Is BRRRR a risky strategy for first time buyers?

Question

Hello BP Family!

After listening to multiple podcasts and reading books it seems like the BRRRR method is well received and makes so much sense because it allows your money to go further.

My question is it tougher to do a BRRRR deal than a normal conventional 20% down loan.

I know there are more moving parts to a BRRRR but I am familiar and comfortable with the refinancing process. I guess the part that makes me nervous is the all cash buy and then moving on to paying all the renovations in cash too and hoping you did your homework right to get the right ARV.

Am I overthinking this?

My last purchase was three years ago. Being stagnant has killed my productivity and I feel like I have never bought an investment property at all!

Russell Brazil · Answer

The risk involved with BRRRR is often understated by those that advocate it.  There is nothing wrong with risk, but you should deploy capital based on your risk tolerance.  There are several risk factors that should be considered when using this strategy.

You are essentially starting with a property to flip..but instead of having an end buyer, you are in essence the buyer.  So the risk factor here is starting with the normal risk factors of flipping.

You have the location, asset class, tenant base risks involved with being a landlord.

You have the risk of leverage. Highly leveraged properties, cash out refinances carry risk.  I sell a lot of properties for landlords that have used their properties as piggy banks over the years, then we go to sell, and their owed taxes end up being more than they would walk away with. Capital gains and deprecation need to be considered.

Its a great strategy, and one thats been around a lot longer before it was attached the title of BRRRR and made popular here. But the risks need to be considered, which here they often are not.

Russell Brazil · Answer

@Mitchell Litam correct it is not taxable when you do the cash out refi.  But that money is in essence taxable later to some degree when you sell, because that money is part of your gain...and that is what Im referencing.  Investors sell these houses years later, and have these huge capital gains, and depreciation recapture....but they actually spent that capital gain money years earlier when they did the cash out refinance.  So they sell the house, and owe more in taxes than they actually get from the sale of the house.

If you are going to 1031 the money, it's less of an issue, because you are kicking the tax down the road.  But let's say you want to sell the house for another reason...you want to pay for your kids college, or buy a new house yourself, or any reason.  But oops, you owe $50k in taxes, but the net proceeds from the sale are only $25k.  You actually have to come out of pocket to sell the house.  That's what I run into several times a year when Im working with a potential seller...but they never took the tax consequences into mind since they were not considering depreciation recapture....or the fact that their actual gain is not the net sales proceeds, but rather the delta between the purchase price and sales prices (or really the difference between the cost basis of each)

Russell Brazil · Answer

@Alexander Felice Everyone's a genius in a bull market.

@Mitchell Litam and risk isnt bad.  You have to have risk to get a potential return.  My observations though, and I said this on the podcast, is people have a real blindness to being able to properly analyze risk.  There is this new wave of investors taking on high risk projects, but because they lack a fundamental education in investing and finance, they have convinced themselves that the activities they are partaking in are lower risk strategies.

It's the same across all types of investment classes. Im investing in huge growth stock, Chipotle, or Amazon, or Netflix....now Ive convinced myself because those returns are higher, that they are lower risk than a boring old Aflac or Microsoft.  But that doesnt change the inherrent risk that growth stocks are riskier than blue chips.  For every Chipotle, there is a Pets.com,

I often say that Market Knowledge is the greatest mitigator of risk in real estate.  But it is also a double edged sword.  Our Market Knowledge, also often blinds us to the inherent risk in the strategies we are good at, and warps our perception of risk in strategies we are less familiar with.

Alexander Felice · Answer

@Russell Brazil is very right. People have an easy time investing, and then think investing is easy. It's called the 'turkey problem'. The turkey thinks the farmer is safe because every day for his whole life the farmer feeds him. He build zero defense, zero suspicion, and plans for no risk because he has felt none......then thanksgiving rolls around......human nature makes it hard to consider long term risks, especially when we don't experience it first hand.

We are in an up market where everyone is winning and real estate is easy. This will provide people will false confidence. Leverage is risk to the downside and the more you get, the more risk.

@Mitchell Litam best way to measure and mitigate risk? put your underwriting on paper and stress test it. Then let someone else look at it who will be conservative because everyone fudges numbers in their favor. It will cost more than you think, rehab will go slower than you expect, vacancy will cost you more sleep than you plan for, etc. I don't know of any books really, I went to work at a bank so I could learn U/W ;)

I'm not trying to be negative by any means, sounds like you're in good shape to move forward. I just like to rain on people's parades (it's my nature). Also, real estate is super easy on paper and much harder to actually live with, and that's hard to build into your analysis.

Frank Wong · Answer

Hi Mitchell,

If you do a BRRRR deal it will require more work because you have to rehab most of the home.  To answer your question, yes it will be tougher in the fact that its a lot more work.

Buying with a 20% down conventional will allow you to leverage and use the remaining cash you have to do any upgrades like paint, flooring, countertop etc.  The deals you can buy with a lot of upsides will be limited.  Why?  If you can buy with a conventional loan that means other buyers can too.  More competition = worse of a price you can get it at.

If you pay cash.  You will be able to get houses that finance buyers can't.  These deals usually require much more work but the upside is way higher.  Your money will be tied up into the house though because you have to pay cash and pay the rehab.  Once complete you can cash out refinance and get a portion of your capital back.  If for some reason you can't. Well, you have your self a nice little investment that cash flows really good.

If you have the cash and don't mind it tied up into the property.  This would be the preferred strategy I would do.

Brian Ploszay · Answer

For a young investor, the BRRRR strategy has some appeal.  Real estate is capital intensive.  Most of us don't have the capital lying around that it takes for down payments for multiple investment properties.  So either you raise / borrow / partner / save / inherit.   BRRRR is another way.

Be careful that you are not creating a portfolio of financial assets that consists of over leveraged properties.  This can be a house of cards in a real estate downturn.  Make sure your assets can create value over time and you'll be fine.  Assets that cash flow, can be paid down or appreciate.  These types of deals are increasingly hard to find.

@Russell Brazil has a good point, but applies more for seasoned long term owners.  Be careful of sucking all the equity out in a refinance, because the tax obligation becomes a major stakeholder in the property.

Michael T. · Answer

@Mitchell Litam yes the BRRRR method is the best way to make your money work for you, however, it does come with more work and risk.

You're buying a property that will most likely require work to get a higher ARV and be able to pull all of your money out of the deal.

Similar to many things life the more work required the more reward typically gained.

It's okay to do a few BRRRR's and then a few conventional.  You don't have to over leverage yourself if it doesn't make sense.

Mitchell Litam · Answer

@Alex D. glad you thought so. I hope you can use it and make lots of money!

Alex D. · Answer

This was a very good conversation and very informative.

Mitchell Litam · Answer

@Russell Brazil I bought my first investment property with a business partner and have since did a cash out refi to buy him out. Does that basically screw me when I go to sell the house? Who would be the best person to consult? Is that my real estate agent or my tax accountant?

For 1031 There is no amount of times you can do that right? You can basically just 1031 until you die and the tax just goes away and doesn't pass on to your relatives or whoever inherits the properties?

Is BRRRR a risky strategy for first time buyers?

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