There are a lot of different rules of thumb for running any business in any industry. In real estate, you will often hear about the 70 percent rule when flipping houses.
The 70 percent rule is a rule of thumb that when followed gives you a high probability of being profitable on a house flip. In this article, we’ll dive into the calculation of the 70% rule for house flipping, go over some examples, and talk about some shortcomings of the rule.
- What is the 70% Rule?
- Why is the 70% Rule Important?
- Problems With the 70 Percent Rule.
- The 70 Percent Rule In Practice.
- When Should Properties be Bought for More Than 70% of ARV?
- 70% Rule Conclusion
What is the 70% Rule?
The 70% rule suggests a real estate investor should pay no more than 70% of the value of a house after repairs are complete. This is used to calculate the maximum offer on a property by calculating the After Repaired Value (ARV) then subtracting out a 30% margin and also repair costs, to ultimately give an offer price.
How to Calculate the 70 Percent Rule.
The 70% rule is an approximation, not a hard and fast rule. So, don’t take it too seriously. In fact, in many markets, you could never find a deal at 70% of ARV, as many houses will sell 80%, 85%, or even 90% of ARV. While it may not be advisable to purchase deals with that high of a ratio, many people do that anyhow.
The 70% Rule estimates the maximum price you can offer for a given property with respect to two primary variables – After Repair Value and Estimated Repair Costs.
The formula for the 70% rule is:
Offer Price = 0.7*ARV – Repair Costs
This formula is generally used to estimate the purchase price of a fix and flip. It can also be modified to make offer prices for wholesaling. If you were to modify it for wholesaling, you would simply subtract your wholesale fee in addition to the repair costs. The 70% rule for wholesaling would be:
Offer Price = 0.7*ARV – Repair Costs – Wholesale Fee
70% Rule Example For House Flipping.
Let’s say you want to purchase a property in your local market. After doing a comparative market analysis, you determine the property will be worth $250,000 once all the upgrades and repairs are complete. You also estimate the cost of repairs will be $50,000.
So, the ARV = $250,000 and Repair Cost = $50,000. Let’s punch this information into the formula:
Offer Price = 0.7 * $250,000 – $50,000
Offer Price = $175,000 – $50,000
70% Rule Offer Price = $125,000
70% Rule Example For Wholesaling.
The 70 percent rule states that a real estate house flipper should not pay more than 70% of the ARV minus any repairs.
As a wholesaler, you’re aware of the rule that investors are following, so you should strive to match it. As such, use the 70% rule and subtract your wholesaling fee. Let’s use the example above.
The ARV = $250,000
Repair Costs = $50,000
Wholesaling Fee = $7,500
Let’s remember our formula is:
Offer Price = 0.7*ARV – Repair Costs – Wholesale Fee
Offer Price = 0.7 * $250,000 – $50,000 – $7,500
Offer Price = $175,000 – $50,000 – $7,500
70% Rule Offer Price = $117,500
Why is the 70% Rule Important?
This “rule” is critical because the ARV and rehab are used in conjunction to calculate the formula. If either of these numbers is inaccurate, there’s the potential to operate on less-than-desirable margins. If the wrong price is calculated, profit margins can quickly diminish or be wiped out completely.
ARV and rehab should always be fixed numbers based on the investment exit strategy; however, the ARV percentage amount minus repairs should be variable. Furthermore, this rule may be completely disregarded as investors become more creative in real estate investing.
For instance, if investors intend to buy and make a long-term hold play, betting on appreciation, they may very well be able to afford to pay more. If this is the situation, investors may be able to buy at 101% ARV if the financing is favorable and the area is desirable. The point is that exit strategy matters.
Problems With the 70 Percent Rule.
The problem with this “rule” is that many interpret it literally. There is quite a bit of misinformation surrounding this rule, and the goal of this blog post is to dispel false information and educate individuals on how to be more competitive in their local marketplace.
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. In fact, it is not really a rule at all, but rather a guideline—especially in today’s hot housing market, when investors may need to more carefully examine their investments and calculate the numbers to make more attractive offers.
Investors who try to uniformly apply this 70% rule will get fewer offers accepted and miss out on deals because their offers will be less competitive. Being in tune with the market is also key and allows investors to make more competitive, fairer offers that have a higher chance of being accepted.
The 70 Percent Rule In Practice.
For this formula to work correctly, it is critical the numbers for both the ARV and Repair Costs are accurate and also conservative. Don’t forget to always calculate a cushion!
Adjust the 70% Rule for the Local Market.
Certain costs in real estate are fixed. The higher the cost of the house, the smaller the closing costs are as a percentage of the value of the house.
Also, the profits people are looking for don’t adjust perfectly for different priced houses. You might want a $20,000 profit on a $100,000 house but you probably don’t expect a $200,000 profit on a $1m house. Maybe you expect $100k instead.
So, the 70% rule should be lower for cheap markets and higher for expensive markets.
A small rural house worth $100,000 you might be able to negotiate the price to a 65% or even 60% number. Unfortunately, it is highly unlikely you’ll pick up the $2m triplex for a 40% discount. Competition will drive that number up and you’ll likely pay 80-90% of the ARV.
Similarly, you need to adjust for the local market demand. Major metros generally see higher ratios whereas small towns see much lower ratios.
So, cheap houses in small towns have the lowest ratios in general. On the other hand, expensive houses in major metros have the highest ratios and least amount of discounts.
Adjust Based on Your Exit Strategy.
You can adjust the rule based on what you intend to do with the property. As we’ve already stated, there are two primary uses for the 70% rule – for house flippers and wholesalers. So, you already know you can adjust the rule.
But, rental property holders use this rule as well. A landlord who will hold this property for years is expecting to get rent on top of appreciation. Also, they don’t need to calculate selling costs upfront because that is a cost they will incur 5 or 10 years from now.
So, adding back in the 5-6% closing costs, and another 5% or more because of the different strategy, and landlords often pay 80-85% of the ARV which allows them to refinance and take out most of their initial investment.
When Should Properties be Bought for More Than 70% of ARV?
The 70% rule is a good indication of the price you should offer, but it is not the only tool and should not be used alone. It would be crazy to purchase an expensive property without listing out every single cost you plan to incur and accurately calculating your returns.
The savviest investors will calculate a precise offer based on all of the costs and a budgeted profit margin. An investor will estimate all the carrying costs, budgeted rehab, and planned profit margin.
Costs to Consider When Buying Property
There are dozens of potential costs to consider when purchasing a property, regardless if it’s a wholesale, flip, or rental property. The biggest cost categories to consider are:
- Carrying costs (utilities, HOA, insurance, taxes)
- Closing costs (Front and back end)
- Miscelanious costs (pad your budgets)
Also, don’t forget to include your planned profit margin.
The 70% Rule vs Other Models to Estimate Offer Price.
A more precise formula would look like:
Offer Price = ARV – Profit – Carrying Costs – Closing Costs – Rehab Costs
So, using the previous example, let’s say you calculated the closing costs and carrying costs for the property.
Closing Costs: $6,000
Carrying Costs: $3,500
Budgeted Profit Margin: $25,000
Offer Price = $250,000 – $25,000 – $6,000 – $3,500 – $50,000
Offer Price = $165,500
As you can see, this alternate method gave a higher offer price than the 70% rule.
Every market will reach some sort of equilibrium for those profit margins. What that means is if the average profit is $0,000 in a market, prices will reflect that. If more investors enter the market and are willing to take a lower profit margin, then prices will creep up over time.
When to Not Pay More Than 70%
There are a lot of reasons why investors pay more than 70%. But, most of them boil down to one thing – taking a cut in profits to be more competitive with the offer.
As stated earlier, every market will achieve some sort of equilibrium and it definitely will not be exactly at 70%. It may be close, but markets don’t work so specifically as to follow a single rule.
Instead, the real questions should be 1) Are you willing to accept the prevailing market profit margin and the risks associated with it? and 2) Am I willing to cut into that profit margin to win a deal?
If the answer to #1 is a ‘no’, then you should find a different market to invest in that has higher profits or lower risks.
Your answer to #2 should be ‘no’ but many investors ignore that. Here are some common reasons why investors eat their own profits to win deals.
Real Estate Agents
The number one reason people pay more than the 70% rule is that they are a real estate agent.
Agents earn a commission when they purchase the property and they also get a commission when they sell it. On average they earn 2-3% of the purchase price and another 2-3% of the sales price. So, many agents are willing to cut into their commissions in order to win a deal.
For example, if they purchase a property for $100,000 and sell it for $200,000 they earn somewhere between $6,000 and $9,000 in commissions. Many agents are happy to offer an extra $5,000 or $7,000 on the offer price to win the deal.
Another issue is a new investor trying to break into the industry. It can be difficult to be taken seriously with no experience, so many investors may have to take a significantly reduced profit margin in order to get their first deal done.
Unfortunately, many of these investors earn very little or even lose money on their deal which puts them out of business right when they’re trying to get started.
When It’s OK To Pay More Than 70%
Investors that have been flipping for years will know the costs and values more confidently than other investors.
Because of this, they can offer much more than other investors because they have reduced uncertainty in their pricing. Additionally, they may have negotiated lower prices for many services because they provide a lot of volume to the contractors or suppliers.
Another reason to adjust the rule could be about your financing. A newbie house flipper getting a 12% loan with 2-3 points can pay a lot less than an experienced landlord with long-term financing lined up at 4%.
Additionally, an investor with 90% Loan to Value financing may be able to pay more than another investor with a lower LTV, but you can still earn the same or higher return on investment.
70% Rule Conclusion
Use the rule as a starting point then make adjustments based on your market, your strategy, and your profit expectations.