Five Reasons To Stop Relying on The 70% Rule

The 70% rule is a nice high-level guideline to see if a deal passes the sniff test. However, if the 70% rule is the sole basis of your go/no-go strategy, it’s a lazy evaluation tactic that misses too many variables involved in a project. Some projects that hit this “golden metric” might not be worth the time and there are plenty of opportunities for projects that don’t quite hit this mark.

Before we dive in, the 70% rule states that your purchase price and rehab estimate should be no more than 70% of the after-repair value of the property.

So if ARV is 400k, and your rehab is 100k, you shouldn’t pay more than 180k for the property. 400k * .70 = 280k. 280k should be the combined total of your purchase and rehab costs. The rehab is estimated at 100k, therefore your high level purchase should be 180k. 280k-100k = 180k. Now that we’ve established that baseline, below are the reasons why the 70% rule cannot be utilized in a vacuum:

#1: The 70% rule does not accurately account for holding costs.

Th 70% rule lumps your profits, soft costs, holding costs, and realtor commissions into one giant 30% bucket. The main issue with this tactic is that holding costs can swing wildly from project to project. A 9-month rehab vs a 3-month rehab can carry three times the amount of holding costs, yet this variation is not accounted for in the 70% rule.

Another huge driver of holding costs is how you finance the deal. We currently have deals with a local Chicago hard-money lender at 8.5% (need to close in 2 weeks and/or deal is two small for a local bank to consider) and other deals with local banks who do acquisition/construction lending at 4.5%. Acquisition financing can also be structured where you either pay interest on just the drawn amount, or you pay interest on the entire loan balance upfront, regardless of how much of the rehab draw you’ve utilized to date. The latter will lead to much higher carrying costs. Again, none of this is part of the 70% rule evaluation.

#2: Gross margin is not a one-size-fits-all metric.

30% gross margin on a deal with a 100k ARV is much different than a 30% gross margin on a deal with a $1M ARV. On a 100k ARV you have 30k to cover all costs on top of your purchase and rehab and then profit. On a $1M deal you have 300k. In which example can you live with a slightly lower margin? Gross margin is important, but should not be used in isolation as a one-size-fits all metric. You need to consider how much money will actually enter your checking account upon completion of the deal and weigh that against the potential risks.

#3: Projects can have the same all-in costs, yet carry completely different levels of risk.

The 70% rule combines your purchase and rehab costs into one number. Take a look at the two projects below:

Project A) 225k purchase price and 25k rehab

Project B) 125k purchase price and 125k rehab

In both examples you’re “all-in” hard costs are 250k. However should you quantify that 25k rehab project the same as a 125k rehab? Absolutely not. That 125k rehab will take longer, involve higher holding costs, demand more supervision and juggling with contractors, and ultimately entails more risks. This doesn’t mean it’s a bad deal, it just means it can’t be quantified exactly the same as project A which only has a 25k rehab.

#4: ARVs should be viewed as a spectrum, not one individual number.

ARVs are not an exact science and should not be evaluated as a concrete number that produces a binary go/no-go decision. You need to plan for an ARV range and ensure you can live with the downside of that range. Making the ARV 500k in your 70% rule calculation doesn’t really mean anything if you actually sell for 460k.

Even if you are super honed in on an area, you can only make predictions on what the actual market will bear in half a year when your flip hits the market. There is no way you can confidently state the ARV will be exactly "X."

If you feel the ARV is 500k, you need to run your numbers in multiple scenarios. What if we are 10% off? What if the market drops 10%? What happens if we have to sell at 475k? What is the upside potential of actually getting 525k? What is my lowest downside and can I live with this scenario?

#5 The 70% rule ignores individual project risks and opportunity costs.

This is to no fault of the 70% rule as these are highly individualized metrics. However, it is your job as a responsible investor to consider these attributes in your decision-making process. If you have a project that is within a mile radius of five similar projects you’ve done that all had multiple offers when you sold, will you accept a lower margin than a project in an area you are unfamiliar with and less sure of the ARV and buyer expectations?

Same goes for rehabs. If you constantly tackle cosmetic rehabs at 30k, I would assume you need to see a higher margin/buffer if you are now taking on a full gut for the first time. How about if your current workload demands that you use a crew that you haven't used before? Risk is admittedly very tricky to quantify, but at least attempting to consider these factors will help you formulate a better decision.

Similar to risk evaluation is opportunity cost analysis. Even with all the lending options available in today’s market, flipping is a capital-intensive business and every dollar you spend on project A is one less dollar you can spend elsewhere. Everyone’s situation is different and you need to accurately evaluate if tying up $X for the next four to nine months is the best use of your funds compared to your alternative options.

Conclusion

Sorry 70% rule, I didn’t mean to turn this into a rant against you. It’s not your fault, as you do your job of providing a high-level guideline. It’s us investors that turn rough guidelines like yourself into biblical truths instead of putting in the work to make better decisions.

As an investor, you need to establish your desired outcome (actual dollar amount per deal, margin...whatever), become an expert on the numbers in the geographical area(s) you play in, and truly understand your total all-in costs, risks, and potential rewards. Doing all this on the front-end allows you to bypass potential analysis paralysis when a deal presents itself and you can instead operate from a position of confidence.

Tom Shallcross is a Chicago investor, licensed IL real estate broker with Second City Real Estate, and co-host of the Straight Up Chicago Investor Podcast.