70% - Repairs?

Question

I've never purchased a property with the intention of flipping. Always with the plan of buy and hold. I know many flippers look for property that they can buy at 70% of ARV minus the cost of repairs. I assume this equation applies primarily to property that they dont plan on generating any income from while owning the property.

My question is, if I you plan on generating some rental income during the time that you own the property would that change how much you would be willing to pay for the property?

For example:
If the ARV of a property was 100k and repairs were 10k and there is no possibility of rental income I assume most people would be willing to pay 70k-10k=60k max purchase price.

What if you could realistically expect to generate 4k in rental income with the same scenario. Would you then be willing to pay 70k-10k(repairs) +4k(rental income)=64k?

Seems like if i'm buying based on the first equation and my competition is buying based on the second equation then I might be pricing myself out of many deals and getting beat by my competition.

Jon Holdman · Answer

IMHO, no.  Consider the rental aspect and the flip separately.

If you're doing a fix and flip, you're likely using some sort of short term, high rate financing like hard money.  Hard to get enough rent to cover that.

If you're going to fix, put a renter in place, then try to sell, you're just hurting yourself.

1) A renter being there is going to make it harder to sell.  It will be harder to show, and very likely messier.  They will probably be there when showing (I've looked at many, many tenant occupied houses and the tenants are very often present.)  They can make it difficult if they have some rooms blocked off.
2) The tenants will have to leave on short notice.  Hard to get a tenant to sign up to something like that.
3) The tenants will do damage.  Maybe minor, but damage all the same.

Now, if you mean you're going to buy, fix up enough to rent, hold a few years, then sell, that's one thing.  But if you just mean a few months or even a year, don't bother.

Sam M. · Answer

It doesn't make any sense to me to spend 4k more now with the expectation of getting 4k out later. You are figuring nothing as a return on your extra 4k and you will take on some additional risk renting the property.

How does this make sense to you?

Jon Holdman · Answer

If you don't have high money costs, you can pay more and still have the same profit.  Built into that 70% formula is an assumption that you are using hard money and that you can complete the deal in about six months.  That means the money costs will be about 10% of the amount borrowed, or about 7% of ARV.  If you have your own cash, you could pay about 7% more, or 77% of ARV and still have the same profit.

OTOH, you could take that cash and do had money loans yourself, or something else.  So to completely give up the profit from the cash is probably not the right answer.  So maybe 73-75% would be appropriate.  That means you'll be able to do deals others can't.

With multis, occupancy has a strong influence on value.  A 50% occupied multiple is worth quite a bit less than the same multi occupied at 90%.  So, a big part of flipping a multi would be to buy one with low occupancy and bring the occupancy up.  If you buy right - that is, based on the current occupancy and not a proforma fantasy - you should get a significant discount.

So, yes, I would consider the rent I would receive.  However, I would also consider the usual rental property expenses.  I would consider the rent as a "negative holding cost".

The 70% rule is only a starting point.  It works OK as long as you fit into its assumptions: hard money to buy, six months to hold, sell with a normal real estate commission.  For what you describe, those assumptions don't fit. So, you have to go back to basic principles.  Take what you think will be your eventual selling price.  Subtract off:

1) Selling costs
2) Holding costs
3) Repair costs
4) Money costs
5) Purchase costs
6) Desired profit.

What's left is your max purchase price.

In your case, you have zero explicit money costs.  I'd still include some amount of money costs because you could do something else with that money.

If you expect to actually be renting for some length of time, I'd estimate holding costs using the 50% rule and the scheduled gross rent.  That gives you your routine expenses for a long term rental property and assumes a nominal amount of vacancy.  Call that 10%.  If your vacancy is higher than the 10% figure, compute the lost rent and include that in your holding costs.  Now, add back the gross scheduled rent.  The net (that's the net operating income) should be a positive number, if the occupancy is fairly high.  If occupancy is low and you're doing a turnaround, the net operating income may be negative at first, the turn positive as you fill up the property.

Keep in mind that as you're doing your fixup, some tenants may have to be moved around and may leave.  Its reasonable to expect that you will raise rents as you renovate the units, and that will cause some turnover, too.  Just be sure and account for these factors.

I suspect you'll be hard pressed to fix and flip an apartment building, or even a tri or quad, in a few months.  SFRs have lots of potential buyers.  Much smaller buyer pool with multis.  So that means a longer holding time.

Andy More · Answer

Thanks for the replies so far, keep em coming!

Vikram, makes sense, look at the whole picture and make sure the return of the whole project justies all the risk.

Sam, your point makes sense also, seperate the risk of each aspect of the investment. Maybe if i'm very confident that I could get 4k in rental income while owning the property I should only pay an extra 3k in purchase price thereby providing me with added return on my added risk. I guess the extra amount I would be willing to pay for a property would be dependent on likelihood of my actually getting that extra income. Maybe if I was only moderately sure I would get the extra 4k I would only pay an extra 1-2k for the property to account for the extra risk.

Jon, let me clarify a couple things about what my plans are. 
1. I will be paying cash for these properties so will not be using any high cost short term loans.
2. I am only looking at multifamily rental property which will likely have tenants in the property when I buy it and the end buyer will expect to put tenants in the property into the property after they buy if there are not quality tenants in the property.

My goal would be to sell quickly(few months) but I would be completely willing to sit on the property for years and rent if I had too.

With this being said does this change your opinion?

Thanks!

Vikram C. · Answer

You are correct.  The 70% minus repairs is just a general guideline to ensure that you have adequate profits and an adequate margin of safety.  If your specific property can give you a satisfactory return with a different ratio, by all means use that.

Do understand though that the reason for having a margin of safety is that repairs usually go above estimates, the selling price usually comes under the ARV projections and the holding period is often longer than anticipated.  The less your margin of safety, the more likely you are to make less money than expected, and even a loss.

70% - Repairs?

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