The BRRRR strategy is an incredibly powerful method of building wealth through real estate. The market cycle for the past few years has acted as a catalyst, greatly amplifying its power. Increasing home prices, falling/record low interest rates, and open credit markets have all put time on the investors side. Today’s BRRRR investor faces challenges that we haven’t seen since the financial crisis of 2008.
Interest Rate Risk
As you can see from this chart, interest rates have been declining for roughly 40 years now.
Yes, we’ve had a few periods of rate hikes but a decade hasn’t started with higher rates than the prior one since 1980. Well a few years ago we finally hit rock bottom. Short rates have been at or near 0 for years. The economy is finally starting to show signs of traditional recovery, CPI was a positive surprise this quarter, wage growth has finally picked up, and the Fed already started raising rates last year. A few weeks ago Wall St. was expecting 3 rate hikes 2018. Now some are expecting 4. The Fed usually raises rates 25 basis points, or ¼ of a percent, at a time. If we see 4 rate hikes this year we 2019 could have mortgage rates a full percentage point, or more, higher. If you are house hacking in a rising interest rate environment, you can’t assume that your rate and payment on the refi loan will be lower than your FHA loan.
To hedge against this risk, make sure your property cash flows with your FHA rate + 85 bps of PMI. You could take an Asset Liability Management (ALM) approach by purchasing variable rate fixed income instruments to offset some costs as you benefit from increasing coupon payments. Interest rate derivatives could be another way to profit from rising rates and offset some of your costs. Asking your lender about pricing on rate locks is another option to consider.
Frozen Credit Markets
During tough economic times, credit markets freeze up. Banks will not lend when they are worried about their own profitability and liquidity. Investment property lending is the first to go as it’s considered more risky for lending institutions. Are we headed for a recession? Who knows anymore. I honestly thought we were at a market top 4 years ago. When the next recession will hit is very hard to predict. What we can say for sure though is that the economy along with equity, bond, and home prices cannot continue at the rates they’ve been going forever. If we sink into another recession while you are in the middle of rehabbing a property, you may not be able to find a lender willing to underwrite your refi mortgage. Fortunately rental investors can ride out economic storms.
As long as the deals you are doing have enough spread, it may just mean that you need to account for a year or two of extra costs associated with your acquisition loan. If you’re house hacking then just like with rising interest rate markets make sure your property cash flows with PMI. If you are using private or hard money, try to either structure your notes with long dated maturities, or make sure that the penalty/default rate on a short term note doesn’t kill the deal.
If we do fall into another recession, housing prices will likely come down as well. Will we see as disastrous of a fall as we did from 2006-2011? Again, who really knows. The important thing to keep in mind is when running your numbers, understand how your deals will look if your ARV comes in at say 5%, 10% and even 20% under what you expect.
To beat a dead horse, will you be able to survive a few years without being able to refi out of your acquisition loan? Do you have enough cash in reserve to bring to the refi table if your appraisal doesn’t come in how you want it?
Over the next few years BRRRR investors will face new challenges. This shouldn’t discourage you from taking the plunge but instead serve as a reminder to take extra caution when running your numbers. When analyzing a property, see what the returns look like when you have to hold your acquisition loan for an extra 1,2, and even 3 years. Check your cash flow with a refi loan when rates jump up 1-2%. Ask yourself if this is still a good deal if your final ARV ends up 10-20% lower than what you expect. These runs aren’t meant to serve as an expected case but are designed to ensure that you can survive the worst case. Remember, no one knows what the future holds. Even the top hedge fund managers in the world don’t know for certain where markets will be a year from now. Your best defense against adverse market moves is to understand how they will impact your deal, plan accordingly, and budget for the surprises.