BRRR Method with High Mortgage Rates

[Nicholas Martinez]

I'm a newbie with only one rental in the Seattle area. I'm looking at purchasing distressed properties with hard money and then doing a cashout refinance once the property is rehabbed. I'm in construction and have done extensive remodels on very high-end homes, so I'm not worried about the rehab process. 

I'm wondering how to make the BRRR work. For example, purchase price of a distressed single-family home is 300k. I take out a loan for the home plus rehab, let's say 350k. ARV is 550k once rehab is complete.

Where I'm getting stuck is how to refinance out. Market rate for this single family is roughly $2,500, but a mortgage on a 550K home with 20% down is roughly $3,300. What are the options here? To make a DSCR loan work I'd have to have 275k in the home to get the mortgage and rent even out, which isn't possible with only 200k in equity. Am I missing something or would this just have to be a flip?

Thanks for your thoughts and expertise. 

[Dan H.]

Quote from @Nicholas Martinez:

I'm a newbie with only one rental in the Seattle area. I'm looking at purchasing distressed properties with hard money and then doing a cashout refinance once the property is rehabbed. I'm in construction and have done extensive remodels on very high-end homes, so I'm not worried about the rehab process. 

I'm wondering how to make the BRRR work. For example, purchase price of a distressed single-family home is 300k. I take out a loan for the home plus rehab, let's say 350k. ARV is 550k once rehab is complete.

Where I'm getting stuck is how to refinance out. Market rate for this single family is roughly $2,500, but a mortgage on a 550K home with 20% down is roughly $3,300. What are the options here? To make a DSCR loan work I'd have to have 275k in the home to get the mortgage and rent even out, which isn't possible with only 200k in equity. Am I missing something or would this just have to be a flip?

Thanks for your thoughts and expertise. 

First the multiple posts that advocate purchasing the cash flow via lower LTV clearly have not performed the underwriting comparing the two options in Seattle. Leverage is RE superpower.

I agree with your assessment that most rehabs do better as a flip than a brrrr, especially in the short term.   But flipping is a job, and the long term numbers may depict something very different.

I will use your numbers but believe they would be challenging.   I am usually content if the value add is more than double the rehab costs.   Your numbers reflect a 5x value add compared to the cost of the value add.   I may have achieved 4x (barely), but never 5x but I digress. 

$550k ARV - $350k purchase & rehab = $200k of added value.

Refi at 80% LTV is $440k. The implication is you start with $90k in your pocket; the $90k near instant return makes this a no-brainer. If you flip with selling costs, additional hold time, and paying income tax you will be lucky to net $120k. $30k difference is substantial, but let's look at this as a hold.

50% rule (which is conservative in high rent market like Seattle) shows this to be very negative : $2500 * 0.5 - $3300 =$-2,050/month.  Negative $24.6k/year

Note alternate rent models (str, MTR, rent by room) could reduce this negative cash flow.  I would not expect any of them to add enough revenue to make this positive cash flow.  

Equity paydown near $7k.  Negative $17.6k year.   The $90k in your pocket or $200k total value add can consume many years of this before being depleted.

But what appreciation do you need to make this even?   $17.6k/$550k=3.2%   

What is Seattle's appreciation?  5% average for this century

https://www.neighborhoodscout.com/wa/seattle/real-estate

If you get the 5% appreciation, is $27.5k.   Total profit would be $9.9k. Note the appreciation and rent compounds so that profit increases annually.

Now look at the return. $0 invested (not quite accurate as you had something invested until the refi but maybe 25% of the $350k for a short duration, but we will forget a short outlay because it quickly becomes trivial). ROI is infinite.

Because the property ends up acquired for no money, the cost of entry is irrelevant.  You own this high value property having not only extracted al, your investment, but in addition you pocketed $90k from the value add shortly after acquisition.

How long would it take to make $90k in the cheap market that many of these post advocate? Is it even possible to add $250k of value to a SFH in these cheap markets.

1.5 years ago I added a half bathroom out of existing space on a property with over $2k psf ARV. That half bathroom added $50k of value per the comps (if anyone wants to verify, mission beach 5 homes from the ocean). How much do you think a half bathroom in existing space can add in Cleveland?

Note brrrr have challenges, but if I could achieve the numbers you specified, I would do it and I expect crazy returns from my RE efforts.   I typically do not consider purchasing RE unless the return is far over 20%   This qualifies, easily.

Also I am not adverse to negative cash flow.   I purchased the largest negative cash flow non commercial property I have ever heard of.  $2.3m purchase fully occupied at a total $6k rent.   The property was up $1m above my purchase and rehab in 3 years.   I expect revenue will exceed $20k/month this year and has significant positive cash flow.

Lots to consider.    As I already mentioned, I think your 5x return on the value add will be a challenge and because I used your numbers, this is one reason this is a no-brainer to pursue.  Lower value add multipliers will reduce the numbers, especially the $90k into your pocket at the refi.   

Good luck