If you have been around BiggerPockets for any length of time, then you have most likely heard of the BRRRR method of investing (Buy, Rehab, Rent, Refinance, Repeat) that Brandon Turner conceptualized so well.
I would like to state up front that this article in no way is meant to be disrespectful toward Brandon. I respect him a ton. However…
When it’s coming up on 2020 and you’re still rocking the real estate investing equivalent of the VCR (for the millennial generation, that is a machine that would play movies on large tapes), it’s time for an upgrade. And this is your upgrade!
The BRRRR method of real estate investing was fantastic for its time. It was the epitome of investing with little to none of your own money, yet still quickly and efficiently growing a real estate portfolio.
So with such a great investing method, why change it or add to it? Simply because of man’s desire to create greater things… and this is the greater thing.
What Is BRRRLO?
The BRRRLO model uses the best of what the BRRRR method has to offer, then it cuts out the worst parts and adds on even better parts. Let me explain.
The “Buy, Rehab, Refinance, and Repeat” portions are fine. Let’s keep those. But the “Rent” part is lame!
Renting brings with it renters. And renters can be very lame! (I say can be rather than certainly are because some people who read this are renters. Maybe they are sensitive, and it will hurt their feelings to say it the other way.)
Renters tend to come with renter mentality, which can sound like, “Oops, did I do that? I wonder if the landlord will notice. I hope not.” Or, “Mr. Landlord, I need you to call a plumber. Little Timmy got ahold of the baby wipes again and flushed the whole packet of them down the toilet this time. Now poop is coming up all the drains in the house.”
With the “It’s your house. Come fix it.” mentality, it can get pretty old being a landlord.
“But I don’t manage my own properties,” you say? That’s fine. But someone’s getting the calls, and someone’s getting the bills. And guess who that person is who’s getting the bills?
That’s right, you guessed it. In one way or another, the actions of renters can take cash out of the investor’s pockets.
How BRRRLO Differs From BRRRR
What if there was a way to stop renters from damming up our streams of cash flow? Well, there is. The answer is to stop renting to renters, and start renting to buyers.
In general, buyers tend to have a different mentality than renters. Buyers tend to want to keep their things nice because it’s theirs. Whereas, renters look at things as not theirs and therefore are less attached to your things and less sad when your things break.
How do you rent to buyers rather than renting to renters?
LO = Lease Option
This is where the LO of the BRRRLO model comes in. LO stands for Lease Option, baby! That’s right: lease with an option to buy.
Lease options involve two separate contracts for two different purposes: the lease contract obviously explains the lease, while the separate option contract gives the tenant buyer an option to eventually buy the property.
Some people say that there is a third contract, which is the purchase contract. OK, fine. There is a purchase contract that eventually comes into play at the end.
How Is the Lease Structured?
So, how does this type of lease differ from a standard lease agreement? It is different in a few ways.
For one, this lease is usually at a price above market rents. In fact, it is quite a bit above market rent, because we charge a premium and we give discounts.
How does that work?
Well, we usually charge about $200 more than market rents on the lease agreement. This is because people who really want to own their own home but are unable to qualify for a bank loan are willing to pay a premium to get into a house they can someday own—one that the landlord isn’t going to sell out from under them.
We go over the lease agreement with the potential tenant. If they see the amount and think it seems too high, then we go to section 15 of the lease, which outlines the volunteer nuisance repair clause option. This states that the tenant may perform landlord duties, such as specified repairs, maintenance tasks, alterations, and remodeling. By taking care of those minor repairs, the tenants can receive a $100 rent credit for the month.
However, the rent credit is only available to them if they are abiding by the lease agreement and paying the rent on time. Paying late takes that rent credit away and adds additional late charges. Needless to say, most of our tenants pay on time.
Wait, what if there is something majorly wrong with the property?
Let’s say that there is a major problem with the roof or the plumbing. If the property has been rehabbed and a major problem is found within the option period, then we usually just come in and fix it. We would have fixed it in the first place if we had known about it. But because we didn’t live in the property and weren’t aware of the major flaw, we just take care of it as soon as we find out about it.
But this is usually only for major issues, such as flooring, plumbing, roofing, and electrical. Most minor things are taken care of by the tenants.
Another difference in the lease agreement is the length of time. Our leases usually go for a much longer timeframe than the average lease. These leases are written for three, four, or five years (whatever timeframe the option is written for).
How Is the Option Structured?
What about the option agreement? How is that written?
The option agreement gives the tenant the option to purchase the property within a certain time period for a certain price, as long as they are occupying the property. In the option agreement, the tenant buyer agrees to pay the closing costs. These are mostly just title transfer fees, since there are no Realtor commission fees.
What about a down payment or monthly credits? The option fee is not a down payment. It is simply a one-time fee that is collected up front that gives the optionor the right to buy the house for a specified price within a specified period of time. It is non-refundable, and does not in any way goes toward the purchase price.
What about monthly credits toward the paydown of the property? There are no monthly credits toward the paydown of the property.
With an option fee that doesn’t go toward a down payment to buy the property and no monthly credits toward the purchase, why would anyone want to do a lease option like this?
Well, I’ll tell you why. The type of person who would like to do an option like this would most likely be someone who is tired of moving around, they want to set down roots, and the only thing that is holding them back is that they cannot get a bank loan to purchase a property right now.
Instead of watching the market go up while they are repairing their credit, a tenant buyer can get into a house that they can customize for themselves sooner rather than later. They can lock in that price now (even though it might be a price that is higher than current market value), rather than wait and chance that the market may be much higher later on when they are finally ready to buy.
BRRRLO vs. BRRRR by the Numbers
What do the numbers look like for a BRRRLO? Are they really better than a BRRRR property? I’m glad you asked.
Here are the numbers for a BRRRLO property in Arizona compared to the traditional BRRRR method.
|Address||905 Main St.||905 Main St.|
|BRRRLO Numbers||BRRRR Numbers|
|Closing Costs, Carrying Costs, Hard Money||$6,000||$6,000|
|Months From Purchase to Leased||5||5|
|Bank Loan at 70%||$87,500||$87,500|
|Appraisal, Doc Fee, and Closing Fees||$2,000||$2,000|
|Our Portion Before Option Fee||$5,500||$5,500|
|1st Month’s Rent||$1,025||$925|
|Total Left in the Property (Original Investment)||$575||$4,575|
|Long-Term Loan Payment (5% for 20 Years)||-$575||-$575|
|Repairs, CapEx, Turnover, Vacancy||$0||-$92.5|
|Agreed Upon Sales Price||$135,000||$0|
|Market Value (If Increased 3%/Year for 3 Years)||$136,591||$136,591|
|Month to Exercise the Option||36||36|
|Total Outstanding on Loan||$79,250||$79,250|
|Net Profit Upon Sale After 3 Years||$54,400||$0|
|Total Cash Flow Throughout 3 Years||$12,600||$2,340|
|Total Profit After 3 Years Minus Original Investment||$66,425||-$2,235|
|Average ROI Each Year or IRR Over 3 Years||2310.43%||-9.77%|
|Total Equity Left in the Property||$0||$57,340.88|
As you can see, after three years, the total collected in cash flow from the BRRRLO model was $12,600, while the BRRRR method created $2,340 in cash flow in the same time span. The higher cash flow numbers helps with the debt-to-income ratio, which ultimately helps get more loans for more properties.
Although the tenant buyer can exercise it at any time, all the math in this example is done as if they exercised it the last month of the option period. So, let’s just say that happened.
Now, you have $54,400 from the sale of the house. You can either take that $54,400 and pay the 15 percent long-term capital gains tax, which would leave you with $46,240, or you could 1031 exchange the whole $54,400 from the sale into a new property or a couple of new properties. It’s your choice.
Then, let’s say you repeat the same process over the next three-year period, but this time you were able to do it with three houses from the proceeds of the first house. This allows you to triple your returns. And because you are able to get the majority of your money out of the deal, you now have about 4 times the amount or roughly $216K. This is after six years of doing four deals compared to $79,590 equity build-up in the first deal from the principal paydown and supposing the same 3 percent per year of appreciation.
But here is the main problem with the long-term hold strategy: Things start to wear out and break. Now the 10 percent held for maintenance, CapEx, turnover, and vacancy isn’t enough to cover a lot of the repairs. In fact, just one turnover could take up your total cash flow from one year to get the property up and running again.
Also, if you are planning on selling it in the future, the property (or at least parts of it) will probably need to be rehabbed again to get it ready to be sold.
What If the Tenant Backs Out of the Purchase Option?
But what if the tenant decides not to exercise the option to purchase the property? What then?
Well, to be honest, you then get the best of both worlds.
Let’s say the tenant is fully intending to purchase the property. They have been repairing their credit or getting closer to those coveted two years of self-employment tax returns they’ll need to qualify for the loan. Then out of the blue, they get a call about a new job opportunity in a different state that is exactly what they were hoping for. Or they get a call informing them that their mother is ill and needs help being taken care of. Whatever the circumstance, they need to walk away from the property instead of exercising the option.
In that case, the tenant doesn’t have to worry about getting the house ready to sell. They can just give their 30-day notice and move forward without any ties—without money and time spent trying to sell the house. The owner of the home would just get the property ready for the next tenant buyer. Bonus: It usually doesn’t take much to fix up because the first tenant who intended to buy likely took good care of it.
And the new $3,900 option fee should more than take care of the costs associated with getting the property ready for the new tenant buyer.
Now, I understand that the person following the BRRRR method could likely save up $4,600 for another property—or even do that several times over. There are a lot of variables in this comparison. And the BRRRR strategy is a really fantastic way to build wealth quicker than most traditional real estate investing strategies.
But this much I can say after doing the numbers, comparing the BRRRLO strategy to the BRRRR strategy: BRRRLO properties cash flow more, have less expenses, less turnover, less vacancy, take less time and effort to manage, and less money is left in them after the refinancing and receiving the option fee.
Simply put, the BRRRLO strategy, when done correctly, is easier to manage and provides greater returns.
I hope this new strategy helps you build your real estate empire in 2020.
What do you think? Would you considering doing a BRRRLO?
Let’s talk below in the comment section!