I have questions on how the BRRRR method works. refi/appraisal?

Question

Hello there real estate/investors. I'm looking to run my first BRRRR on a single family home soon. I have done a few flips and I'm looking to get the ball rolling in the rental game. What I'm mostly confused about is the refi portion. My main question is what happens when the appraisal comes back higher than what you have initally thought. Is that a good thing? I'll try to make it short and simple.

purchase price: 120k

down payment: $24k

loan amount: 96k

rehab cost: 30k

So I'm all in at 54k. I now go and find a tenant and then refi in 6-12months depending on the seasoning period. Next, I go to refinance the property and the appraisal comes back at ARV of 250k. They only lend up to 80%. So I'm apraised for 200k.

I pay back the initial loan of 96k then I get my down payment back and rehab total of 54k (24k down payment+rehab cost 30k).

Now I am into the single family rental property with no money in the investment. But my question is what about the additional 50k left that I made. Is that my money to keep and is it a good thing that the appraisal came back high and I made additional 50k ?

Dan H. · Answer

I have done the BRRRR quite a few times and I have yet to receive a refi appraisal that I believed to be true market value, it is always less. I think the odds of it coming back higher than you expected are small (real small in my market). In my market, I tell BRRRR RE investors to expect the refi appraisal to come in at least 5% below true market value.Now let's say somehow it does come in higher than planned. You take all that you are permitted if you are using a conventional loan. There are a few reasons: 1) There is no cheaper money than a conventional loan. At today's rates, with the government printing money to deal with the virus, it is as close to free money as there may ever be. The money you pay off the loan in 30 years will likely be work less than 1/360 (30 years) of the inflation adjusted dollars. This means that they are basically paying you to borrow the money. 2) It is similar to getting an advance on cash flow. Would you rather have an extra $5K today or an extra $5K spread over the next 5 years? The answer for those that understand money is you take the money now. 3) Any return is compounded with max leverage. If you have 95% LTV and the RE appreciates 5%, you have a 100% return. However, if the same RE has 90% LTV you have 50% return. I do want to warn about over leverage. This implies you do not take the extra money obtained in the refi and squander it unless you have reserves to handle a Great Recession event (which this virus may be a GR like event).Take the money now, but if you do not have sufficient reserves consider using it to build those reserves. I am a big fan of leverage, but I am also a big fan of having the necessary reserves to deal with anything that may come.Good luck

Alex Bekeza · Answer

@David Szaflarski A few things: 1. If you opt for a commercial/asset-based loan you could actually cash out much sooner if you have it renovated and leased quickly (90 days title seasoning). Rates are a bit higher of course but these offer the ability to scale (no limit on number of properties), don't have personal DTI requirements, allow LLC vesting if desired, etc etc. However, like most of the non government backed programs these are on pause temporarily until markets settle down from the virus. 2. The appraisal coming back higher than expected would be a great thing! You could either take the same loan amount you originally had in mind and keep some extra cash flow or cut into cash flow a bit and take the extra cash out. The bank doesn't force you into any particular LTV as long as it's at or below whatever their max is. (typically 75%). Hope this helps! Many developments to come in terms of lending options in the coming weeks and months here.

Thomas Zuck · Answer

I am looking to do my first deal as well, but the way I understand it, yes that is absolutely a good thing! You can take all that cash (that you created) out of the deal provided you a.) have it leased so that the house will still cash flow with the new mortgage PITI, and b.) feel comfortable with that amount of leverage on the property. Just because it appraises that high, doesn't mean you have to take all that cash out of the property, but it is trapped equity at that point.I struggle with this as I am trying to figure out what I want for my first deal as well. Part of me says yeah get 3,4, 10 deals like this done, and then start paying off debts, but the inexperienced part of me is nervous and would rather keep my debt low and own my properties outright. Curious to see what the pros say...

Todd Rasmussen · Answer

Just elaborating on Alex's first point; before you go to commercial or asset based loans, there are ways to avoid seasoning. Also, traditional non conforming loans are typically fairly inexpensive as well.

Todd Rasmussen · Answer

@David SzaflarskiAlso consider cash flow. "Making 50k" comes with higher loan payments and BRRRR's tend to be tight on cash flow and it gets worse by pulling out more than you put in.

David Szaflarski · Answer

@Thomas Zuck Ok I see what your saying. What my main question here is what would be better to just get the initial investment back while still cash flowing or take the additional profit from the high appraisal while still cash flowing and keep repeating to next properties?

Todd Rasmussen · Answer

What expense % are you using to calculate cashflow? And it's just a trade off. If you have enough of a margin, you should pull more out and reinvest it. The trap is that newer buy and hold investors sometimes calculate cash flow as scheduled income less PITI and end up in the red as soon as anything happens.

Thomas Zuck · Answer

@David Szaflarski it is trapped equity in that you will only realize it when you sell the property, or leverage the equity. Trapped equity is not necessarily a bad thing. In my personal home, I have about 300k in trapped equity, it adds to my net worth, but I wont realize the equity until I sell the house. using the numbers from your example:250k appraised value200k mortgage50k equity trapped in the house until you sell, or leverage it. Not a bad thing.If you were to only leverage 150k into your mortgage, you'd have all your money out of the deal, and have 100k in equity.

David Szaflarski · Answer

@Thomas Zuck what do you mean as in its trapped equity ?

David Szaflarski · Answer

@Todd Rasmussen I understand that loans will tend to be slightly higher but what if I'm also cashflowing $800 monthly?