Question about the 70% rule

[Brian Garrett]

So I know the "standard" way to calculate the 70% rule of thumb is to take the ARV x 0.70% and then subtract the rehab costs to come up with your MAO.

My question is why wouldn't you take the ARV and subtract the rehab costs from that and then multiply by 0.70% to get your MAO?

For example let's say the ARV on a property is $100k for arguments sake. Let's also assume that it requires $20k in rehab to reach the ARV of $100k.

The "standard" way would give you an MAO of $50k.

The "other" way would give you an MAO of $56k.

If a property is worth $100k AFTER it has had $20k in work done that essentially means the property is only worth $80k as it sits TODAY.  Why wouldn't you base the 70% off the $80k value?

I know it results in a higher number this way ($6k in the given example) but I'm just curious on the logic behind this and why it works out differently.  Hopefully someone can help clarify.  Thank you!

[Steve Babiak]

It's really simple.

Let's say you were buying to hold as a rental; you buy all cash, rehab all cash, then go for the cash out refinancing. As an investment property, the bank will probably cap the LTV at 70% or so, so let's stick with 70% to match the example posted earlier. If you do it the wrong way, you will not be able to pull all of your cash out - you will have that extra $6K from the posted example still stuck in the property. If you do it the right way, you get all your cash back when you refinance.

For a flip, those numbers aren't the same because there is no planned refinance - but in the event that the property must be held, all cash could still be recovered when the time comes to refinance.

Now let's use a different example. 200K ARV, 100K repairs. So MAO the "right way" would be 40K; the other way it is 70K - a much bigger differential than the example posted earlier. So if you do it the incorrect way, you are then into the property for 170K and that does not leave much of a cushion to cover other holding costs and closing costs when it comes time to sell.

Moral of this - don't reward the seller for what the seller has neglected to have done.