What is Buy and Hold Real Estate?
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Originally Posted On: https://www.dohardmoney.com/what-is-buy-and-hold-real-estate/
Multiple real estate investing strategies exist. All of these options can make choosing the best one for your situation challenging. To help new investors make the right choice, I love answering questions. In particular, I frequently hear this: Ryan, what is “buy and hold” real estate?
With the buy and hold strategy, investors purchase real estate to rent out for an extended period of time – as opposed to quickly selling for a profit. This approach lets investors make money several ways: 1) property appreciation; 2) loan amortization; 3) cash flow; and 4) tax advantages.
In the following article, I’ll outline more details and considerations to buy and hold real estate. Specifically, I’ll cover:
- An Overview of Buy and Hold Real Estate
- Buy and Hold Long-Term Objectives
- Keys to Buy and Hold Success
- Finding Solid Buy and Hold Deals
- The Do Hard Money Rental Calculator
- Wholesaling / Flipping vs Buy and Hold
- Final Thoughts
An Overview of Buy and Hold Real Estate
Investors can pursue countless real estate strategies. For instance, single-family home investors often opt to fix & flip properties. This approach involves buying a distressed property, renovating it, and selling the final product – at a profit.
Some investors pursue a longer-term strategy. Enter buy and hold. With this approach, investors buy a property, rent it out to tenants, and continue to do so for an extended period of time. When you hear someone discuss a “portfolio of properties,” they’re likely referring to a number of buy and hold homes they rent to tenants. Simply put, this strategy focuses primarily on long-term wealth building – not an immediate profit.
Buy and hold aligns with the common real estate saying: “don’t wait to buy real estate; buy real estate and wait.” That is, if you hold a property long enough, it will generally increase in value (among other profit avenues), making it a sound strategy.
Buy and Hold Long-Term Objectives
Whereas flipping a property entails a single profit objective (i.e. make as much money on the resale as possible), buy and hold investors pursue six interrelated objectives:
Profit Objective 1: Property Appreciation
In the short-term, property values can fluctuate up and down. While not as volatile as stocks, real estate values can still vary considerably in the short-term (e.g. during the Great Recession when property values in many markets absolutely plummeted).
But, in the long-term, real estate tends to appreciate, that is, increase in value. And, it generally appreciates at a rate greater than inflation. For investors, this means that if you hold a property for a long enough period of time, you will become wealthier solely due to the increase in that asset’s value. This appreciation plays a central role in the profit strategy of buy and hold investors, and it separates them from short-term investors like house flippers.
Profit Objective 2: Loan Amortization
Holding a rental property for an extended period has another major benefit: loan amortization. A technical term, amortization simply means that a portion of each mortgage loan payment goes to principal (that is, paying down the loan balance), and the other portion goes to interest (that is, what you pay the bank for the privilege of borrowing money).
At the beginning of a loan period, the bulk of every loan payment will go to interest, with only a small portion paying down the loan principal. However, towards the end of a loan, this breakdown switches, with the bulk of each payment going towards loan principal.
This amortization schedule means that, the longer you let a tenant pay your mortgage for you, the more your loan balance decreases. In real estate, equity equals the amount of a property you actually own free and clear. Mathematically, equity equals the fair market value of a home minus the outstanding loan balance. Every time a tenant pays your monthly mortgage payment, the loan balance goes down slightly, so your equity – or ownership – in the home increases. And, when you then decide to sell the home, you can convert that equity into cash rather than pay off a huge loan balance.
However, if you only own a home for a short period of time, this amortization schedule also means you won’t gain much equity. As stated, your first few years of mortgage payments apply mostly to loan interest – not principal. If you sell quickly, you’ll still have a fairly large loan balance to pay off with the sales proceeds.
Profit Objective 3: Long-term Cash-out Refinance Potential
This increase in equity leads directly into the next major profit objective for buy and hold investors. While you can access your equity in a home by selling the property, another option exists that lets you convert rental property equity into cash without selling: a cash-out refinance.
Let’s say that your home has a current market value of $450,000. With a $200,000 mortgage balance, you’d have $250,000 in equity in the property ($450,000 value minus $200,000 loan balance). To access some of that equity, you could complete a cash-out refinance. Most lenders will provide a cash-out refinance up to 80% loan-to-value (LTV). This means that, in this example, you could receive a refinance loan up to $360,000 ($450,000 value times 80%). But, since you have a current mortgage balance, the first $200,000 of your new loan would go to paying off that balance, and you would pocket the remaining $160,000 as cash (ignoring transaction costs).
Of note, not all lenders will provide a cash-out refinance, and the ones that do will charge a higher interest rate than a comparable refinance of a primary residence. But, this technique provides investors a great option for tapping rental property equity to: A) complete capital improvements, or B) pursue other investments.
Profit Objective 4: Cash Flow
Yes, buy and hold investors look to long-term returns. But, that doesn’t mean they don’t also enjoy the advantages of recurring cash flow. If a tenant’s rent payments exceed operating expenses and debt service, owners can pocket the difference as cash flow, which provides a recurring profit source.
But, owners also need to take caution when taking cash from a deal. Before pocketing monthly cash flow, ensure that you contribute a portion of it to your reserve account. These excess funds cover A) vacancy, B) maintenance, and C) long-term capital improvements so that you don’t need to pay for them from operating cash.
Profit Objective 5: Tax Advantages
Related to cash flow, buy and hold properties provide real estate investors outstanding tax advantages, most of which revolve around depreciation. When you buy a rental property, the IRS does not let you deduct the entire purchase price in the year you buy it. Rather, it lets you expense a portion every year over a set period (27.5 years) in a process known as depreciation. Due to this cash-less expense, many rental properties operate with positive cash flow despite taking a tax loss. And, as with any other business-related activity, you can also deduct all necessary operating expenses from a rental property (e.g. property taxes, insurance, HOA fees, maintenance, utilities, etc.).
Profit Objective 6: Overall Increase in New Worth
Lastly, many buy and hold investors look to the strategy as part of their broader financial health. An individual’s net worth equals all assets (real estate, cash, stocks, bonds, etc.) minus liabilities (mortgages, credit card debt, student loans, etc.). As the value of a property increases and the associated mortgage decreases, an investor’s overall net worth grows, making buy and hold real estate a solid pillar to general financial planning.
Keys to Buy and Hold Success
To succeed as a buy and hold investor, you need to answer one question: how can I have the staying power to hold this property for the long-term?
Ultimately, the answer to this question comes down to choosing the right property. At a minimum, you need to have an investment property that breaks even, that is, cash in equals cash out. To confirm this, you need to conduct a cash-flow analysis, making sure that market rents – even in a downturn – will cover associated cash outflows (e.g. operating expenses, debt service, capital improvements, etc.).
To accomplish this, I like to look at the worst-case scenario for rents. In other words, in a downturn like the Great Recession, what’s the lowest market rents will go? Plenty of data exist to answer this question. If the lowest average rents for your market still cover the property’s cash outflows, you know that, even in a worst-case scenario, you’ll continue to break even.
Related to this, I also look to a particular property type. When the economy suffers, people generally downsize homes. For investors, I recommend buy and hold properties in areas that will both A) absorb these people downsizing, and B) appeal to families, regardless of economic environment. Specifically, I look for the sweet spot – neither mansions nor complete dumps. Instead, I like to buy properties in safe, reliable blue-collar neighborhoods tailored towards families, as families tend to stay in rental homes longer than single tenants.
Finding Solid Buy and Hold Deals
After outlining the above keys to buy and hold success, the question remains: how can I find good deals? It depends on your approach. Technically speaking, I’d argue that the BRRR strategy really represents a subset – or modified version – of buy and hold real estate. As such, finding solid buy and hold deals depends on the level of work you want to put into properties. That is, do you want to use the BRRR approach for distressed properties or buy ready-to-occupy homes at retail price?
Finding Long-term BRRR Deals
As one would expect, “BRRR” is an abbreviation, not a word, and it stands for: buy, renovate, rent, and refinance. These are the key steps to this process, and it’s worth discussing each element in turn:
- Buy: Investors buy distressed properties – ideally at a deep discount – in need of major repairs. As such, BRRR investors largely look for the same properties as fix-and-flip investors.
- Rehab: Investors then rehab the property. However, they don’t rehab it to sell it. Rather, they do their renovations with an aim to appeal to renters. Rehabbing a rental property usually means picking far more durable materials than if rehabbing for sale. You’ll need materials that can handle the wear and tear of multiple tenants. And, you don’t want to have to complete repairs every year. This rehab leads directly into the next step of the strategy.
- Rent: Once you’ve completed the renovation, you need to market the property for rent and secure quality tenants. You can certainly hire a property manager to do this. This saves you a ton of headaches, but it also costs money. And, from an experience perspective, I recommend investors manage at least one of their own properties. This provides you a solid understanding of the leasing and property management process, and you’ll be better positioned to hire and supervise property management companies down the line.
- Refinance: Once you’ve rehabbed the property and signed a tenant lease, you can refinance the property. Typically, BRRR investors (and flippers) use hard money loans to finance a property purchase and rehab. However, these loans have high interest rates, as they’re designed for short-term investment use. Once a property meets traditional mortgage quality standards and is rented out, you’ll want to refinance into a traditional mortgage. This new loan will pay off the outstanding hard money loan.
After completing this refinance, a BRRR property becomes a de facto buy and hold one. In other words, nothing differentiates it moving forward from a home you purchase and rent out immediately. But, investors must take a different approach finding these deals. With distressed homes in need of major repairs, owners do not list them on the Multiple Listing Service (MLS). Instead, you’ll need to pursue these properties with an off-market strategy, looking for homes with owners who A) have equity in their homes, B) have a motivation to sell, but C) haven’t listed on the MLS yet.
Buying Retail Properties
Alternatively, some buy and hold investors prefer purchasing a home at retail price directly from the MLS. While you pay a premium for these homes, you also don’t need to pour time, effort, and money into renovating them. As such, investors can qualify for traditional financing – as opposed to hard money loans – to purchase buy and hold properties at retail.
And, despite the premium you pay for MLS properties, the long-term nature of the buy and hold strategy means that you’ll still profit on the deal. If you hold a home long-enough, it’ll A) appreciate, and B) the loan balance will decrease – even if you don’t pull in a bunch of monthly cash flow.
But, to successfully purchase a buy and hold property from the MLS, you need to also conduct a cash-flow analysis, confirming that cash in will cover cash out – to include your reserve funds.
The Do Hard Money Rental Calculator
For new investors, this cash-flow analysis can seem daunting. I want to help! The Do Hard Money team and I have put together an outstanding rental property cash-flow calculator. If interested, text me your e-mail address at 435-294-0433, and I’ll send you this awesome tool!
Wholesaling / Flipping vs Buy and Hold
New investors frequently ask about other real estate strategies, as well. In particular, people often ask me about wholesaling and house flipping. More precisely, do these strategies make more sense than a buy and hold one?
I’ll first provide an overview of real estate wholesaling, in general. At surface level, this strategy only involves a few steps. Investors 1) find a deal, 2) negotiate with the seller, 3) put the property under contract, and 4) sell – or assign – that contract to a third-party investor who actually purchases the home. And, wholesalers do this for a fee, making a profit on the transaction. In other words, wholesalers make money without the hassle of dealing with a rehab.
As a result, wholesalers don’t actually purchase homes. Instead, they simply find the properties to put under contract. But, as they generally assign these contracts to fix & flip investors, they need to find properties that fit their investment criteria. Broadly speaking, fix & flip investors look for distressed properties that they can purchase for a discount. That way, they can purchase and rehab a property for less than the after-rehab sales price, creating a profit margin on the deal.
To be clear, wholesaling, house flipping, and buy and hold investing are not mutually exclusive. Rather, I see them working as a progression. Wholesaling and flipping are great ways to build initial capital. But, they’re also extremely active. Once you stop doing these deals, you stop bringing in money.
Accordingly, I recommend using the proceeds from wholesale and flip deals to purchase buy and hold properties. Eventually, you’ll put together enough cash for a down payment on your first rental property. This property will then start to reap the above benefits of the buy and hold strategy. Gradually, you’ll grow your buy and hold portfolio, using the cash from wholesaling and flipping to purchase more and more properties. At a certain point, you’ll own enough buy and hold homes that the cash flow from them will provide you enough income to stop the other investing strategies entirely.
The buy and hold strategy entails purchasing real estate to rent out for an extended period of time – as opposed to quickly selling for a profit. This approach lets investors make money through a variety of different profit avenues. And, more than any other strategy, buy and hold real estate helps build an investor’s net worth.