Private Lending and The BRRRR Strategy
The BRRRR method (the acronym for Buy, Rehab, Rent, Refinance, Repeat) is a residential investor’s approach to scaling up their portfolio. Investors with a long-term hold objective implement this strategy with private money loans for the acquisition, rehab, and rent phases.
When the renovation scope is completed and stable cash flow is achieved, the short-term rehab loan is then often refinanced with a long-term rental loan, namely DSCR (Debt Service Coverage Ratios) loans.
The focus of this article is the phases within the BRRRR strategy and the proper placement of a private money loan. As with any plan for investment in a residential product, there are points for consideration when using the BRRRR method.
Key Takeaways
- If properly applied and managed, the BRRRR method can place the investor in the optimal position for scale-up
- BRRRR is the acronym for Buy, Rehab, Rent, Refinance, and Repeat and is utilized by investors with the long-term hold objective
- Private lenders utilize two formulas: after-repair value (ARV) and the maximum allowable offer (MAO)
- The crux for a successful BRRRR approach is for the investor to reduce personal debt, find motivated sellers, and identify a private money lender
The BRRRR Strategy
The strategy is a rhythm that is repeated over and over once the investor is scaled up to support a continued deal flow. The rhythm is:
- Buy
- Rehab
- Rent
- Refinance, and
- Repeat
And timing is essential. The phases in the BRRRR method are concurrent, not consecutive. When a property is located for purchase, the rehab’s scope and cost (with a reasonable contingency) need to be calculated into the deal before a purchase price is offered. The sooner the property stabilizes, the sooner the investment will qualify for a long loan.
The equity generated by the value-add renovations can be cashed out at the refinance and used as capital for the next deal.
This strategy is the tried-and-true approach for many long-term investors in the residential market.
How the BRRRR Method Works
Before explaining each phase, let’s review the standard terms.
- ARV – after-repair value
- MAO – maximum allowable offer
- 75% Rule – MAO is 75% of the ARV
- Cost – actual price
- Value – perceived worth
- LTC – loan-to-cost ratio
- LTV – loan-to-value ratio
With the above in mind and knowing how a private lender will determine its MAO, the phases of the BRRRR strategy are explained below.
1-Buy
The approach is common to investing: buy low, create value, and secure recurring cash flow. For example, let’s say that a home can be purchased for $150,000.
The preliminary cost estimate, with contingencies, for the rehab, is $50,000. The $50,000 will create a value (or a perceived worth) of $100,000.
The difference between the cost and the created value is $50,000. This created value is additional equity.
When applying the ARV formula: purchase price + value add, the home’s after-repair value is $250,000.
- $150,000 + $100,000 = $250,000
It is important to note that the value created is not the cost of the rehab.
The next step for the private lender is to calculate the MAO. This is where the 75% rule is applied. The lender’s maximum loan amount is 75% of the ARV. In the above example, the MAO calculates to $187,500.
- $250,000 x 0.75 = $187,500
If the lender is willing to lend up to 90% of costs, the loan-to-cost ratio, then the maximum allowable offer calculates to $180,000.
- (cost of the home + cost of the rehab) x 0.9
- ($150,000 + $50,000) x 0.9 = $180,000
A private lender will offer the investor the lesser of these two calculations, or $180,000.
The above examples illustrate the investor’s need to have at least a preliminary budget number for the rehab scope. Unlike a conventional lender, a private lender will underwrite both scenarios to include the value-add and the rehab costs.
From the investor’s view, the only way to increase the returns on a deal is to negotiate a purchase price lower than what is listed. The cost of the rehab is fixed unless the scope changes. There is more opportunity to negotiate with a seller than with a contractor.
By knowing the costs of the rehab scope and the value-add component supported by the market, an investor can calculate the range of the offered price for the home. From the above formulas, the investor will know the required amount of equity and understand the loan amount offered.
An investor must begin the process with a trusted general contractor, a private lender right for the deal, and an understanding of the seller’s motivations.
2- Rehab
This phase also needs to take place before a contract is signed with a seller. This is the step where the return on investment (ROI) is calculated. An experienced investor knows that some rehab work will add more value than others. The rehab scope affects a return in two ways: it creates value and justifies the higher rent.
With any rehab project, an investor needs to ask:
- will the costs of the rehab project justify a higher rent? and
- will the rehab add enough value for the equity to convert to cash?
The answers to the above questions depend upon the market, the neighborhood, and the type of tenant for the property.
3- Rent
The tenant choice and the cash flow generation are just as important as negotiating the purchase price and setting the rehab scope. The process of screening potential tenants must run concurrent with the rehab.
For the investment to qualify for a DSCR loan, the value must be created, the property must be stabilized, and the amount of recurring rent must be at the desirable level the market can support. A lender would be reluctant to extend a loan on investment property where the risks of value-add and stabilization remain.
4- Refinance
This is the phase where time is of the essence. It is always in the investor’s best interest to achieve the project value and secure a quality tenant.
The longer the investor holds the property at the higher rate and carry costs under the private loan, the longer it will take to realize the accrued equity and to position the property for refinance.
The cash flow may not meet the debt coverage requirements (i.e. how much of rental income covers monthly expenses) of the lender. This will happen when the rent is subject to the higher debt service (i.e. the money required to pay the principal and interest) of the private lender over a longer time than projected.
The investor needs to run the numbers from acquisition to refinance to know the operating ratios of the property and when the property will qualify for a long-term loan. The terms of the loan structure offered by the private lender must be in the proforma.
The investor can only negotiate the best deal if the entire transaction is illustrated in a proforma, by month, from acquisition through refinance. The time periods are critical. Once the subject property becomes stabilized, it’s important to refinance the exiting higher interest loan into a 30-year long-term rental loan.
5- Repeat
When a long-term loan refinances the property, the investor can cash out the remaining equity, capitalizing on the newly created incremental value. This cash can be used as the down payment on another investment deal while the refinanced property continues to generate cash flow. Since the DSCR loan is more heavily dependent on the property and its ability to generate cash flow, the investor can continue to build up the investment portfolio without worrying about the debt-to-income ratio at all.
Points for Consideration under the BRRRR Strategy
The implementation of BRRRR will be different for every deal and investor. The assumptions made within the proforma will be predicated upon the market, neighborhood, and tenant type. The investor’s objectives and targets will depend on the tolerance for risk and financial strength.
The explanations of the BRRRR steps are general and will apply to any residential value-add investment. This holds true for the following points an investor must consider:
- Purchase the home at a low price with a motivated seller
- Create equity to access at the refinance, and
- Achieve the scenario where the property generates consistent monthly cash flow.
These are the positive points, but there is always the scenario of timelines not being met or the rehab scope changing as the work progresses. Some of these negative points can be:
- An aggressive proforma
- The misinterpretation of the market as to the value created or the rents generated
- A lower-than-expected appraisal, or
- A longer time to accrue the required equity.
Conclusion
An investor with a long-term hold objective has different considerations. Ultimately, the investor needs to qualify for a long-term DSCR loan before the merits of the investment are considered.
To this end, the investor will need a higher liquidity position, an excellent credit score, and a low income-to-debt ratio.
An investor must be prepared to walk from an acquisition opportunity if the seller will not accept an offer within the price range needed for the investment hurdle. The phase of the BRRRR strategy with the most negotiating power is the buy phase.
An investor will not meet the optimal time periods to achieve the value and cash flow projections if the purchase price is too high.
If properly and realistically implemented, the BRRRR strategy will prove lucrative over the long term. The investor will create and access equity for the next deal as the portfolio grows.
So, we covered building a real estate portfolio with private money today. We hope you enjoyed reading our content. For more, you’ll check our private lending blog, and see you in the next informative article.
