The 70% Rule: One Critical Formula Investors Need to Know
The 70% of ARV (after repair value) "rule" is a formula commonly referred to by real estate investors, and used as a barometer when purchasing distressed real estate for a profit. The formula will calculate the maximum you can pay for a given property once you input two key factors, namely the ARV and estimated repair costs.
For this formula to work correctly it is critical the numbers you have selected for both the ARV and ERC are accurate and conservative. The problem with this "rule" is how many interpret it literally. There is quite a bit of misinformation and myths surrounding this rule, and the goal of this blog post is to dispel false information and educate individuals how to be more competitive in their local market place. In fact it is not really a rule at all, but rather a guideline. It is critical to realize the 70% "rule" is not a one size fits all model that can be applied universally to all situations, markets or exit strategies. As a result investors who try to uniformly apply this 70% rule will consequently get less offers accepted. If you treat it with such regard, you will miss out on deals because your offers will be less competitive. Being in tune with your market is key and allows you to make more competitive, fair offers that have a higher chance of being accepted.
In this first section we will discuss how this rule is often referred to in theory. In the latter half of the article I will touch on how this rule is used in practice.
The formula itself is rather simple. Once you have calculated the ARV and ERC, you simply plug in the numbers. For this hypothetical example we will use a house that has an ARV of $100,000 and needs $20,000 in rehab. The last variable to figure out then is what discount you need to buy at. In this case we will use the traditional 70% rule, so we will plug in .7. Please refer to the chart below that illustrates the calculation.
Why is This "Rule" Critical?
This "rule" (read guideline) is critical, because as we all know, you make money in real estate when you buy. If you come in at the wrong price your profit margins can quickly diminish or be wiped out completely. The ARV and rehab are then used in conjunction to calculate the formula. If either of these numbers are inaccurate, you have the potential to get in over your head, or operate on less than desirable margins.
ARV and rehab should always be fixed numbers based on your exit strategy; however, the % ARV you buy at less repairs should be variable. Furthermore, this rule may be completely disregarded as you become more creative in your real estate dealings. For instance if you are intending to make a buy and make a long term hold play, betting on appreciation, you may very well be able to afford to pay more. If you are purchasing subject 2 , you may be able to buy at 101% ARV if the financing is favorable and the area is desirable. The point is exit strategy matters.
Housing Inventory Price Point:
The 70% rule can adjust depending on the price point of the housing inventory. For instance if you are purchasing lower end housing here in Texas (ARV $70-$90k) you may be able to buy at deeper discount, for instance 65%. The best way to get in tune with your local market area is to review what recent cash sales have been in the same subdivision as the subject property. If you are rehabbing, it will show you what margins everyone else is operating on. If wholesaling is your exit this will show you how much of a discount you need to buy etc.
Major Market Area:
All real estate is local, and major market areas influence the formula. You will need to adjust the formula based on the market you are buying in. For instance, in California you may need to adjust the 70% figure to go as high as 80 or 85%. Compared to the Dallas - Fort Worth Texas where housing is more affordable the 70-78% should serve you well. Even more important is the hyper local factors based on the subject property itself. The ARV % you can buy at will fluctuate from zip code to zip code, subdivision to subdivision, even within the same major market area.
This rule will fluctuate based on the exit strategy as well. For instance land lords will be able to pay more typically than someone who intends to flip the house. Why? The rehabber will have a higher level of finish out, thus their repair costs will be higher, plus they need to factor in realtor commissions and other expenses. In contrast, a landlord will be able to pay more because their strategy is completely different, often trying to gain short term cash flow and long term appreciation. For example, here in North Texas land lords are commonly buying at 76-80% ARV for their rentals.
Other investors may prefer a different formula, for instance calculating your offers based on what YOU want to earn on the project. For example, if you wanted to rehab a house and net at least $18,000 after accounting for factors such as: holding costs, closings costs, realtor commissions etc there are models for that as well and a viable alternative to the 70% "rule".
The 70% rule is more of a guide line and not a hard and fast rule. The % of ARV you can pay, minus repairs, will vary based on: local markets, exit strategy and housing type. You need to take all of the above into consideration when calculating your offer. If you do so, your offers will be more competitive and in tune with your local market place instead of trying to apply the 70% formula as a blanket rule. I hope this article has been educational and informative. If you have any questions, feel free to leave them in the comments below and I will do my best to address them. Thank you for reading.
The best stock formula
It's no secret that investors tend to be impatient with the market, but the best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.
This article is Copyright 2014 BiggerPockets, Inc
The article The 70% Rule: One Critical Formula Investors Need to Know originally appeared on Fool.com.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.