How to effectively use the Rule of 70% in House Flipping!

How to effectively use the Rule of 70% in House Flipping!

Whether you are a new or seasoned real estate investor flipper, calculating how much you should offer on a property is one of the most important factors to consider.

So how do you determine what you should pay for the property?

Following the “70% Rule” in real estate will help you easily determining if you are over paying for a property. It is said that you make your profit on the buy, so you don’t want to come out of the gates overbidding for a property!

So how exactly is the 70% Rule applied in house flipping?

When calculating the highest price you should consider in purchasing a property, the 70% Rule of real estate investing mandates that you should pay no more than 70% of the after repair value (ARV), minus repair costs.

For those of you new to real estate flipping you might be asking: “What is ARV in real estate investing?” In essence, the ARV is the estimated value of a property after all repairs are completed.

For example, if a property’s ARV is $300,000, and it needs $50,000 in repairs, then the 70% Rule mandates that the most an investor should pay for it is $160,000: $300,000 times 70% = $210,000, minus $50,000 = $160,000. The notion is that carving out that 30% should leave ample room for both your profits and miscellaneous expenses like soft costs.

But the 70% Rule in house flipping is not a hard and true maxim. It is simply a frame of reference to help you get into the right property at the right price with a profit when you exit the investment.

Uses of the 70% Rule in real estate:

The 70% Rule is is like another set of eyes to help you determine if the house you intending to flip is even in the within the range of being a good value proposition. There are obviously other contributing factors you will be considering in determining as to whether you should make an offer. The rule of 70% will serve as a valuable benchmark when evaluating prospective deals.

The 70% Rule will serve you as an effective guideline. This allows you to focus on the two most important numbers when considering a deal. First the ARV ( after repair value) and the actual repair costs, also referred to as rehab costs. Naturally there are other soft costs ( which we will discuss), but the meat and potatoes is the ARV and repair costs.

When forecasting those numbers accurately, it’s highly unlikely you’ll lose money on a investment. But if you miscalculate in your ARV and repair costs estimate, you could easily lose untold thousands of dollars.

Concentrate on these numbers when evaluating potential deals and make sure you are realistic and accurate as possible before deciding how much to offer on a property. Next, you want to analyze the comparable (comps) properties in your market with the precise methodology.

Perhaps get a second opinion of the ARV. Remember you want to being looking at properties that are similar is size and style that have sold within the last year. The less closely the comps reflect the property in question, the less accurate you should consider your ARV estimate.

Based on estimated ARV and repair costs, you can back into your offer price. You are business to make money, which will be a representation of which properties to make offers on and how much to offer. The 70% Rule in real estate cuts to to the critical numbers in a house flipping deal, and forces you to pay close attention to them.

Lets take a closer look at the math in House Flipping:

How well does the 70% Rule holdup in house flipping against in more detailed analysis?

A deeper analysis on return on investment analysis, investors should account for are expenses such as financing costs, settlement costs, carrying costs, and other so called soft cost associated with real estate investing.

Prudent investors realize how important it is to budget extra for unforeseen repair costs, so they’re not blindsided.

Here’s an example of a deal and a breakdown of expenses:

Repair Costs: $80,000
Repair Cost Buffer/Reserve: $16,000 (20% of known renovation costs as a general best practice)
Settlement Costs (including both transactions): $30,000
Financing Costs (including both lender fees and interest): $10,000
Other Carrying Costs: $3,000
Total Expenses: $138,000

These are all part of expenses of flipping a home.

According to the 70% Rule in real estate, I should pay no more than $200,000 for this property ($400,000 X 70% = $280,000, minus $80,000 = $200,000). In my more detailed analysis, let’s say I want a profit of at least $60,000, 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 $400,000 ARV, I subtract the total expenses ($138,000), then subtract my minimum acceptable profit of $60,000, to reach a maximum offer price of $202,000.

In this example, the 70% Rule matched up closely with the more detailed expenses analysis. However, that is not always the case.

How accurate is the 70% rule in house flipping?

Remember the 70% is a rule of thumb. There are always exceptions to the rule.
In real world of real estate investing, there are instances where you may only want to offer 60% of the ARV, minus repairs. Or in other scenarios, you can comfortably offer 75% or 80%.

Here a few points that influence how much you can offer in practice:

Market Price Point:

In lower-end property markets, you might experience high related expenses to getting the deal across the finish line. You might encounter a lender wanting higher points for risks associated with theft, vandalism or stolen equipment. One has tp be careful with loses that can be associated with crimes. Such loses can eat way at ones profits

Bear 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. You can get economies oof scale with a higher-end project.

Exit strategy:

While the 70% Rule can be a useful tool for flipping houses, however it’s less effective for other exit strategies. Rental investors may not be needing to renovate the property as extensively and are planning to hold the property long-term. Because their primary goal is cash flow, rather than a one-time payout based on ARV, their estimations typically center 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 venosity if 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 should head the 70% Rule:

As outlined above, there are plenty of reasonable scenarios to buy higher or lower than the 70% Rule suggests. However, 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.

Final Thoughts:

The 70% Rule in real estate makes for an instant figure for a ceiling price on your offers. However, before actually making an offer, you’ll want to run a more detailed expense analysis.

Moreover, be cautious and conservative with your repair costs and ARV estimates. These numbers are the cornerstones for 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 calculating your numbers, be sure to include soft costs, like financing. Remember, it’s better to make more money on fewer deals, than to do more deals and risk losing a lot of 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 banking more!

- Ted Root

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