As property values have increased in most major markets in Canada, investors continue to look for ways to enhance their ROI. One of the ways to do so is to increase the rent-to-price ratio by increasing the rental income a property generates. While there are various ways to do this, the buy-renovate-refinance-rent (BRRR) strategy has gained particular popularity in recent years, as it enables investors to achieve exactly that.
While many investors understand the benefits of BRRR and know how to deploy it as a strategy, they often lack understanding of what involved from a financing standpoint to both enter and exit a deal. Let’s identify some of the common financing traps associated with BRRRs and figure out how to avoid them.
Trap #1: Taking a fixed rate
Many investors opt for fixed-rate mortgages, which are very attractive right now relative to variable rates. The problem with taking a fixed rate on a BRRR is that you’re assuming you’ll be able to go back to that same lender and top up your loan or add a secured line of credit once the reno work is done.
Depending on how you (and the property) qualify and the guidelines of the lender you have locked in with, you may or may not be able to go back and refinance immediately after you’re done the work. For example, some lenders require a buffer of at least six months from the date you purchased the asset before they’ll consider a refinance at the newly increased value. Some want to wait a year.
In some cases, your finances or the lender’s guidelines might change by the time you’re done with the renovation. If you’ve taken a fixed rate, you will either have to pay an often large penalty to move your file to another lender that can get it done or wait – and that comes with an opportunity cost or other holding costs you didn’t plan for. For that reason, we always recommend taking either a variable or an open rate going into a BRRR.
Trap #2: Making false assumptions around rate and down payments
Two misconceptions regularly doom BRRR deals: that all investors will qualify for financing with 20% down and that your rate going into the deal will be around 2%.
With a BRRR in particular, the condition of the property plays a huge role in determining the type of financing you can obtain at acquisition. As an investor, you might have been pre-approved for a certain loan amount and terms, but until the lender sees the asset they will secure their money against, you can’t seal those terms.
It’s one thing to buy a property that’s dated but livable and requires some updating, perhaps even a secondary suite. But it’s a completely different story to buy a property that requires gutting or has issues such as water damage, knob-and-tube wiring or foundation problems. You might need 25% or more in down payment funds, and you might end up with an alternative or even private lender (at a higher costs of capital) versus working with a bank.
Always consult with your mortgage broker regarding the condition of the property before going firm on a deal. Ideally, allow for a visit from the appraiser to avoid any surprises. Until the lender sees the property and reads the appraisal report, you can’t seal the financing terms. Unless you’re prepared for a private mortgage, do not go firm.
Trap #3: Expecting maximum equity too soon
The power of a BRRR done right is the forced appreciation a property often experiences upon the completion of the work.
As mentioned above, even when the value has appreciated and you qualify, some lenders will not allow you to extract equity so soon. Therefore, it’s important to do your homework and have your broker validate your exit-strategy financing assumptions by confirming a couple of things for you upfront, including:
- How much will you be able to take out in funds upon completion, taking into consideration the after-reno value, increased rents, the property’s location, your lending ratios, the legality of the units and the guidelines of the lender you will initially finance your deal with?
- If you are using private financing to acquire the property, how much leverage should you go with? And will you be able to gain enough lift in value and qualify to pay back the private loan once the work is done?
Trap #4: Thinking renovations can be rolled into the loan
A very common question we get is whether a lender can roll the renovation costs into the mortgage. While this might be possible with private loan financing arrangements, which are set up like construction financing loans, such an arrangement is not possible with institutional lenders.
The closest thing to getting renovation capital with banks is the purchase-plus-improvements product, where the lender approves you upfront for the mortgage plus the improvements loan. But even with that product, you will not get capital upfront to renovate the property. The lender expects you to renovate it from your own resources; only once the work is done will they release to you 80% of the renovation capital you were approved for upfront. They often give you three months to complete the job. Technically, the bank is financing the renovations, but in reality, they are advancing the capital once the work is done.
For an investor, a purchase-plus-improvements product works best for a property that does not require a major renovation and where the lift in value in not expected to significantly exceed the amount of money invested in the renovations. For sources of renovation capital, we often recommend secured/unsecured lines of credit as a first line of support, as long as the investor can pay back most or all of the outstanding balances at the time of a refinance.
Dalia Barsoum is an award-winning mortgage broker, real estate investor and finance advisor with more than 20 years of experience in the banking sector. Barsoum is the winner of CREW’s 2017 Mortgage Broker of the Year Award and is a regular speaker and contributor on the topics of investing and financing. She is also the best-selling author of Canadian Real Estate Investor Financing: 7 Secrets to Getting All the Money You Want. For a complimentary consultation or to learn more, email her at [email protected] or visit streetwisemortgages.com.