Does anyone really use the 70% rule when buying in today's market?

Question

Hi everyone, I was just reading through this article today,

http://www.biggerpockets.com/renewsblog/2013/01/16/how-to-lose-money-flip/?utm_source=BiggerPockets+Newsletter&utm_campaign=65d81ad5e0-January_17_2013_Newsletter&utm_medium=email

when I came across this paragraph

So based on the typical house flip formula of 70% of after-repaired-value, minus repairs, he should not pay more than $65,000 ($100,000 * .7 – $5,000 = $65,000).

And I was just wondering if anyone is really sticking to the 70% rule in this competitive buying market? The reason why I'm asking is because i'm currently working on a flip in Orange County, CA, which I believe I should be able to make a profit on, but my buying was way off the 70% of ARV mark.More like 80% of ARV.

But if I was to offer 70% of ARV value less repairs, I am pretty much 100% sure there is no way I would have a shot at purchasing the property or any property I have been making offers on, because even in REOs and short sales, the banks will give a discount, but not even that much of a discount based on my experience of past offers.

So was wondering if anyone was actually sticking to the 70% rule and actually managing to buy inventory? Also does the rule of thumb, 70%, vary depending on states or cities? ie, 70% works well in AZ but perhaps 75% in Coastal CA would be more accurate?

Thanks in advance.

Jon Holdman · Answer

That 70% rule of thumb contains a bunch of assumptions. Two key ones are financing and profit margin. Its assume you're using hard money and that you're going for a 15% of selling price (ARV) profit. If you have your own cash, you don't have to pay for a HML. OTOH, if you have cash, you could be the HML for another rehabber and make that part of the profit with less effort. Or, if you're willing to accept a lower profit, you can go higher than 70%.

But if you're using hard money and paying 80%, your potential profit is down to about 5% of ARV if everything goes well. Problems will reduce that profit, though. And its not far from 5% to 0% or a loss.

But if you're using hard money and paying 80%, your potential profit is down to about 5% of ARV if everything goes well.  Problems will reduce that profit, though.  And its not far from 5% to 0% or a loss.

Jeff S. · Answer

Hi David C.,
Good question.  I should have been clearer.  These are the estimates our borrowers use to buy and we use to lend -- consistent with the 70% “rule.”

We actually do keep track of their actuals simply by asking them what they sold their properties for and roughly how much they ended up spending for the rehab.   It helps us determine how “good” they are with their numbers so we get an assessment of consistency and risk.  For the outliers, we’ll generally have a conversation about what went wrong and what went right so we all learn what to be careful of next time.

For the same number of recent deals (different in a few cases than those above because some above are not yet sold):

Average of Actual sales price/Estimated ARV = 105%
If I go back to every deal we ever did, the number is still 105%.
 
Average of Actual rehab costs/Estimated rehab costs = 117%
Includes a 217% x estimate due to extraordinary foundation issues (sh*t happens) but also a home that came in at 40% of estimated costs.

In general, all our statistics are pretty tight (i.e. narrow standard deviation), except for rehab costs.  These can be all over the map.  Even if I throw out the high and low outliers for rehab, the average is still 114%.  More reason not to overpay when you buy.

This shows that it’s easier to estimate ARV than rehab costs, which I suppose should be expected.

Jeff

Jeff S. · Answer

We keep pretty good statistics.  Here are some from our recent loans in Los Angeles County:

Average purchase price/ARV = 62%
Average rehab cost/ARV = 11%
Average (purchase price + rehab cost)/ARV = 73%

Another metric would/should be to make sure the deal offers at least $100k to $125k in gross profit.

I can’t tell you how many calls we get from those new to the business asking us to loan on 80%+ properties.  We don't.  The usual complaint is, “Well, how else can we get in?”

The properties are out there, just fewer and fewer.  No one has a golden touch.  The easiest way to lose money is to overpay for a property and it can happen to you.  I suggest you keep looking.

Will Barnard · Answer

CK, Just keep in mind that any rule of thumb needs to be adjusted according to circumstances, there is no one rule that fits all.

Secondly, and most importantly, if you are buying to flip in So CAL and are in the $200k-$500k acquisition price ranges, then the 75% rule works and allows for profit, hold costs, resale costs, and debt service. It is possible to go as high as 80%, but agian, only under specific cirumstances and I would not recommend it if you have expensive debt and/or are a rookie.

everybody has their own way of doing things and that is fine. For example, J Scott uses a slightly different formula that has more items in the formula, whereas mine is a simple one % calculation. When I compared his math to mine, we end up at almost the identical profit margins, so in essence, we use the same formulas.

Lets use this as an example:
Purchase of $200,000
Rehab of $40,000
ARV of $320,000
That is 75% all-in.
I have 5% agent fees and 1.5% title/escrow/transfer taxes/misc for a total Resale cost of $20,800 - Lets round to $21,000 (I ALWAYS purchase a owners title binder on acquisition to cut my title costs on escrow, if not, expect to pay 2% total.
Assume 12% interest and 3 points for financing, plus $1k in fees and assume you can borrow 100% of purchase, you bring $40k rehab funds for skin in the game. Also assume 4 months holding time.
Total loan costs for 4 months = $15,000

Recap: $320,000 sold price
Less   $200,000 Acqiuisition
Less   $  2,000 Acquisition Costs * Not talked about above
Less    $40,000 Rehab costs
Less    $21,000 Resell Costs
Less    $15,000 Financing Costs
--------------------------------
Total Profit $42,000
You used $42,000 of your money so that is a cash on cash of 100% in 4 months

CK Hwang · Answer

@Amy yes, that's the method I use too, where i tend to spend more on inspections initially to minimize the surprises later on, because I've found it hard to be competitive with my bids if I have to pad for any rehab surprises.

Will Barnard thanks for your input, it's valuable for me because it's good to know that there are variations in the market, as I was finding the 70% rule worked in some markets but not others and I thought I might be factoring something wrongly.

Will Barnard · Answer

Ck, the 70% rule is a rule of thumb and a great basis point for deal spread, but it must be adjusted according to several factors including market conditions in your area, price points, and rehab costs.

Can you find deals in So CAL at 70%? Of course, but they are not easy to find and in most cases, they are in the upper to higher end markets like above $700k exit values.

If you are in the $200k-$400k acquisition price range, you will have the largest amount of competition and thus, finding a deal with a 70% margin here in So Cal would be highly irregular in this curretn market. back in 2009, you could much easier.

If you go all-in at 80%, you only have a 20% margin for resale costs, holding costs, financing costs, profit, and margin for error. That can get dangerous unless you have a deal that is a guaranteed easy seller, only needs lipstick so your rehab is 3-4 weeks MAX, and you keep your resale costs and any loan costs down.

Amy A. · Answer

I never trust the 70% rule for rehabs or the 50% rule for apartment buildings.  If you're evaluating a lot of deals they might help you determine which ones to investigate further.  I only do a few per year, so calculate every light fixture, every window, every fee, etc.  So far it has worked well for all except one property that I bought in a bad neighborhood and underestimated how severely that would effect the ARV.

CK Hwang · Answer

Thanks for the input everyone. Just out of interest, with the 70% rule of thumb, is this based on a 15% nett profit?

Josh, the formula you gave (MPP=ARV-rehab costs-money/holding costs-desired min. profit) is the one that I am using instead of the 70% rule of thumb, and that's why i raised this question because based on that formula my offer price is above the 70% mark.

One of the questions I am wondering though, is if the percentage value holds the same for all properties no matter the price range? The reason I ask is because I recently came across this situation where I found a person with a home they wanted to short sell. The loan on the house was $700K, and the ARV value of the house was approximately $690K. We wanted to negotiate a short sale with the bank for $500K, which the bank flat out refused. As an aside, my banker friend told me that 200K loss on a house was a lot and unlikely to be approved by the bank since they could sell it for more on the open market given the current demand. If I used the 70% rule less repairs, that would be even lower, with an offer of $433K. However, if it was a $300K house, the absolute figure would be less and could possibly be pushed through. Are people getting different percentage values in different price ranges?

Account Closed · Answer

That is the exact formula, the challenge is determining ARV and rehab cost, and to a lesser degree the holding costs, profit is the "free" variable, it can actually go negative, as many of us have experienced, including me.  GIGO (Garbage In, Garbage Out ... a computer term), although good, the MPP formula above is only as good as the inputs.

All the "rules" (Rule of 72, 70% Rule for PP, etc) only work over a range, they aren't exact, you have to be very careful about relying on these things too much.  When you get to the extremes (very low or very high) you can throw them out the window.

I still like the rule that if you need a rule (or calculator) you are paying too much, a good deal will smack you upside the head.

Josh R. · Answer

I have seen J Scott use this formula.

MPP=ARV-rehab costs-money/holding costs-desired min. profit

He works in the 100k-140k ARV range and usually shoots for 15k minimum profit which is in line with Jon Holdman's thoughts.

Does anyone really use the 70% rule when buying in today's market?

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