(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
What is the 70% rule?
The 70% rule says that an investor should pay no more than 70% of a property's after repair value (ARV).
This includes the price you pay for the property itself as well as any estimated repair costs.
ARV is the estimate of a property’s value after all repairs and upgrades are completed. It calculates the margin between a property's present day value, and the property's value once it's been renovated.
The 70% rule is a back-of-the-envelope rental property calculation and has its limitations, but it's a good starting point.
70% rule quick example
Using the 70% rule is simple. You multiply the property's ARV by 0.7 to determine the maximum price you would pay for that property.
For example, if you estimate that a property's ARV will be $300,000, this means that you should spend no more than $210,000.
Remember, you also have to take repair costs into account.
Say you estimate that the property will need $50,000 in repairs. That means your purchase price should be no more than $160,000.
70% rule vs. detailed analysis
The 70% rule is a back-of-the-envelope calculation. It's a good starting point for comparing potential investment properties.
But, it doesn't take the place of a more detailed analysis.
When running a more detailed analysis, experienced investors will include additional items such as:
- Financing costs
- Settlement costs
- Carrying costs
- Extra budgeting for unforeseen repair costs
Example of a detailed analysis:
Say you're interested in a property that is listed for $200,000.
After doing a bit of research, you learn the following:
- After repair value (ARV) - $300,000
- Repair costs - $50,000
- Repair cost reserve - $10,000 (Best practice is 20% of known renovation costs)
- Settlement costs - $20,000
- Financing costs - $10,000
- Other carrying costs - $1,000
- Total costs - $91,000
According to the 70% rule, you should pay no more than $160,000 for this property ($300,000 X 70% = $210,000, minus $50,000 = $160,000).
Now, for the more detailed analysis
Let's say you're expecting a profit of at least $60,000. This is based on factors such as risk level, extensiveness of the rehab, and expected time to complete the rehab. Experienced investors will always go into a deal with an expected profit in mind.
Starting with the $300,000 ARV, you subtract the total expenses ($91,000), then subtract your minimum acceptable profit of $60,000, to reach a maximum offer price of $149,000.
If you had only used the 70% rule, you would have paid $11,000 more than you should have for this property.
This is why you should start with the 70% rule to narrow down a list of comparable properties.
After you've narrowed down a list of potential investments, you want to always perform a more detailed analysis before putting in an actual offer on a property.
Should you use the 70% rule?
As mentioned, the 70% rule is a back-of-the-envelope real estate tool and a starting point only.
Sometimes you may only want to offer 60% of the ARV. Or in other cases, it makes more sense to offer 80% or 85%.
Keep in mind, you always want to be conservative with your repair costs and ARV estimates.
These numbers will make or break your profits, so invest the time to get them right.
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