There are 4 important variables to figure out in order to run the numbers on your potential real estate. One of the most important of those is the ARV, so you need to know how to calculate the after repair value.
What is a property worth in its current condition? What about if you add a bedroom? What if you convert the garage to living space? What about a kitchen upgrade?
Knowing the fair market value of a real estate deal is fundamental to determining if you will be creating value and making money, or losing money.
Understanding the ARV is so key that I’d go out on a limb and say you’ll never be successful if you cannot figure out what a house can be worth.
So, embrace it, learn it, and love it.
- After Repair Value Definition
- How to Calculate ARV
- Is an Upgrade Going to Be Profitable?
- How to Use the After Repair Value When Making Offers
- The 70% Rule to House Flipping
- Your Exit Strategy Affects What You Will Pay
- Knowing After Repair Value
After Repair Value Definition
After Repair Value is the estimated value of a property after all necessary repairs have been made, deferred maintenance has been corrected, and major upgrades or renovations have been finished.
ARV is an estimate made before the property sells. Once the property is sold, the selling price is generally considered the actual market value.
How to Calculate ARV
Calculating the after repair value is very similar to doing a comparative market analysis. There is one important difference though.
When determining the ARV, you will be using your subject property, but using hypothetical information based on the upgrades you will be performing. This is because repairs and upgrades haven’t been made yet.
You do this by taking the current value then adjusting it by the value of upgrades, which are determined using the CMA method.
Estimating the Value of an Upgrade
Let’s use a hypothetical 3 bedroom, 2 bathroom, 1,250 square foot house that is worth $125,000 in its current condition. You want to know what the property would be worth if the kitchen and bathrooms were upgraded.
Step 1) Find several similar properties with a few that have no upgrades and a few that have the upgrade you’re looking for.
Step 2) Make any adjustments for any other differences.
Step 3) Take the average price for each group of houses.
Step 4) The difference between the two is the value of the upgrade.
Example of Estimating the Value of an Upgrade
We found 3 great properties that are in a similar condition to our subject property. We also found 3 that have upgraded kitchens. Let’s compare
Average – $125,416
Average – $145,333
To estimate the value of this upgrade just subtract the two.
$145,333 – $125,416
Value of a New Kitchen = $19,917
Calculating the ARV
Once you have a list that estimates the value of each upgrade, you can just add them together.
Current Value – $125,000
New Kitchen – $19,917
Bathroom – $4,570
Estimated After Repaired Value – $125,000 + $19,971 + $4,570
ARV = $149,541
Is an Upgrade Going to Be Profitable?
At the most basic level, we can compare the increased value to the cost of upgrades to determine if it’s profitable. If the project cost is $20,000 and the value of the house is expected to increase by $24,541 then we can estimate that you will have created almost $5,000 worth of equity.
With this sort of granular level data, you can dig very deep into your project to determine which upgrades you need to perform and which are not worth it. We know that kitchens generally have the highest return on the upgrade, so let’s dig really deep into that.
You may be looking at two possible kitchen designs for this house, a premium and an average level. With the premium upgrade package, you would put in better cabinets, appliances, and countertops than the base level. But there are obviously different costs involved.
The quotes from your contractor are:
Base Level: $15,000
Premium Level: $25,000
Will the better quality kitchen give us better or worse returns?
Upgrades Should Match the Market
Not all upgrades are going to be profitable. Many people over or under improve a property.
You might be wondering what it means to over-improve a property. To understand this, we need to understand the psychology of shopping.
Perhaps you want to buy a car. You need it to get to work and a few places around town, but that’s all. You don’t want something fancy to get these things done.
When shopping, you find a slightly used car without many features, and it’s selling for $10,000.
You also find another slightly used car, but it’s the top trim package and is selling for $25,000.
While the more expensive car is clearly much better, you just need it for some basic usage. Would you pay the extra $15,000 for the car?
A house is similar, especially this 1,250 square foot starter home for $125k. This house is like the base package for the car – it has few amenities or upgrades because the buyers don’t need them and aren’t willing to pay for them.
Doing the crazy kitchen remodel might make the house sell for far more, or the buyers aren’t willing to pay that premium for that upgrade.
Comparing Upgrades to ARV
So, it’s important to check the value of the upgrades for each house and area because nicer upgrades are not always better.
Continuing this example, you can do two sets of analyses to determine the value of the kitchen upgrades. The first one you already did and the kitchen upgrade adds $19,971 to the value of the house.
And let’s say the nicer kitchen adds $27,000 to the value of the property. Now it’s time to compare. Since we are looking to make a profit, we want to see which one makes more profit for us which is value – cost = profit.
Base Upgrade Profit = $19,971 – $15,000 = $4,971
Premium Upgrade Profit = $27,000 – $25,000 = $2,000
Based on our numbers the base upgrade package is actually more profitable for this particular house. If we were looking at premium quality houses, then the answer would be different. But for this starter-home, the base package is better.
How to Use the After Repair Value When Making Offers
You will want to make an estimate of ARV any time you plan to do work on a property. Generally, when we purchase property, we plan to make upgrades. So, determining the ARV should be part of every transaction you are ever involved in.
Let’s use the numbers above and say you found a property that you think will have an ARV of $160,000. Now let’s work backward to determine your offer price.
First, deduct your profit goal from the number. Let’s use an even number of $10,000.
So Purchase Price – Profit Margin
$160,000 – $10,000 = $150,000
Now deduct fees, closing costs, attorney costs etc… To make it easy, say it’s an even $10,000 also.
$150,000 – $10,000 = $140,000
So far we can offer $140,000 and break even. But we aren’t in business to break even so let’s continue.
You plan to do a ton of work on it. Your contracts quoted you $35,000 and you add $5,000 for contingency expenses. $40,000 total
$140,000 – $40,000 = $100,000
Based on this simle example, our offer price should be no higher than $100,000.
That seems a little too simple… right?
Well, we can get more complicated and factor in some additional unexpected costs or reduce the estimated sale price to give us more margin. But, we’re keeping it simple for illustrative purposes. But, this is truly how simple the process is.
The 70% Rule to House Flipping
There is a “rule of thumb” that many real estate investors use to determine their offer prices. It’s called the 70% of ARV rule.
Like any other rule in real estate, it is more of a guide than a rule.
All the rule states is that you should never pay more than 70% of the ARV, once accounting for repair costs. So, with the example above, 70% of $160,000 is $112,000.
Now subtract the repair costs from that ($112,000 – $40,000) and you get $72,000.
Why is the 70% rule so different from the example?
You probably noticed the answers are dramatically different in the two examples.
In the first example, I didn’t build in much miscellaneous expenses and I also had a very small profit margin of only $10,000. It’s because in the first example I didn’t build in any margin for error. If you took 10% off the ARV for safety and added 10% to the repair costs, you’d get an offer price of roughly $80,000.
Alternatively, you could bump up the profit margin to a healthier $25-$40k and also get to a similar answer.
Additionally, the 70% is a bit more conservative than breaking down every line item. That’s because it bakes in a 30% gross margin. This will work in some markets on some types of properties, but the 70% rule gives too low of offer prices in most markets.
The 70% Rule is Meant to Be Broken
Every market is different and this “rule” is just a guideline.
A highly competitive market may require your “rule” to be more like the 80 or 85% rule. A less competitive market may allow you to go even lower than 70%.
So, don’t just take this rule and assume it’s the answer. You really need to look at your market and estimate a ton of deals before you get an idea how competitive it is.
Your Exit Strategy Affects What You Will Pay
The example above has been for a flip, so, what if you plan to keep it? Should you pay more for a property you want to keep for a while instead of flip?
The answer is: absolutely.
Landlords are generally willing to pay a bit more for a property than a house flipper because landlords take a long-term approach.
I’m not saying you should pay more for a property than you need to, but it’s completely realistic to say that your goals affect your strategy.
Let’s take the example above and say you couldn’t get your offer price, but you could get it for $10,000 more.
That would completely wipe out the estimated profit. It would definitely make this a bad deal for any house flipper.
But, $10,000 is only about a $50/month difference on the mortgage. The landlord can almost definitely absorb that cost and still have solid cash flow on the property.
The landlord may also benefit from appreciation in the property if the market appreciates over the holding period.
The key to being successful: know your numbers and see how they relate your goals and strategy.
Knowing After Repair Value
The after repair value is one of the most fundamental pieces of data we will have when doing deal analysis for any real estate transaction. Without knowing the ARV you are flying completely blind.
But, with the ARV you can tailor your projects and ensure you get the maximum profit for each deal you do.