About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.
As a new real estate investor, how do you know how much you should offer on a property?
The “70% Rule” in real estate offers an easy guideline for new investors. After all, the last position you want to find yourself in is overbidding for a property! Your profits as a real estate investor are overwhelmingly made (or lost) when you buy a property, based on what you pay.
What is the 70% Rule in house flipping?
When determining the maximum price you should consider paying for a property, the 70% Rule of real estate investing dictates that you should pay no more than 70% of the after repair value (ARV), minus repair costs.
Which, in turn, begs the question: “What is ARV in real estate investing?” To answer, the ARV is the estimated value of a property after all repairs are completed.
To use simple math, if a property’s ARV is $100,000, and it needs $25,000 in repairs, then the 70% Rule suggests that the most an investor should pay for it is $45,000: $100,000 times 70% = $70,000, minus $25,000 = $45,000. The idea is that chopping out that 30% will leave room for both your profits and miscellaneous expenses like soft costs.
But the 70% Rule in house flipping is far from written in stone. In fact, the word “rule” is a misnomer–it’s a loose guideline that is meant to offer a quick shorthand for a frame of reference.
Uses of the 70% Rule in real estate
The 70% Rule is useful in house flipping to help you instantly evaluate whether a potential deal is in the right ballpark. While you shouldn’t make offers only based on the 70% Rule, it serves as a simple framework when evaluating prospective deals.
It’s that very simplicity that makes the 70% Rule an effective guideline. It forces you to ignore everything but the two most important numbers when first looking at a deal: the ARV and the repair costs. Sure, other numbers matter, such as soft costs (more on these shortly), but at the heart of any house flipping deal are the ARV and repair costs.
If you forecast those numbers accurately, it’s extremely unlikely you’ll lose money on a deal. But if you’re wrong in your ARV and repair costs estimate, you could easily lose tens of thousands of dollars.
Fixate on these numbers when evaluating potential deals and make sure you get them right before deciding how much to offer on a property. Then, analyze the comps in your market with exacting detail. Talk to a Realtor about their opinion of the ARV. Remember that the less closely the comps mirror the property in question, the less accurate you should consider your ARV estimate.
Based on estimated ARV and repair costs, you can work backwards to determine an offer price. Your profits for a deal are determined by the decision about which properties to make offers on and how much to offer. (Read more about the 8 steps of flipping a house here.)
The 70% Rule in real estate cuts directly to the most critical numbers in a house flipping deal, and forces you to pay close attention to them.
The math in a house flipping deal
How well does the 70% Rule in house flipping hold up compared to a more detailed analysis?
In a more thorough deal and return on investment analysis, investors will include expenses like financing costs, settlement costs, carrying costs, and other soft costs associated with real estate investing. Savvy investors also know to budget extra for unforeseen repair costs, so they’re not taken by surprise.
Here’s a breakdown of a deal I ran across not long ago:
After Repair Value (ARV): $200,000
Repair Costs: $40,000
Repair Cost Buffer/Reserve: $8,000 (20% of known renovation costs as a general best practice)
Settlement Costs (including both transactions): $15,000
Financing Costs (including both lender fees and interest): $5,000
Other Carrying Costs: $1,000
Total Expenses: $69,000
These are all part of how much it costs to flip a home.
According to the 70% Rule in real estate, I should pay no more than $100,000 for this property ($200,000 X 70% = $140,000, minus $40,000 = $100,000). In my more detailed analysis, let’s say I want a profit of at least $30,000, based on the extensiveness of the rehab, my experience, risk level, and what I estimate the length of the time the deal will take. Starting with the $200,000 ARV, I subtract the total expenses ($69,000), then subtract my minimum acceptable profit of $30,000, to reach a maximum offer price of $101,000.
In this example, the 70% Rule aligned closely with the more detailed expenses analysis. But it doesn’t always happen that way.
How accurate is the 70% rule in house flipping?
While the 70% Rule in real estate makes for fast and easy shorthand, it should remain a starting place only. After a more detailed expense analysis, you’ll often discover the 70% Rule falls short of the mark.
In real life real estate investing, sometimes you may only want to offer 60% of the ARV, minus repairs. Or in other cases, you can easily offer 75% or 80%.
Here a few factors that impact how much you can offer in practice:
Market price point
In lower-end property markets, you’ll run into additional expenses and risks that should impact your investing strategy. For example, you may have a high risk of break-ins, vandalism, stolen equipment, and appliances. Early in my career, I invested in lower-end real estate markets and lost a lot of money to crime-related expenses.
Also keep in mind that some settlement costs are fixed and not dependent on the purchase or sales price. Lenders may charge a minimum fee, such as, “three points or $3,000, whichever is higher.” Many title-related fees are fixed and not based on sales price. That means that as a percentage of your deal, they’ll be higher than in more expensive deals.
In contrast, higher-end deals often come with fewer headaches and expenses.
While the 70% Rule can be a useful shorthand for flipping houses, it’s less useful for other exit strategies.
Rental investors may not be renovating the property as extensively and will be holding the property long-term. Because their primary goal is cash flow, rather than a one-time payout based on ARV, their calculations typically revolve around annual yield and income.
Similarly, if you’re wholesaling deals, the numbers may look different for you. Repair costs and ARV are still critically important, but if you have a strong buyer list and know that one of your buyers will pay significantly more than your contract price, the 70% Rule is less important than knowing your buyers and market.
Labor and your target profits
Some deals require more work on your part than others. And some investors want to earn more profit per deal than others.
If you find a deal that will involve minimal work and a quick turnaround, capitalizing on high velocity of money, you may be willing to accept a lower profit margin on the deal and pay more than the 70% Rule would dictate.
The one reason you shouldn’t break the 70% Rule
As outlined above, there are plenty of sound reasons to buy higher or lower than the 70% Rule suggests. But there’s one reason you shouldn’t break the 70% Rule: the assumption of appreciation.
Real estate values do not always rise. Look no further than the housing crisis in 2008 for a not-so-distant reminder of just how far–and how fast–real estate values can drop.
Use today’s ARV for your calculations and err on the side of being conservative.
The 70% Rule in real estate makes for an instant, back-of-the-napkin calculation to give you a rough ballpark figure for a ceiling price on your offers. But before actually making an offer, you’ll want to run a more detailed expense analysis.
Most of all, be cautious and conservative with your repair costs and ARV estimates. These numbers will make or break your profits, so invest the time to get them right by talking to as many people as you need to in order to feel confident in your numbers before settling on an offer price. If you can’t get inside the property to verify repair costs (such as when buying a foreclosed home), use worst-case-scenario numbers.
As you’re running your numbers, be sure to include soft costs, like financing. LendingHome offers competitive rates starting at 7.5% on bridge loans, with rate quotes provided in as few as three minutes when you submit the particulars of your deal.
Remember, it’s better to make more money on fewer deals, than to do more deals and risk losing money or only breaking even. Protect both your profits and your time by being precise and conservative in your cost estimates and you’ll find yourself working less and earning more as you find houses to flip.
Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. Please consult your tax advisor. All calculations and information shown here are for illustrative purposes only. All third parties listed above are for demonstration purposes only and are not affiliated with LendingHome. All views and opinions expressed in this post are the author’s own. NMLS ID: 1125207 Terms, Privacy & Disclosures. Copyright LendingHome Corporation 2019.