Real Estate Investor · Palm Beach County, FL · Member since 2017 · 3k+ posts · 2k+ votes
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!
Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
9y
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.
Realtor · Shreveport, LA · Member since 2015 · 79 posts · 23 votes
9y
But that is assuming you actually have to pay the MAO, as investors we strive to get a Purchase Price that is lower than our MAX so we can have a greater profit. Basically we use the ordinary 70% rule because if worse comes to worse we can refinance and pull out our initial investment from a property, but as always this rule isn't perfect and there are ton's of ways a deal can go wrong even if you follow this rule.
At the end of the day it is mainly a safeguard agains't the risk associated with an investment property
Realtor · Shreveport, LA · Member since 2015 · 79 posts · 23 votes
9y
If your okay with the added risk of the other way with the benefit of a higher MAO, then that rule can be just fine for you to use, because afterall it's only a guideline for your property investments
Investor and Property Manager · Mount Pleasant, SC · Member since 2016 · 24 posts · 21 votes
9y
@Brian Garrett I think there have been a lot of great comments on here and different approaches to something we all take for granted...the 70% rule.
I think the answer to your original question regarding why to multiply the 70% first, then subtract repairs was answered extensively. Basically, if you subtract repairs first, it reduces the basis of the 70% rule, which means you will spend too much money on purchase and your all in budget will be above the threshold to maintain proper LTV and profit margin.
The follow up question I hear you asking is, does the 70% rule work, specifically if you are going to buy, then rent and refinance. This is a bit more tricky, because rent is not properly reflected in this rule of thumb.
You referenced holding costs which make your all in budget go beyond 70%, this is true, however, if you are planning to rent the property as your exit strategy, you better hope that your rent exceeds your holding costs, if not, don't buy the damn thing!!! :)
Here is the silver lining: assuming your rent covers your holding cost, that nullifies the holding cost over the 6 month period while you are seasoning the property for a refinance, thus, you are still only into the property for 70% of ARV, and you in theory would get every last dollar back.
OK, that's theory, but as a primary buy and hold investor and only occasional flipper, I would say, the 70% rule is only for flips, and the key metrics to look at for buy and hold is: Cap Rate and Debt Coverage Ratio, then subsequently cash on cash return on investment, IRR etc... I almost never use the 70% LTV rule for my properties, but I mostly buy multifamily, not singles.
I think if you plan to flip, keep using the 70% rule, but if you are looking to buy and hold it's not very helpful other than letting you know you have a good equity cushion in the property if you had to sell, but this speaks nothing to rental performance.