Real estate investors whose field of occupation is flipping houses often resort to the so-called 70% rule. This approach is suitable for both newcomers in real estate investing and skilled investors. In this article, we will focus mostly on house-flipping as a real property strategy. We will review several examples of the use of a 70% rule and analyze the accuracy of the rule. Also, we will consider the cases when the 70% does not work and enlist the reasons. Further, we will explain the main principles of this rule and how to apply them in practice.
What Is 70% Rule In Real Estate
The 70% rule in flipping houses business is a practical approach that is widely used by real property investors and helps to determine the price for the house or apartment. This rule states that if the real property investor looks forward to receiving a positive income from the flip, he should pay 70% of ARV (After-Repair Value) and subtract the ERC (Estimated Repair Value) for a distressed property from this amount. Let us take a closer look at the above-mentioned terms.
- ARV – approximate value of the investment property after all renovations and repairs. To determine ARV, you need to add the purchase value to the amount of finance for renovations.
- ERC – costs from renovations and repairs. These expenses are such works as plumbing, painting, replacement of the cooling system, roof replacement and new flooring.
It is vital to make an accurate calculation of the after-repair price and estimated repair costs in order to avoid losing money. If your forecasts about ARV and ERC are wrong, then there is a great risk to go broke after closing the house flipping deal. Before concluding a real estate contract, you need to partner with a real estate agent or realtor who will help you to estimate these costs in a proper way. Also, you may check the prices of real estate comparables, or the properties that are similar to yours.
Why Use 70% Rule
To gain positive cash flow real property investors usually buy the commercial or residential properties for investment with a discount. This is being made not only to gain the return but also to eliminate the negative cash flow connected with the expenses on financing the purchase, maintenance, repair and sale of the property.
When you multiply the after-repair price by 70%, the investment piece of real estate is discounted by 30% to cover the revenue and fixed amount of expenses – 15% of return and 15% of fixed expenses.
If you implement the 70% rule, you will not overpay for the real property and also, you will be able to increase the revenue.
The formula for the 70% rule is the following:
After-Repair Value x 0.70 + Estimated Repair Value = Maximum Purchase Price
To understand how this formula works, we will review several examples.
For instance, you buy the distressed property which is estimated at $150,000. After analyzing the investment property for sale, you define that:
- After-repair value = $280,000
- Estimated repair value = $25,000
If we implement the 70% rule, then:
Maximum Buying Price = $280,000 x 0.70 – $25,000
Maximum Buying Price = $171,000
Next, we will review the other example. Imagine that the distressed property is being sold for $90,000. After the analysis, you come to the conclusion that:
- After-repair value = $200,000
- Estimated repair value = $70,000
If you apply the 70% rule, then the maximum price of the property will constitute:
Maximum Buying Price = $200,000 x 0.70 – $70,000
Maximum Buying Price =$70,000
So, the seller is asking $20,000 more than the Maximum Buying Price, according to the 70% rule.
The Accuracy of 70% Rule
The 70% approach is not a one-size-fits-all solution. Note that some flipping scenarios are different. Sometimes the investor wants to propose less than 70%, and in some cases, more than this number. The offer may depend on various reasons and factors.
If you are a real property investor and you have your personal real property license, you have the opportunity to save a large number of costs on commissions and loan payments. In this case, you will be able to propose about 75-80% of the after-repair price. When you are using a real property agent and hard money lender who helps you throughout the transaction, then the percentage will be about 60-65%.
The price that you can offer on a house depends greatly on the real estate market that you are putting money in. Lower-end markets require a higher possibility of risks and extra expenses, in comparison to higher-end markets. If you put money in a lower-end market, you may face various unpleasant things like robberies, break-ins, vandalism, and other crimes that may result in extra costs needed to cover the circumstances. In this case, the 70% rule does not work, so you will need to propose about 60-65%. On the contrary, if you chose the higher-end market for investment, you will receive such benefits as lower risks and hidden costs. In this case, 70% may be increased to 80-85%.
How To Calculate After-Repair Costs
Further, we will describe how to calculate the amount of after-repair costs if you are analyzing the house-flipping transaction. The formula includes the costs of purchasing, holding, maintenance expenses and the costs of selling along with the expected profit from the investment property. The formula is as follows:
Percentage Discount = 1 – [(Holding Costs + Buying Costs + Financing Costs + Buying Costs + Expected Profit)] / After-Repair Value
We will provide some examples that will show you how to apply the above-mentioned formula.
For example, the property that you are going to invest in is worth $90,000. The thorough analysis of the costs shows that you receive the following results:
- After-Repair Value = $200,000
- Estimated Repair Costs = $70,000
- Purchasing Costs= $3,000
- Holding Costs= $4,000
- Selling Costs= $16,000
- Financing Costs= $8,000
- Expected Profit= $30,000
Insert all the received numbers in the following formula:
Percentage Discount = 1 – [($3,000 + $4,000 + $16,000 + $8,000 + $30,000) / $200,000]
Percentage Discount = 69.5%
We receive a percentage discount of about 69.5% that is about 70%.
The Bottom Line
The 70% rule is one of the most common strategies applied in the real estate industry. However, real estate investors should not fully rely on this rule and define the offer. You can use this method if you need to make a quick analysis of the property for flipping and you need to estimate the approximate offer. Also, this analysis is useful when you need to make a detailed analysis of the expenses.
The calculation of after-repair price and estimated repair costs is vital for every real property investor because they affect the final profit and can influence the negative cash flow.
If you are new to real property investing, especially in the house flipping, then the best decision for you will be to make up a business plan. In addition, you can also ask skilled real estate investors and other specialists in this sphere for advice. Thus you will be guaranteed the lesser risks and more accurate estimates.