Looking to start flipping houses? Then, one term you’ll be hearing a lot is the “70% rule”. This rule is widely used throughout the real estate world by both beginner and experienced fix-and-flip investors. Keep reading as we explain what the 70% rule in real estate is and how you can use it when flipping a house.
What Is the 70% Rule in Real Estate?
The 70% rule in real estate is a rule of thumb used by fix-and-flip investors to determine how much to offer on a house. It states that a real estate investor should pay no more than 70% of the After Repair Value (ARV) minus the Estimated Repair Costs (ERC) for a distressed property in order to gain profitability on a flip. This, in turn, begs the questions: What is ARV real estate, and what is ERC?
- The ARV is the estimated future value of an investment property after it has undergone all the necessary repairs and renovations. It is the sum of the property’s purchase price and the value of renovations.
- The ERC is the expenses that are expected to come about from repairs and renovations. They may include works such as painting, plumbing, re-roofing, new flooring, replacement of heating/cooling system, fixtures, etc.
To use the 70% rule, it is extremely important that you forecast the ARV and ERC accurately. If you are wrong in your ARV and ERC estimates, you could easily lose tens of thousands of dollars on a house flipping deal. That’s why we recommend that you consult a real estate professional who can help you get accurate estimates for these numbers. What you can do next is check your numbers by analyzing real estate comps in your housing market.
Why Do Real Estate Investors Use 70%?
Why 70%, you might wonder? Well, in order to succeed in the house flipping business, real estate investors have to buy properties at a large enough discount to not only make a profit, but also to cover all the other costs associated with purchasing, holding, selling, and financing the property (fixed costs).
Multiplying the ARV by 70% means you are discounting the investment property by 30% to cover your profit and all the fixed costs: 15% for your profit and 15% for the fixed costs.
Using the 70% rule in house flipping will, therefore, help you avoid overpaying for an investment property and put you in a good position to maximize your return on investment.
The 70% Rule Formula
The formula for the 70% rule in real estate is as follows:
ARV x 0.70 – ERC = Maximum Purchase Price
Let’s take a look at a few examples to better understand how the flipping formula is used.
Example 1
Say you find a distressed property and the seller is asking for $150,000. After performing a thorough analysis on the investment property for sale, you find that:
- ARV = $280,000
- ERC = $25,000
According to the 70% rule, the maximum amount you can pay for this property is:
Maximum Purchase Price = $280,000 x 0.70 – $25,000
Maximum Purchase Price = $171,000
Example 2
Now, let’s consider that you find a distressed property that is offered at $90,000. After performing a thorough real estate investment analysis on the property, you find that:
- ARV = $200,000
- ERC = $70,000
According to the 70% rule, the maximum amount you can pay for this property is:
Maximum Purchase Price = $200,000 x 0.70 – $70,000
Maximum Purchase Price =$70,000
In this case, the seller is asking for $90,000 which is $20,000 more than the Maximum Purchase Price of the 70% rule.
How Accurate Is the 70% Rule?
While the 70% rule makes for a quick and easy shorthand, it should not be applied to every house flipping scenario. If you were to analyze your expenses more thoroughly and in more detail, you will often notice that the 70% rule falls short of the mark. In some cases, you may want to offer less than 70% of the ARV minus the ERC on a real estate deal. And in other cases, you might consider offering more than 70%. There are, in fact, a lot of factors that influence how much you can offer on a property.
For example, if you are a cash investor and have your own real estate license, you can save a lot of money on loan payments as well as commissions on your sales. In that case, you may be able to offer 75% to 80% of ARV. On the contrary, if you are using a hard money lender and a real estate agent to sell your investment property, you may need to offer 60% to 65% to account for the higher fixed costs.
The real estate market you invest in also affects how much you can offer on a house. If you invest in a lower-end market, you will have to deal with more expenses and risks than you would in a higher-end market. Lower-end markets are typically associated with higher risks of break-ins, robberies, vandalism, and other crime-related acts that could end up costing you a lot of money. To account for these potential expenses, you may need to change the 70% in the rule to 60% or 65%. In contrast, higher-end markets are associated with less risks and hidden costs, and so the 70% may need to be bumped to 80% or even 85%.
How to Calculate Your Own Percentage Discount
As you can see, it is important for a house flipper to know what percentage of ARV to use when analyzing a house flipping deal. Luckily, there’s a formula that you can use to calculate that percentage. It takes into account all of the buying, holding, selling, and financing costs, as well as your target profit. Here it is:
Percentage Discount = 1 – [(Buying Costs + Holding Costs + Selling Costs + Financing Costs + Desired Profit)] / ARV
Let’s see how you can use the formula to calculate your percentage of ARV.
Example
Say you find an investment property offered at $90,000. After conducting a thorough analysis of all the costs, you come up with the following numbers:
- ARV= $200,000
- ERC= $70,000
- Buying Costs= $3,000
- Holding Costs= $4,000
- Selling Costs= $16,000
- Financing Costs= $8,000
- Desired Profit= $30,000
Plugging in all the numbers into the formula:
Percentage Discount = 1 – [($3,000 + $4,000 + $16,000 + $8,000 + $30,000) / $200,000]
Percentage Discount = 69.5%
As you can see, the percentage discount in this case is 69.5%, which is pretty close to 70%.
Conclusion
While the 70% rule is one of the most widely used rules for flipping houses in real estate, it should not be relied upon as the final word for what you should pay for a flip. The rule is helpful in giving a quick and approximate figure of what your top offer on a deal should be, but you will also want to perform a more detailed expense analysis as well.
Above all, be very careful and conservative when it comes to estimating your ARV and ERC. These numbers will either make or break your profits. So, be sure to consult with one or several real estate experts so as to get the most accurate estimates.
If you’re just getting started in real estate and considering the fix-and-flip real estate investment strategy, the first and most important thing you should do is create a house flipping business plan. You can then move on and start finding houses to flip. Check out the Mashvisor Property Marketplace to find the best investment properties for sale in the US.