Is the 70% Rule Too Aggressive in High-ARV Markets?

9 Replies

Hi BP,

I am currently based in the Greater Boston area, considered by many reports to be the second most unaffordable real estate market in the country. Just like anywhere, finding deals isn't easy, but the question I have for you is if abiding by the sacred 70% rule increases said difficulty unnecessarily. 

One of the arguments I've heard is that, mathematically, the formula just doesn't make sense once you get past a certain level of ARV because rehab costs don't have a linear relationship to ARV. So, if you are looking at a $200K ARV and a $600K ARV home, the kitchen in the latter is not 3x more expensive than that in the former, which is what is implied by a static ratio like the formula. However, the great counter that I've been given to this is that this argument is invalid because the 70% rule does not use renovation costs as a % of acquisition/sale, so the repairs are actually accounted for correctly.

Long story short, where do folks stand on this? Can I hear a few different views on what's a more reliable way of analyzing deals? Should it just be 80% instead, which allows for the expensive reality of the high-priced market, but still makes finding deals more feasible? Would you strictly avoid going above 70%? Would love to gather the inputs of as many who have gone through this exercise as possible - maybe you've changed your flexibility over time or maybe you've gotten burned when you did? Would love to learn from you all.

Thanks, BP!

Francisco

There is nothing "sacred" about the 70% "rule". The "Rule" is just a "rule of thumb" anyway. I know lots of investors who simply use a dollar amount of profit per deal to determine if it works for them. This gets dicey as your ARV increases, because a higher ARV usually accompanies higher costs in every other category too, such as taxes, cost of capital, etc. For example, it's more expensive to borrow hard money here than in some other markets. So if a deal starts to go south, it can do so in a big way, wiping out your profit.

@Francisco Feliz My formula for high ARV is different. MAO = ARV - 10%*ARV - Rehab Costs - Your Preferred Profit.

The said 70% does not include any rehab costs, so your assumption is wrong. The 70% rule will yield you 20% potential profit. That is at least what I am told.

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I agree with @Ann Bellamy in general. A target dollar-based profit is good, but depending on the size of the deal, the 70% rule (guideline) will likely provide a better cushion in case the property doesn't sell for ARV (or sold to a flipper who doesn't agree with your repair estimate). Just some thoughts. Thanks all!

@Francisco Feliz - doesn't the term "ARV" mean after repair costs? Why subtract another 10% of ARV (which I'm assuming is meant for your profit) which seems to duplicate your "Your preferred profit". Would you mind expanding?

@Francisco Feliz i understand where you are coming from ... i started my investing career 19 years ago on a west coast real estate market (portland, oregon) .  our market was steadily appreciating, interest rates were low, and the 70% rule was NOT applicable.  we worked off set amount of dollars per deal... we were cautious to make sure all of our costs (hard money, holding, etc) were in factored accurately and we did great.   In real estate we hear lots of rules... these "rules" all came from a good place but should probably be more referred to as  guidelines.   good luck happy to help, feel free to reach out. 

I mean anyone can use any formula that they want.

Just keep in mind if you use a percentage based guide that if you raise the percentage higher the only thing you are cutting is profit since paying more for the property doesn't really effect anything else.  Well aside from increasing any financing costs, which just will reduce the profit more.

Lets look at some numbers to see where these different properties would land.

Okay so a few assumptions. We'll say they are basically the exact same house and need pretty much the same renovations, so the ARV gap is just the location. We will assume they have the same tax RATE and call it $10/$1K of assessed value to keep it simple. To also keep in simple somehow the town assessment is ARV for both of them. You are also doing the deal with Hard Money and the terms will be 2pts and 12% interest with them financing 70% of the purchase and 100% of the rehab. Holding term will be 6 months and total renovation costs are $50K. In the end you will sell with a real estate agent with a 5% commission.

ARV 200,000 600,000

70%           140,000             420,000

Reno            50,000               50,000

Purchase     90,000               370,000

70%             63,000               259,000

HML 113,000 309,000

COSTS:

Financing       9,040                 24,720

Taxes (6M)     1,000                   3,000

5% Comm    10,000                 30,000

Other              4,000                   4,000

Total:            24,040                 61,720

Profit = ARV - Purchase - Reno - Costs

                     35,960               118,280 

% of ARV 17.98 19.71

So when you get higher in price the profit does in fact go up since some costs do not really scale (This is grossly oversimplified as that "Other" line won't be the same but won't be drastically higher).

And of course while a $36K profit is very nice you don't have a huge cushion if things go bad you people will be a little leery to cut off too much of that.  While on the other hand $118K does make you say "Well I can be more than fine if I only expect to make $80K" or whatever number you want to put there.

Now what does it look like with an "80% Rule"?

ARV 200,000 600,000

80%                160,000              480,000

Reno                 50,000                50,000

Purchase         110,000               430,000

70%                   77,000               301,000

HML 127,000 351,000

COSTS:

Financing            10,160                28,080

Taxes (6M)            1,000                  3,000

5% Comm           10,000               30,000

Other                      4,000                 4,000

Total:                    25,160                65,080

Profit = ARV - Purchase - Reno - Costs

                             14,840                54,920

% of ARV 7.42 9.15

So pretty different than before. Looking at the high priced place it still looks okay but you lost most of the cushion. I would do that deal if I felt pretty solid on ARV and my repairs, but it doesn't take too much for that to get slim. The lower priced one I would not even consider. Way to thin! Obviously nobody will go poor making $15K on a deal but there is no margin of error on that one at all. One price drop and an extra month of holding costs (since those things often end up going together) and you are pretty close to break even.

Draw your own conclusions but to me this is saying that using a 70% screening for deals in the low to moderately priced range should give a good feel if you should dig deeper into it.  Once you get into the half a mil or more you might want to be a little looser on what is in the ballpark before dismissing a potential deal.

Now it should go without saying that one should never buy a property if your total due diligence was MAO = 70%*ARV - Repairs... So use these "rules" to screen deals to figure out which ones are worth working harder and which will be mostly a waste to time from the start.

You also have to look at your particular situation.  The deals that I outlined were VERY expensive to do.  If you have an RE licence and can get a bank commercial construction loan at 1pt/6% (which is actually high) you just cut you financing and commission line items in half.  So you can pay that much more than Hard Money Harry and still make the same profit.

ARV at 70% in high end markets from my experience does not go well with the high end markets. The rule is really good for low end markets from $0-200K I would say. Most people talk about this rule as the only rule because most people work in these markets. I work in southern California where the average list price is around $500k. From my experience, most investors out here typically buy around 79-81% depending on their cost for rehab or what they have in terms of prior negotiations with commissions, etc. 1% goes very far in the $500k range and higher.

Hope that helps!

I can show you properties in my market that would be 85% and still yield huge profits. I can also show you properties in my market that would be 50% and the profit wouldnt be worth the time to take on the project.

Always translate the percentages into actual dollars.  Would you rather have a 5% return and make $75,000...or a 20% return and make $10,000? (Im just making up numbers to prove a point, no actual math involved in this section)

Man, this is fantastic! I want to thank all of you for taking the time to reach out and thoughtfully provide your input on this - and it looks like I got a diverse group of responders here!

I take away from this that the math makes it such that small percentage point moves really amount to significant dollars in terms of cushion and overall safety in the deal. Thank you for running that scenario, @Shaun Reilly , as I just needed to see that math done out like others here also said. Looks like I just need to run out the numbers, try a few different formulas, and just keep in mind that the 70% rule is a guide - and only that.

Thank you all !