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 highly recommend that you do that and bring with you the appraisal done for your hard money loan, the lists of repairs done, any updated compensation that supports its value. With these documents, we have seen fantastic results, but you must understand that this is always a risk. If the appraisal is low, you may have to cover the difference out of pocket or, worst case scenario, sell.
- The initial loan is made incorrectly: I have not seen this, but our preferred lenders have told me that this is common. If you’re dealing with someone who doesn’t understand this strategy, it could ruin your initial loan and make it difficult for you to refinance. Some common errors are:
- How it’s titled: The best loan right now for your refinance is a Fannie Mae loan. They have fantastic 30 year fixed rates and no title experience. Title preparation just means how long you have to hold the title or own the home before you can refinance. Many banks or lenders have title preparation guidelines. Fannie Mae No. What they do have, however, is a guideline for not lending to an entity. This means that they want you to own the house personally. It may be possible to stop claiming the deed to the house from your entity in your personal name, but the loan process is much easier if you buy in your personal name. After your loan is current, it might be a good idea to stop claiming the property with your entity at that time.
- Withdrawals: I’ve heard of some lenders not keeping construction money. When a lender does this, he will get the full amount of the loan at closing. If the lender loaned money for the repairs but did not list it correctly at closing, it will appear that you received a cash refund and the refinancing lender will not make the loan. These are rate and term refinance loans, meaning they will only refinance the debt that was used to purchase the property. If you repay a loan that was used to put cash in your pocket, it’s considered a cash-out refinance and you won’t qualify.
- Link: It sounds simple, but the link that the lender places on the title is a big deal. The biggest problem is that they actually put a link. This should appear on the title search and be disclosed in the closing disclosure, making it clear that your refinance loan is being used to pay off the purchase money debt. The lien must also match the amount on the payment statement, and it’s best not to modify that loan or increase it in any way after you buy the home. 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 problem. Debt to income. I was making money, but much of that money was not showing up on my taxes. These could be non-refundable deposits to be reported at a later date, money from the military to pay for some of my expenses while I was in college, or to write off or depreciate assets. I also had some roommates who helped me with my bills. If I looked at my tax returns and mortgage payments, I wouldn’t qualify for the loan. It was only because declared income loans were allowed that I qualified. Since we no longer have declared loans, we have to be very careful here.
For Pine Financial, we require our client to be pre-approved for refinancing before lending them money IF they plan to refinance. That’s not a requirement for pinball machines, but we want to help our customers succeed, so we pay attention to this little detail. After it is approved, it would be a great idea to do a stress test. What if the rent is $100 less per month than you project? How about $200?
I hope I did not scare you. The point is not that, it is to keep you safe. If you haven’t experienced the BRRRR strategy, it’s hard to understand the power behind it. If I had to give one piece of advice, it would be to explore this, but also understand the risks involved. 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 help.