Residential Real Estate by definition is real estate where people live. An investment in residential real estate can take many forms from single family homes, townhouses, and condominiums. Before we start with what a residential real estate investment is, let’s talk about what a residential real estate investment is not.
What a Residential Real Estate Investment is Not…
The thing that new real estate investors and sometimes even seasoned real estate investors must know is that a piece of residential real estate where you and your family live is not an investment. It is an asset on your balance sheet. It can appreciate, but waiting for property appreciation does not make your primary residence an investment. Residential housing that you live in is an operating cost. You have to be able to service the mortgage, real estate taxes, home owner association bills, utilities, and any and all repairs and maintenance. As such, residential housing that you live in in actually an operating expense rather than a property that generates a return. The only real counter to this argument is if you are renting out rooms in your primary residence, which could offset a number of the property expenses. Barring that example, an investment should generate income or it should be able to generate income in a short amount of time. Housing that you and your family live in rarely fits that description.
Fix-and Flip – A “Tweener” Residential Real Estate Investment
We all know the stories of successful fix-and-flip investors. They are not sasquatches…they exist. I’ve personally known many such investors. Candidly, I have never successfully pulled off this strategy. I have bought a few properties with the intent to do a quick fix-and-flip. However, circumstances changed after I purchased the property and completed the renovations. In every instance, I calculated that my overall return on investment (ROI) and internal rate of return (IRR) would be better by holding for cash flow for a number of years and then selling for a larger profit. The operative word in my analysis is cash flow. In my residential real estate investments, I knew that I could make a return from cash flow while holding. And I knew that my purchase price plus renovations also left me with upside potential on my equity invested, which provided me with two exit strategies.
My problem with many fix-and-flip strategies is that they are solely based on market demand. The strategy requires that buyer demand remain strong and that prices continue to rise. The model can work for a long-time, but when markets go flat or decline somewhat, there is a risk that the flipper loses significant amounts of money.
To illustrate the point, I will provide two side-by-side comparisons:
For Rent Model For Sale Model
|Total Cost||$175,000||Total Cost||$175,000|
|Rent||$1,200 per month||Sales Price||$225,000|
|Expenses||$400 per month||Sales Costs (6%)||$13,500|
|NOI ($1,200×12 – $400×12)||$9,600||Proft (Sales Price – Sales Cost – Total Cost)||$36,500|
|Annual Cash-on-Cash (NOI / Total Cost)||5.49%||Return on Investment (ROI) (Profit / Total Cost)||20.85%|
This is not an actual example, but I have looked at a number of deals that look similar to this. This example assumes that no leverage is used. Getting leverage with a reasonable interest rate could easily enhance the returns achieved from both cash-on-cash and return on invest standpoints, but it would also reduce the total cash returns to the investor. My return requirements are higher than what is provided in the For Rent Model, but it is right on the margin where I may consider the deal if I see other opportunities to enhance cash flow. My business has never been the fix-and-flip model although I know many flippers who would do the for sale model because if they could complete the acquisition, renovations, and sale within 3 months, they could theoretically redeploy their capital 4 times in one year, which in theory would enable them to yield 83.43% (20.85% x 4 quarters) on their money if they could replicate the same results. It would take the same investor who invested for cash flow 15.2 years (83.43%/5.49%) to obtain the same return if they were to buy, renovate, and hold. Granted, they could still have appreciation over that time, but it becomes clear why many flippers keep flipping. The two big issue with flipping in my opinion are (1) you have to assume that the market continues increasing while continuing to find good deals and (2) the market flippers are selling to are emotional buyers. The reason for that is that most buyers will be individuals and families looking to buy a house to live in for themselves. The fix-and-flip model requires strong underlying fundamentals (employment growth, job growth, low crime, good population growth, good schools, etc.) and a pool of willing and able buyers.
My personal issue with flipping is that it starts to feel more like gambling than investing as you need to continually ride the market up. As a flipper, you have to buy at market and hope that market moves up by the time you are ready to sell.
Residential Real Estate Buy, Hold, and Rent
When acquiring a property for rental yield with the intent to build a portfolio of real estate properties, that model has recently been dubbed by the acronym “BRRRR” because you would Buy, Rehab, Rent, Refinance, and Repeat in this investment model. The model is quite simple, however, it can require patience, as it can sometimes take years before you can successfully do the tax-free, cash out refinance that is required for the repeat portion of the model. This model does not have to be long-term, but it requires a mindset that is more long-term.
The process begins similarly to the fix-and-flip model. You look to acquire properties in market that are of interest to you where you believe there is profit potential. Everyone should come up with their own investment thesis. I personally like B-class assets in B-class neighborhoods. Generally, these properties should cost a bit less than buying an A-class assets even in the same neighborhood. Some of my colleagues like A-class assets because they believe those assets are more resilient in a downturn and are usually better located, so would be the last properties affected by a downturn and the first to come out of a downturn. Other colleagues believe that C-class assets are the best investments because even if people are affected negatively by an economic downturn, there are no shortage of qualified people that could rent the property.
We are at the end of 2019, and we have seen a long expansionary period. While many pundits believe that we have further economic expansion in front of us for at least a couple years, it is wise to start thinking about downturns in your analysis. As the market continues to stay steady or improve, rents should also stay steady or improve. However, towards the end of a cycle, you may see rents plateau while prices continue moving higher. This can last for awhile, but should a correction come, prices could then plateau or drop. Since you are using the BRRRR model, you do not necessarily care about short-term price declines. You do care about cash flow, so my advice is to be steady in your analysis. Continuing to buy through a cycle is not a bad investment plan so long as you are honest with yourself about the cash flow potential. Continue to do your analysis using in-place rents, but you may want to consider looking at both the worst-case scenario and the best-case scenario. What happens in a downturn? Do rents drop, and if so, what is the worst-case percentage drop you feel could occur for your investment market (e.g. 5%, 10%)? Do expenses stay flat or do they increase? On the positive side, assuming the economy continues growing, what is the best-case scenario for rent growth? It is good to look at past rent growth, but we have been in a rent expansion period for so long that I always force myself to temper rent growth in my analysis. I would rather be pleasantly surprised than negatively surprised.
I am a believer that it is possible to buy in all cycles. I, however, am not a believer in buying foolishly or buying just to buy. You must stick to your principles. You must stick to your investment thesis. In my experience, it just gets harder to buy at the top of a cycle and it also gets harder to buy during the early stages of a downturn. The trick is to stick to your rules and find properties that you are happy owning during all cycles.
Once you acquire a property, the level of rehab depends heavily on your comfort level and team. I have bought properties for good prices that needed not much more than a good cleaning and I have bought a property that was about to be condemned because a section of the roof had been so devastated by rain that it was creating a mold issue inside the house and was no longer habitable. I have bought a whole range in between.
When you do your initial analysis, accurately consider your costs to rehab and what the return on that rehab will be. For example, if you buy a house for $150,000 and the market rent is $1,200 assuming $400 per month in expenses, you would net $800 per month or $9,600 per year, which is equivalent to an unlevered cash yield of 6.40%. If you spend $25,000 in rehab costs and can get a $200 per month rent increase, your return on the rehab is equal to 9.6% [($200 x 12)/$25,000]. You must come up with your own metrics as to what is acceptable for you on a rehab. I like to see a 25-30% return on the rehab, however, I admit that those numbers have been decreasing over the last couple years to somewhere between 15% and 25%. After rehab, your return would increase in total, but only slightly due to the incremental increase. The math is as follows:
Rent ($1,200 + $200) $1,400 $16,800
Expenses $400 $4,800
NOI $1,000 $12,000
With your new cost of $175,000, your new cash yield would be 6.86%. It is up to you whether the extra time and cost would be worth the rehab. I would seriously consider the rehab in that case because it adds to your total return. You could also look at getting the house for a lower price. It may also be interesting to see if you could get the same rental increase with less work. If you could get that monthly rental increase, but only spend $5,000 or $10,000, the math quickly changes. Again, do the analysis and then determine various courses of action that you could take…after the analysis, make your decision and continue moving forward.
Once you complete any rehab work, it is now time to rent your property to a tenant. You can either rent it yourself or through an agent. If you decide to rent it yourself, make sure that you have the proper legal documents and disclosures for your State. Also, make sure that you have a leasing policy so that prospective tenants are treated the same. The leasing policy covers the Income to Rent ratio that is acceptable (2.5x to 3.0x is common), the lowest acceptable credit score (i.e. above 500), whether you allow people who have evictions in their history, and depending on your State law, whether you allow people with felonies into the apartment. And make sure that you do not judge tenants by race, color, creed, religion, gender, or sexual orientation. I am not a licensed attorney, so please contact your counsel for legal advice. If you judge everyone by the same criteria and do not discriminate, you should shield yourself from lots of the issues that landlords describe as their tenant “horror” stories.
One beneficial aspect of the US tax code is that you can refinance a property and take equity out on a tax free basis assuming you meet the criteria to do so. I am not a licensed tax professional, so please contact your tax professional prior to engaging in this strategy. Assuming the market value of your property has increased after acquiring and rehabbing it, and assuming a lender allows you to take out a larger loan, you should seriously consider doing a refinance. Not only will the refinance put cash in your pocket, but it also gives you the ability to undertake the final step in the BRRRR model, which is to repeat.
This strategy is one that I have employed numerous times. It allows you to “snowball” your unit count especially as the market increases. One thing that I always ensure is that the cash flow is still sufficient to cover all expenses and mortgage costs. You should do the same. Debt is a wonderful too, however, you want to be able to cover your expenses and mortgage expenses should the market suffer a downturn. I always look to a Debt Service Coverage Ratio (“DSCR”) of at least 1.20x. In the example above with the $1,400 monthly rent and $400 monthly expenses, the annual NOI is $12,000. If I want a 1.20x DSCR, then I would divide $12,000 by 1.20. This math shows that my annual debt service should be no more than $10,000 and my monthly mortgage should be no more than $833. If I assume a 3.75% interest rate on a 30-year amortization, the property can support a loan of $179,940. That is an 80% loan-to-value on the original purchase. This strategy has allowed you to take out all the cash you invested in the property including rehab costs plus an additional $5,000. You still have a cash flowing asset and you can now go undertake a similar project to increase your portfolio size. BRRRR…I just got chills…what a strategy!
After receiving you money at the closing table from the refinance, you can re-invest that cash in another deal. By doing this while also continuing to be disciplined in your investment approach, you have the opportunity to not only increase your portfolio size, but you also have the opportunity to increase your cash flow and net worth.
This real estate investment game is a marathon. It really is not a sprint. By staying disciplined, by reinvesting, and by looking for opportunities where you can grow as an investor and/or quickly move to acquire a mispriced opportunity, you will be able to improve your lifestyle over time. It is worth repeating, it takes time to build cash flow and wealth, but it can be done. Candidly, it took me 10 years of investing to get to the place where I was comfortable with my cash flow. I am still investing because I still see good deals, I enjoy investing, and I want to do even better for my family over a longer time horizon. I am 42 years old as of this writing, which means I have over 50 years to continue my investing. I am a money magnet and I bring together like minded people in investments.
Using the BRRRR model is a conservative approach to investing. It takes time, but if you can buy right, rehab to the level needed for the market, rent the property, refinance the asset, and then repeat the cycle, then you are well on your way to increasing your cash flow and your net worth.
Good luck and until next time, happy investing!