Cash Flow is King
Cash Flow* is king. It means your investment is paid for, and then some. It means you’re not just banking on appreciation. It means you have mitigated risk. Simply put, it doesn't matter how much money you will get at some distant point in the future if you don't have enough money to get you from here to there. So then, what do you do when you’re investing in a hot market where cash flowing properties are hard to find? Add value. If you can, add tremendous value.
For those of you that don’t yet know me, my name is Elizabeth and I am a real estate investor in Victoria, BC. Through our company Expansion Properties, my partner Cole and I own and manage 11 doors and are in the process of building two new single-family homes (a first for us). What’s our secret sauce? Adding value and creating positive cashflow through the BRRRR method of real estate investing.
The BRRRR method stands for: Buy-Renovate-Rent-Refinance-Repeat. The general idea is to purchase a distressed property (with a more competitive price tag) that needs work, then refinance after the renovation is complete and it’s been rented. The “sweat equity” (the additional value created by the work) and the rental income allows the investor (that’s you) to pull out most or all the capital investment. Cole and I use a hyped-up version of this model: we look for properties with low basements that we can either lift or dig down to add square footage. Not everyone is interested in such an aggressive renovation, but this works on smaller projects as well.
There are many things that need to be considered when using this investment strategy. I have summarized some of the major points in the following, but of course this is not exhaustive. Feel free to send me any questions you might have, I’m happy to share!
What if I told you a bank would mortgage a property and include the cost to renovate? Cole and I have been doing this for our projects, but most people don’t even know the option exists! It is a game changer.
Typically, a mortgage on an income property requires a minimum 25% down payment based on the purchase price. This can also be higher – we’ve heard up to 35%, but for the sake of demonstration, I will assume a 25% down payment and 75% loan-to-value throughout. The loan-to-value (LTV) ratio is a financial term used by lenders to express the ratio of a loan to the value of an asset purchased. With a construction loan your down payment is based on the after-repair value instead (you must maintain a 75% LTV of the after-repair value as determined by an appraisal).
Say you’re looking to buy a house for $750,000 then put $250,000 into it. Most appraisers will set the after-repair value to be the purchase price + cost of improvements: $1,000,000. You would be required to put $250,000 down, instead of $187,500, but the renovation would be financed! Another bonus, these mortgages are interest only. Even for large amounts, the payments are relatively low. This highlights why it is so important to have a good mortgage professional on your team – some brokers don’t even know about construction financing!
As mentioned, Cole and I do MAJOR renovations where we take houses down to the studs and either lift or dig down basements to add square footage. One of the benefits to this approach is that it reduces maintenance required going forward. The units are essentially brand new, so annual maintenance costs are basically $0. Adding square footage will add the most value to any property you buy. But not everyone has an appetite for that kind of renovation. That’s ok. Perhaps you could add a suite to a 2-level house. Adding rooms is another hack – change the layout so that a 1-bedroom space becomes a 2-bedroom, or a 2 bedroom becomes a 2 + den, depending on what you’re working with. Or if that still is too much, update kitchens and bathrooms – this is what most people will notice anyway!
The thought of renting is terrifying to some people! We have learned that it doesn’t have to be. Starting with a great tenant screening protocol helps. We use a tenant application and screening system called Naborly Collecting data from multiple sources (credit, criminal, court system, social media, etc.) Naborly uses AI (artificial intelligence) to provide an easy-to-read risk analysis of your applicant. I’ve recently been made aware of another system called Certn, employing similar AI technology.
We also do our own reference checks, calling at least one employment reference and two landlord references. We use a list of specific questions to catch people up if they’re being deceitful about who they are (e.g. the cousin pretending to be a landlord, etc.). We always make sure to meet with prospective tenants a couple times before committing to a lease. All this goes a long way when it comes to reducing tenant turn-over (aka vacancy).
Speaking of tenant turn-over, we have some strategies for that too! We strongly believe in the importance of creating quality spaces for people to call home. We go above-and-beyond. For instance, sound-proofing in our units is extensive, even though it is behind walls. Every unit has in-suite laundry. Quartz countertops are beautiful and incredibly durable. We even cater to some aesthetics - high-end finishing’s (stainless steel appliances, tile backsplash, etc.) and exterior landscaping means tenants are proud of their home. At the end of the day, if people are happy with where they live, they are far less likely to leave. All these things also help to maximize rents on a property, critically important to the next point...
Another common obstacle to investing in real estate is of course the financing. But it’s important to know that lenders take rental income into consideration when qualifying for the mortgage. It’s taken as a percentage of the overall total – and this is all over the place, anywhere from 0 – 100%. Some go off lease agreements, some want to see bank statements, others will go off market rents given by an appraiser. Again, it is important to find a mortgage specialist that knows the ins and outs of these products so that you choose the best lender for your situation.
After the project is finished and the units are rented it’s time to get a new appraisal and refinance. As mentioned before, the after-repair-value in the initial appraisal will generally be the purchase price + cost of improvements. Since you’ve added significant value in the renovation, the new value will be higher. Having a good handle on your market is critical to gauging what this new value will be. We continually monitor the market. There may be times when an appraisal comes in lower than expected. Don’t be afraid to challenge the appraisal if it comes in too low, they tend to err on the side of caution. Appraisals are also subjective. Friends of ours experienced this first hand. They had an initial appraisal done that came in way below what they expected. The appraiser had just moved here from out of town and was also new to the industry. They requested a second appraisal and it came in roughly $200,000 more.
The appraisal and refinance are critical to the BRRRR strategy. When the numbers work right, the added value covers the cost of the renovation. I’ll explain what I mean. Continuing from the earlier example:
You purchased a house for $750,000, did a renovation for $250,000, with a down payment of $250,000 (remember, 25% of $1,000,000 – purchase price + renovation). Your construction mortgage then is $750,000. The new appraisal came back at $1,250,000. You’ll recall from before, the bank requires a 75% LTV. Your max mortgage amount would therefore be $937,500 ($1,250,000 x 75%). Do you see the numbers? With a new mortgage of $937,500, minus the $750,000 construction mortgage, you have $187,500 available to you. In addition to the equity sitting in the property – the 25% or $312,500. Bear in mind, there will be some carrying costs, insurance, property transfer tax, etc. that you will have paid in the meantime, but that money from the refinance will more than cover those expenses and still leave you with cash to carry forward.
Here are those numbers again:
Once the refinance is complete, and all your expenses are paid, move the money from one property to purchase the next.
Admittedly, this simplifies a complex process. Renovations are not easy. There is a lot that goes into securing these mortgages – sorting out a budget, for example. But the opportunity is there for those willing to take the risk, are you?
Check out the following links to find out more about Elizabeth and Expansion Properties: