The coronavirus has thrown the entire world into almost surreal chaos. Like most other industries, real estate investors and particularly property managers, have been scrambling in case rent doesn’t come in because too many of their tenants have lost their jobs.
“COVID-19 will be the death of the BRRRR method. There are many people who followed BP’s advice and have a highly leveraged portfolio. Their portfolio is an inch deep and a mile wide. All the rents save a little bit are getting passed through to the bank and not many will be able to stomach the losses for 2-3 months.”
Indeed, someone even hunted me down on Twitter to tag me and note that, “Also this BRRRR thing is real. What happens come April 1 when you have 10 mortgage payments due but no rent coming in?”
The recently passed $2 trillion stimulus bill that provides Americans with direct cash payments may have alleviated the immediate fears of tenants not being able to pay. (Although it may have also entrenched moral hazard with yet another round of corporate bailouts.) Still, we don’t know how much longer the threat of coronavirus will last and how deep this recession will be. We also don’t know when the next black swan event will come around that will throw markets into a tailspin.
That being said, reports of the BRRRR method’s death are greatly exaggerated. There are, however, some misconceptions about BRRRR that do need to die.
Misconceptions About BRRRR
Unlike what the above quotes imply, overleveraging is not part of the BRRRR strategy and never has been. Yes, plenty of investors have overleveraged before and many who have done so are likely in dire straits. Perhaps such investors thought they were doing the BRRRR method, but they were most definitely not.
BRRRR investors are actually no worse off than regular buy and hold investors assuming the BRRRR investors followed the instructions. Both types of investors should have a property with a bank loan of 75 percent of its market value on it. The difference being that BRRRR investors don’t have any of their own money in it, while regular buy and hold investors put about 25 percent down.
Indeed, the goal of buying for 75 percent of market value or less is the most important aspect of the BRRRR strategy. And buying under market drastically alleviates risk. As I noted in my first primer on the BRRRR method,
“The goal behind a BRRRR strategy is to pull all of the money you put into a property out when you refinance it so that you effectively bought a property for nothing, but still have 25 percent built-in equity to reduce risk. So while you may be looking for a different type of property (flippers will usually buy more expensive properties than holders), you still want to get the same equity margin.”
This actually means the BRRRR investor is likely in better shape if a downturn comes as the regular buy and hold investor has their cash tied up in the property, whereas the BRRRR investor does not.
That being said, there is a misconception that the BRRRR strategy is a “no money down” strategy. Yes, it can be, but it often is not and over the long haul, it never is. Stuff happens. Sometimes you will go over budget on the rehab or the appraisal will come in for less than you anticipated. In these cases, you can either:
- Leave money in the property, or
- Sell the property.
If, like many investors including ourselves, you obtained a private loan up front for the purchase and rehab, you will need to bring money to the table if you choose to refinance.
For this reason, I have always stressed that, “An investor planning to use the BRRRR strategy should have at least some savings on hand.”
My general rule of thumb would be around 10 percent of the property’s value, although more is nice. You need to have some money in the bank (or partner with someone who does) in case things go wrong. So aspiring BRRRR investors should first start saving some money in my humble opinion.
The next point is simply that you shouldn’t pile up multiple BRRRR properties at the same time, at least not in the early going. Yes, you can scale your way up to that, but it’s not where you should start.
At first, you should start with one or—at most—two deals at a time. BRRRR one and then move to the next (or buy the second as you are finishing the rehab and beginning the refinance stage on the first). Of course, if the deal of the century comes along, you shouldn’t skip out on it just to fit into this exact schedule, but you also shouldn’t get ahead of yourself.
A major danger an overzealous BRRRR investor faces is to get caught with multiple properties that have private loans on them when a downturn hits, especially if that investor went over budget on the rehab. Then they will be stuck with high-interest loans and no way to refinance. If that investor also has low cash reserves and a substantial number of his tenants are not able to pay their rent, then he could be staring foreclosure or bankruptcy in the face.
What the Coronavirus Did Expose
Two ideas need to die or be greatly augmented, and COVID-19 should make that exceptionally clear.
- Rapid growth is always the way to go.
- Cash reserves are unnecessary.
Rapid Growth Is Dangerous
Talk of 10X growth and the like are great with many things such as productivity and efficiency, but it is something to be cautious with in regard to business growth. Quick growth often follows the “house of cards” model where a gust of wind (such as coronavirus) will knock it down. Rapid growth rarely comes with the systems necessary to sustain such growth and also often comes with way too much debt. Again, overleveraging is bad.
The way to grow properly is to scale. Investopedia describes scaling as follows:
“Scalability is a characteristic of an organization, system, model, or function that describes its capability to cope and perform well under an increased or expanding workload or scope.”
Thus, scaling involves building better systems that can cope with an increased workload. Scaling is an exponential curve whereas rapid growth tries to go straight up and usually comes crashing right back down from overleverage, the inability to manage such a rapidly growing operation, or its susceptibility to black swan events like what we’re currently living through.
Cash Reserves Are Imperative
The second is the importance of cash reserves. Many investors feel like cash burns a hole in their pocket. After all, that cash could be getting a much better return than nothing!
But having cash does two major things. The first is that it gives you liquidity for a rainy day. When you are in a business like real estate that requires a substantial amount of debt for most, a rainy day fund is a must-have.
If nothing else, a rainy day fund helps with your mental health. I can tell you it’s been much easier to sleep at night knowing we have the cash reserves to survive for some time even with major disruptions to our cash flow.
“Taleb believes that trying to predict such rare events is mostly a fool’s errand. Instead, one should try to become ‘antifragile.’ Antifragility doesn’t describe something that can survive disorder or even a downturn. For that, he uses the term ‘robust.’ Instead, antifragility is something that gains from disorder.
“So whereas most companies struggle in a recession, a company that thrives in a downturn would be antifragile… Those who ‘thrive from disorder’ can often grow exponentially while others are declaring bankruptcy.”
So how can real estate investors become antifragile?
First, don’t overleverage or overextend (grow too fast). Second, build up a cash reserve so you can survive dips in cash flow and jump at great opportunities that often come around in recessions. Third, build up your list of potential banks, private lenders, and partners.
In recessions, some of these institutions and individuals will want to sit on the sideline. Thus, it’s important to find more than just what you need. Backups are essential!
Of course, it will take time to build a cash reserve and a long list of banks, private lenders, and partners. This is certainly true. But it should be your goal from the outset.
Don’t plan on growing like crazy right away. Real estate investment is a “get rich slow scheme,” and the way to do that is to grow at a consistent and steady pace while building your systems and saving up a cash reserve along the way.
Investing in real estate that way (whether with the BRRRR method or another strategy) will help keep you solvent for the next downturn while also allowing you to take advantage of the opportunities that will inevitably present themselves.
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