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

[Francisco Feliz]

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

[Shaun Reilly]

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.