We real estate investors — we are such rebels, aren’t we?
We all seem to want to break the rules. I think we’re all guilty of it at times. I know I am.
But every time I break the rules, it ends up hurting me really badly. Breaking the rules may seem like a great idea at first, but when you break the rules of house flipping and real estate investing, you are really just hurting yourself.
There are tons of examples of breaking the rules, including not adhering to the 70% Rule, using “eraser math” on your ARV and MAOs or maybe dealing with a partner or a team member in a way that goes against your morals.
The hardest one to get over is the last one listed above. Whatever you do, I recommend not breaking those rules ever. But the other rules, especially the 70% Rule, can be broken in very special circumstances.
Breaking the House Flipping Rules
I’ve recently had a ton of questions from readers of this blog and my own blog on how to flip houses when the 70% Rule may not apply to their market. It may not apply exactly — but it does still apply.
There are many markets in the country that are more expensive than the one that I operate my house flipping business in. Massachusetts by and large is a fairly expensive place to live, but the sub-market where I operate is relatively affordable by comparison to the rest of the Massachusetts real estate market.
I’m well aware of the fact that Wareham, Massachusetts is really not in the same league as Orange County, California with regard to price. However, I have flipped many houses outside of my market and have been very successful doing it using the same principles that I use in my primary market. These are markets that are a little bit pricier and although the 70% Rule does not apply exactly, it still does apply.
As you may recall, the 70% Rule is a benchmark we use to determine how to do our house flipping math.
How to Flip Houses Using the 70% Rule Review
As you may recall, the 70% Rule keeps you out of trouble when you’re flipping houses. It also prevents you from doing “eraser math” when you’re evaluating how to flip houses. I see lots of different ways to evaluate a property, but the 70% Rule is the rule that I’ve always stuck with because although it does not exactly apply in every circumstance, it is an excellent benchmark to use to keep you honest and ensure a good profit on the property.
So, for example, you’ve determined that the after repair value of a certain house is $200,000.
There are several comps in the area in the past six months that indicate that $200,000 is a fair price. These recent sales give you a good benchmark to begin your math.
1. You take the $200,000 and multiply it by 70%, which equals $140,000:
ARV = $200,000
70% Rule: $200,000 x .70 = $140,000
2. Deduct your repair costs from that $140,000. Your rehab expenses will be $40,000, according to your contractor.
Now, using the 70% Rule, subtract the $40,000 from the $140,000:
Repair costs = $40,000
70% Rule = $140,000
The maximum price you want to pay for this house is $100,000:
Maximum purchase price = $100,000
However, there’s a bit more to it…
This formula is extremely effective at keeping you out of trouble, especially when you are first starting to invest in real estate or to flip houses. But as with any “rule,” there are always going to be exceptions…
Before You Break the Rules…Do this FIRST
Like I said before, Wareham, Massachusetts, is not Orange County or Naples, Florida. There are plenty of other markets that are far more expensive to invest in real estate.
That being said, there will always be pockets of submarkets that are more affordable, carry less risk for the new real estate investor and are perfect for potential house flips.
So if you are new to real estate investing and house flipping, in general I highly recommend you seek out those less expensive submarkets or even neighborhoods or streets within towns that are more expensive and start there.
Doing a house flip for an ARV of $200,000 is far less risky for the new real estate investor instead of doing a house flip for $400,000 or maybe even $500,000. Even in that $400-$500,000 market, there will be submarkets, neighborhoods and even individual streets that will be more affordable.
Seriously. Find them. Look for them. Ask your real estate broker about them. They are out there.
You may have to travel 15 or 20 miles outside of where you live, but it’s far less risky to start in these submarkets than it is to start your house flipping business in the more expensive markets.
However, if for some reason you cannot find those more affordable markets, here are some helpful steps on how you can invest in those more expensive markets by slightly breaking the 70% Rule.
When to Break The 70% Rule – USE EXTREME CAUTION
So let’s say you live in Boulder, Colorado and your market is in the $400,000 range. The 70% Rule can potentially be raised to 80% depending on many other circumstances. Although I would make the case to travel outside of Boulder to find some less expensive homes to flip, like Berthoud, CO 26 miles away with an average sales price of $266,600!
But for the sake of argument, let’s use Boulder, CO as an example.
The bottom line is this: the 70% Rule is flexible and keeps you of harm’s way –- but it depends on your market. If you just absolutely have to invest in Boulder, CO then you can potentially go to 80%.
As a general rule, the higher the price a property, the more flexibility you have on upside for the 70% Rule. In these cases over $200,000 ARV, you may consider that price range to be “higher-priced” in your market. It all depends on your local market.
But if you are going to break the 70% Rule, you have to be absolutely certain that your costs for rehab, financing, carrying costs and any other soft costs are dead on. You cannot use any “eraser math” on any of these cost projections. In addition to that, you must be prepared for the potential for downside risk.
For example, if your ARV suddenly fluctuates downward to $350,000 instead of a projected $400,000, you just gave up $50,000 in potential profits. Yikes!
Let’s say your cost projections for this flip was $60,000 for the renovation, but all of a sudden it’s now $80,000 — because of some issue with the foundation or maybe some major work is now needed on the HVAC system…are you prepared for these cost overruns?
If you’re flipping using the 70% Rule, you’ll have enough cushion to absorb these cost overruns or sudden drops in ARV.
If you use the 80% rule, you will be far less likely to turn a profit. So you need to be prepared for this potential for downside risk.
This is why it’s extremely important that when you’re first learning how to flip houses, stick as close as you can to the 70% Rule. This one simple rule has kept me out of more bad deals that I can even care to remember!
My Experience Flipping Houses with the 70% Rule
By using the 70% rule, it allows me for about a 30% margin on my flips. In some cases its higher than that. I’m very comfortable with a 30% margin because it allows for cost overruns, and gives me some flexibility with an additional value added costs.
If you aim for 30%, your take-home profit will be roughly 10 to 20% on average, once you figure in finance costs and other soft costs.
If you feel the fees disrupt the 70% Rule to the downside then just run a detailed cost analysis of all your expenses and see where you come out.
Not every flip you do is going to make you $65,000 in profit. The media and the house flipping reality TV shows make you believe that this is the case. And it’s been widely reported in some major news publications that house flippers make a ton of money on each and every flip. Its just not going to happen on every flip for you.
When you flip properties that are more expensive, there is the potential to make more profit for sure. But with that potential profit, there is increased risk. So if you break the 70% rule and go to the 80% rule instead, are you prepared?
70% or Bust?
As you may already know, every house flipping market is different, with different taxes, different lending environments and different price points. In some cases, I have gotten questions for markets as far away as Malaysia, New Zealand and Australia on this question.
As you can probably guess, the markets are slightly different from those our market house flipping in Wareham, Massachusetts!
So stick to the 70% Rule as much as you can. Adjust the 70% Rule based upon your market conditions, but don’t get too aggressive. The most important thing to remember is that the 70% Rule is there to guide you and keep you out of trouble, while ensuring a nice tidy profit in the process.
If you made it this far, leave a comment below! Have you broken the 70% Rule? How did it turn out for you? Did you make money, lose money break even? Leave a comment below and let me know!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.