Investors experienced with the buy-and-hold strategy know how to achieve financial independence, long-term appreciation, and equity. This article is directed at the fix-and-flip investor looking to explore the benefits of a long-term hold to diversify their portfolios.
Fix-and-flip investors are well on their way toward the buy-and-hold strategy. Instead of selling the home after the renovation scope, the acquisition loan is refinanced by a long-term permanent loan. This is how the investor is recapitalized while enjoying the cash flows generated from an occupying tenant.
Key Takeaways
- The buy-and-hold strategy will enable an investor to diversify its portfolio with various residential asset classes.
- The average hold period if five years for the investor to recoup the acquisition and loan fees, build wealth through the recurring cash flows, and accumulate equity and appreciation.
- A property in an area with a price-to-rent ratio of at least 16% and an appreciation rate of at least 5% will prove the best opportunity for the buy-and-hold strategy.
- An investor must analyze available financing programs for short- and long-term loans for value-add opportunities under the buy-and-hold strategy.
Defined Terms
Above-the-Line Expenses – the operating expenses applied against the gross rent to calculate the net operating income.
Appreciation – the increase in a property’s value by market conditions without more cash investment by the owner.
Commercial Buildings – buildings housing businesses and multi-family structures housing five or more single-family units.
Equity – the difference between a property’s market value and the outstanding balance due on a mortgage.
Multi-Family Residential Buildings – structures that house up to four single-family units.
Price-to-Rent Ratio – the median home price divided by the median annual rent in an area; a ratio of 16% or greater is a good market condition for renters.
The Buy-and-Hold Strategy Explained
Let’s be clear—the strategy is for these long-term investments to eventually sell. The hold period under this strategy is at least five years for the investor to recoup the closing costs associated with the refinance and to take better advantage of the appreciation, cash flows, and accumulated equity.
Over time, an investor can further diversify their portfolio with different residential asset classes.
The asset classes in a diversified portfolio can include:
- Single-family detached homes,
- Turnkey rentals,
- Vacation rentals,
- Multi-family buildings of not more than four units, and
- Commercial buildings
These asset classes are described below.
Single-Family Detached Homes
The acquisition of these homes is somewhat the same strategy as under the fix-and-flip model. Under the buy-and-hold strategy, the house is marketed to a long-term tenant instead of positioning the property for sale. The marketing can be handled by the same Realtor representing the investor at the acquisition or by the property management company offering tenant location and screening services.
When the tenant is in place, and the property stabilizes, the short-term, high-interest acquisition loan can be refinanced with long-term permanent money.
Turnkey Rental
“Turnkey” means the residence is ready for occupancy without the value-add component. These properties are move-in ready at the time of the acquisition and often with a tenant in place. These properties are not defined as distressed equity sales, and the renovation scope can be omitted from the strategy.
The purchase is financed with long-term permanent money under the traditional acquisition method.
Vacation Rentals
In the context of this article, this asset class can be a single-family home (attached or detached) or a condominium. The properties can be acquired in distressed sales, but this product type is usually a turnkey rental.
The management style of vacation rentals is different than a rental to one long-term tenant. The management is cumbersome as short-term tenants move through the property.
For tax purposes, investors need to be aware of the definition of a vacation rental. As of this writing, an investor can use the property throughout a year for up to 14 days, or for less than 10% of the time the property is made available for rent to third parties.
Should the investor/owner use the property for more days than allowed by the IRS, then, the property is defined as a second home. This means the investment property is not used for business purposes, and the investor cannot take advantage of the deductions for operations, mortgage interest, and depreciation.
Multi-Family Buildings (Duplexes, Triplexes, and Quads)
A multi-family building will remain under the definition of “residential” if the building houses no more than four units. Each unit can have a separate acquisition strategy: a value-add opportunity or a turnkey rental. A separate lease will be in place for each unit, and each unit can have a different owner.
The management aspects of a multi-family building will be cumbersome as tenants move in and out throughout the year.
Depending on the available loan programs and the ownership of the units, the building can be financed under one loan, or each unit can be separately financed. If an investor owns the entire building, the loan programs must be carefully analyzed. Typically, the rates will be lower, the will loan-to-value ratio will be higher, and the closing costs will be lower relative to the loan amount if the building is financed under one loan.
Although the purchase price and the costs will be higher than a single-family detached residence, the cash flow often will not drop to $0. Of course, the cash flow will be less when a tenant vacates, but the property will continue to generate income from the remaining leases.
Commercial Buildings
This product class includes buildings leased to businesses and multi-family buildings with five or more units. These investments are, of course, more expensive relative to the cash outlay and operating costs. The maintenance issues are frequent, the leases are more complex, and the management is a layered plan.
Although commercial buildings can be lucrative in cash flow, these investment properties are not recommended for the novice investor.
The Benefits of a Long-Term Hold Strategy
Investors with the buy-and-hold strategy must have a property management company on their team. Although some investors prefer to self-manage to save on operating expenses, economies of scale prove beneficial when the portfolio contains more than three rental properties.
The value of the investor’s time must be taken into account. Another important consideration is whether the property manager’s services can cross over product classes. Each product class will have a different management scope and pricing levels for leasing and maintenance services.
However, when the property manager is identified and in place, the investor can spend their time productively managing their portfolio as a whole.
In addition to recurring cash flows, the benefits an investor will enjoy are the following:
- Tax deductions,
- Equity, and
- Appreciation
These benefits are explained below.
Tax Deductions
All operating expenses can be used to reduce the rent. These expenses include maintenance, utility charges the owner paid, insurance, mileage, and property taxes. For income tax purposes only, mortgage interest and depreciation are above-the-line expenses. These expenses will further reduce the investor’s taxable income generated from the property.
Equity
Equity in a property is accumulated as mortgage payments are made. With each payment, the interest portion decreases, and the investor’s equity increases. A property is considered “stable” when the rent generated from the leases covers the operating expenses and the mortgage payments.
Equity can convert to cash when the property is sold or refinanced.
Appreciation
Market conditions drive appreciation. Appreciation will increase rapidly over a short time in a seller’s market when the demand is high, and the inventory for sale is low. However, fluctuations in market conditions are not at the forefront of an investor’s concern when the property is held long-term. When the investor is ready to sell or refinance, the market and the economic conditions are then considered with more weight.
Appreciation can also be converted to cash when the property is sold or refinanced. However, unlike equity, appreciation is organic and not predicated upon any added money invested into the property.
The Steps in a Buy-and-Hold Strategy
The investor must research the market, neighborhood, or area identified in their business plan. In addition to the area’s job growth, labor base, and population, the rental market must also be investigated. If a property is in a location with a price-to-rent ratio over 16% and the market appreciation rate above 5%, then opportunities will be a good fit for the buy-and-hold investor.
Identify the Property
The product class of the property will depend upon the area. The market conditions in the previous paragraph will work for both a value-add and a turnkey opportunity. However, the area will dictate whether the product class will be a single-family home, a multi-family building, or a vacation rental.
Turnkey properties are rarely found in areas with population growth and a strong job market. While these properties are move-in ready or stabilized with a tenant in place, these opportunities will have a higher price point with little room to negotiate with a seller.
An important question: How does a turnkey opportunity fit the business plan and cash position?
Remove all Emotions from a Deal
As with any investment, the analysis and due diligence cannot be based on emotion. A buy-and-
hold strategy is a business decision and the numbers must work at the front end.
An investor should not look to a long-term hold to correct an overpayment in the wrong area. Remember, the property and the investor must qualify for the permanent loan, where the criteria for approval are more stringent than with a short-term hard money loan.
The Financing Options
The properties with a value-add opportunity and a long-term hold must analyze two financing options. The first is with a private lender to lend on the acquisition and renovation. The second option is the refinance of the short-term loan with long-term permanent money.
For an opportunity to be thoroughly investigated, the investor must obtain term sheets for both options. An investor must remember that the loan programs promoted by traditional lenders target owner-occupied homes and not investment properties. Traditional lenders will not lend on value-add opportunities.
Amplend can accommodate investors for the acquisition and renovation scope with a short-term loan and a long-term loan at the refinance. A debt service coverage ratio (DSCR) loan is competitive with the loan programs offered by traditional lenders to investors.
The Realtor
The Realtor on the investment team should be able to help locate an opportunity for the investor to acquire and be able to locate and qualify a tenant. Sometimes, a full-service property management company offers tenant location services. Either way, these services are needed for the investment team.
The property management company must have experience and the in-house infrastructure to manage the asset class properly. The investor may have more leverage to negotiate the management fees when the company earns a commission on the lease and manages more than three properties for the investor.
Conclusion
The buy-and-hold strategy will add layers to the process at the front and back ends. To complete a proforma, there will need to be assumptions made for the short-term and the long-term loans to accurately calculate the net operating income, the cash flows, and the value at the time of the refinance. The proforma must be carried through to the tenant occupancy to calculate the debt coverage ratio for the permanent loan.
The services of the Realtor must be thought through, and a property management company must be added to the investment team.
The buy-and-hold strategy will diversify a portfolio by the timings of the cash flows, the sales of the properties, and the wealth creation by the accumulated equity and appreciation.
The business plan and the investor’s analysis methods will change and may prove more cumbersome, but the benefit of financial independence will be worth it.
