When investing, and this includes any type of investing, your goal is to build your assets. When buying stocks, you are looking to watch your money grow through appreciation or perhaps dividend distributions. When buying bonds, you are looking for cash generation or to possibly protect your assets. When buying real estate, you are looking to build equity in your portfolio or profits through sales. What you are not looking to do is build your liabilities constantly and consistently. In other words, you are not looking to continuously pile on as much debt as you can possibly handle.
Such advice might sound strange from a lender that only makes money when you apply for more loans. However, income from our borrowers getting themselves into too much debt is not our goal. Our goal is to maintain quality relationships that grow over time, safely and profitably.
The BRRR method illustrates this point in a way that is easily understood. For those who are unaware, the BRRRR (Buy, Rehab, Rent, Refinance, Repeat) method is used by borrowers in the private lending industry to grow their real estate portfolio and to minimize the cash necessary to scale property ownership. A customer will purchase a property, make a 15% down payment to acquire the property, and borrow 100% of the funds needed to rehab the property. The same customer will then lease the property, wait just a little bit, and refinance the loan into a long-term loan. Then, start the process all over again.
The BRRRR method is an excellent way to grow both assets and liabilities. The single best way to use the BRRRR method is to perform a rate and term refinance of the short-term debt that was used to rehab the property. That leaves 15% of the borrower’s cost basis and equity in the property. That equity is useful for many reasons, most of which are related to future downturns in the real estate market or personal situations that might require an unexpected sale of the property.
Many borrowers want to do a cash-out refinance and take 100% of their original cost basis out of the property upon refinancing, giving them back their 15% down payment and allowing them to do it again. However, it leaves absolutely zero margin for error and does not allow for any downturn in the market or any room for emergency financial management, should it be necessary.
Furthermore, those familiar with how mortgage amortization works know that most of the loan payment in the first 1/3 of the loan term (usually 30 years) is interest. Only in the back half of the amortization period are borrowers starting to make substantial principal reductions in the form of regular payments. So if a borrower takes out their original cost basis completely, they are quickly growing their liabilities and not their assets.
When taken in the context of pure flipping for those that do not wish to build their long-term holdings, remember to take and save your profits instead of pouring them back into bigger and more risky deals. All flippers run into deals that don’t end up working. Losing $20,000 on a flip is usually manageable, but if you are always chasing the next bigger and better deal, the next time you lose money could be your last.
Entire books have been written on these topics, but Lendmarq has a team that has been lending for a long time, including during the financial crisis of 2008 through 2011 where we witnessed borrowers rapidly build their “number of doors” only to lose it all during the downturn.
No risk, no reward, right? Maybe. However, risk management focused on building assets is an integral part of building true sustainable wealth. Debt is a tool and one that should be used judiciously. Wise investors learn the lessons that previous investors have already taught. Build assets, not liabilities. Build equity, not debt.