(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
Why is the 70% rule important?
When buying a rental property there are many factors one should keep in mind.
Obviously, an important decision to make is how much to pay for the property itself.
When you're going to be rehabbing a property, you always want to take into account the repairs you make on the property prior to re-selling it.
A good starting point to calculate the appropriate price you should pay for a property you're looking to rehab is the 70% rule.
This blog will explain how to calculate the 70% rule, when you should be using it, and when it is not the appropriate method to use.
Certain factors make the 70% rule tricky to stick to as a final calculation for price, and this article will also explain when more calculations are needed to be done, over the 70% rule.
What is the 70% rule?
The 70% rule says that an investor should spend no more than 70% of a property's After Repair Value (ARV) on a property.
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 has 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. The idea is that chopping out that 30% will leave room for both your profits and miscellaneous expenses like soft costs.
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, but should be followed up with detailed analysis before actually making a purchase.
The 70% rule in real estate
The 70% Rule is an effective guideline because of its simplicity. 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, but the most important numbers in a house flipping deal are the ARV and repair costs.
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.
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.
The formula for the 70% rule is as follows:
((Property's ARV) x 0.7) - Repairs cost = Highest amount you should pay for the property
70% rule vs. 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.
An investor should always know to budget extra for unforeseen repair costs, so they’re not taken by surprise.
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
Detailed analysis additional items:
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. You should think of the 70% rule as a first step, before the more detailed analysis, not the only step.
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%.
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.
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. 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 involve annual yield and income, not just ARV.
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 with a buyer already in place, you may be willing to accept a lower profit margin on the deal and pay more than the 70% Rule would dictate.
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.
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 cost analysis.
The most important thing to remember when using the 70% rule, is to be cautious and conservative with your repair costs and ARV estimates. As you’re running your numbers, be sure to include soft costs, like financing.
These numbers will make or break your profits, so take your time to get them right. Talk 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.
Remember, it’s important to protect your savings in case of loss in the investment. 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.
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