What do you value more, return of capital or realized gain?

[Stuart Udis]

Evidently Bigger Pockets has given me the distinction of being one of the top recent BRRRR contributors which I find ironic as I am generally posting about flawed logic many BRRRR investors use in vetting investment opportunities. Nevertheless, I thought it would be an opportune time to share some thoughts on the subject. I am by no means opposed to the strategy. Afterall, if you are able to develop a property where your basis is no greater than 70-75% of the ARV, that's wonderful. However, as I become more immersed in Bigger Pockets I've concluded whether the invested cash can be returned is the most important factor in how most underwrite their investments. Let me use the following single family case study to illustrate:

As is the case in most markets, the "C" or "D" tier neighborhoods tend to have the better cash flow on a single family home. Therefore, in this current high interest rate environment, it will be easier to meet the 1.2-1.25 DSCR lenders seek and thus refinance properties at the 75% most require in order to complete a successful BRRRR. Meanwhile, in many "A" or "B" neighborhoods within these same markets, the cash flow is not as strong. Side note: you can make the argument this is not the case if viewed from a multi-year viewpoint when considering higher vacancy, disproportionately higher expenses etc. within the lower tier SF space, but I will leave this alone for now because that's not how lenders will customarily approach debt coverage ratio.

Now let's assume an all-in basis of 75% LTV in a "C" or "D" neighborhood and be able to complete a BRRRR thanks to the cash flows impact on the 1.2-1.25 DSCR (depending on the lender's parameters), but may have an all in lower basis of 70% on a "A" or "B" home where there is a greater barrier of entry and other positive attributes but fail to complete a BRRRR because the cash flow does not allow you to meet the 1.2-1.25 DSCR. This leads to lower leverage of let's say 65% for the purpose of this case study.

I’ve found most in these forums would view the “C” neighborhood investment as being the more successful investment merely because the invested capital can be returned. However, let’s fast forward a year if you choose to sell both assets. As is customarily the case, the lower tier neighborhood single family appraisals tend not to be indicative of actual performance on the sale without appreciation while the single family home in the “A” or “B” neighborhood is more likely to do so. It’s not unreasonable to expect the “C” home to only sell for 90% of the appraisal value because let’s face it, another investor is the most likely natural buyer for this home and will not want to pay retail unlike the “A” or “B” neighborhood where the buyer is more likely be a homeowner.

In the case study I shared, once you factor in closing costs, the realized gain on the successful BRRRR yields very little gain whereas the better situated home that fails the BRRRR test performs quite well. Based on flawed logic, many are turning over their cash with great velocity buying up a bunch of lower tier homes as they are able to complete the BRRRR method, but stand to make much less realized gain relative to the investor who is buying less property (possibly investing less of their time as well) because only some of their deployed cash is returned on a refinance but is generating better realization events when sales occur due to the better assets within their portfolio. Which investor would you rather be?