The 70% ARV Rule is a Myth!!!

I know you just rolled your eyes and you may want to laugh me out of the room with that title/headline but give me just a few minutes and let’s see if I can change your mind. Let me expose my own bias and get it out of the way with this disclaimer: I’m not a fan of gurus. Too many of them make their money selling educational products instead of actually investing in real estate. That’s not to say that they are all useless and do not provide any value. I’ve learned from some of them. However, you will get far superior value going to free and low-cost networking events and club meetings. I’ll never forget a friend actually telling me that I could go online and find a real estate investing course, have the company put my name on it, and market it as my own material and go out and sell it! Money-making opportunities are truly endless! Before you allow yourself to be sold by a guru, ask yourself what products and information can you find at the library or through networking for free? Gary Keller’s books are not a bad place to start and you may enjoy being a member of the RICH Club or Wealth Club in Houston (I receive no compensation for mentioning any of that; I just happen to like them).

So what is the 70% rule? Gurus tout this rule all the time so what does it consist of? It’s a ballpark percentage that says you should be buying at 70% of the after-repair value (ARV) of a property minus repairs. Let’s take an example:

Properties in remodeled/repaired/upgraded condition go for a $100k price in a neighborhood. (Upgraded/Rehabbed Comps Used to Establish ARV)

You estimate that the property you are interested in purchasing needs $20k in repairs/upgrades. Therefore, according to the rule, you need to buy the property at (70% of $100k) - $20k in repairs = $50k.

So you can expect to spend the $20k on your rehab, $10k on closing and financing costs, and perhaps $6k on sales commissions (if a flip is your defined exit strategy versus buy and hold as a rental)

Your price is $50k, your rehab is $20k, your closing/financing/holding costs are $10k, and your commission cost is $6k. If you sell the rehabbed property at $100k, then your anticipated profit is $100k ARV - $50k Price - $20k Rehab - $10k Closing/Financing/Holding - $6k commission = $14k Profit… Is this good or bad? It’s relative.

A hard money lender will typically finance up to 70% of ARV based on their appraiser’s “subject-to” appraisal. When you hear the word appraisal, it typically means an as-is appraisal, as in, “What is the value of the property as-is compared to other similar properties in the neighborhood?” A subject-to appraisal is conducted by the hard money lender’s employee or a company the lender has hired that may (or may not!) have experience with subject-to appraisals. A subject-to appraisal attempts to guesstimate what the ARV of the property would be if x, y, and z repairs are done to it. Some lender’s appraisers are too conservative in their guesstimate, which can be a big problem for the buyer trying to get financing on a distressed property. An appraisal or a Broker’s Price Opinion (BPO) is simply an educated guess on what a property is worth by studying the other houses in the neighborhood using a standard set of rules. I should point out here though that I have gotten 4 or 5 different appraisals on one property and they came in as low as $135k with a high of $170k. Educated opinions are still just opinions and should not necessarily scare you away from pursuing a deal! If the lender is only willing to lend up to 70% of ARV, in our example above, he is lending $70k. The total costs were estimated at $86k so the additional $16k ($86k-$70k) will be coming out of your pocket. It’s what you’ll be bringing to the table to get the deal done.

As an aside, it’s been my experience that you’re either going to bring time or money to the table (sometimes both). You have to decide which. Most of my clients are looking to put savings to work and not have their money earning .01% per year by sitting in a savings account. Are there low money/no money down deals out there? Sure there are. You’re going to spend a lot of your time hunting for them. If you don’t have money and you have a lot of time, that is the route you’re going to have to go. What is your time worth? It’s an opportunity cost you will have to evaluate for your own circumstances. You’ll spend all of your time hunting for deals and by the time you’ve found one, it will be like you’re paying yourself for hunting instead of just outsourcing it to a professional. I call that a job by the way. That’s not an investment (unless you think of it as investing in yourself and sharpening you skills). By the way, if you like to hunt for deals, there’s nothing wrong with that. If you get a deal I’d be happy to talk to you about buying it from you!

Regarding our example above, you expect to come out of pocket for a total of $16k. You expect to make $14k in profit. That’s an 87.5% cash on cash return! (Minus factoring in the time and headaches you’ve spent working on the deal and managing the general contractor… but that’s a story for another day) (($16k cost +$14k profit)/$16k cost = 87.5%)) This beats the pants off the stock market’s 8-10% average annual return any day! This all sounds great and I can see your mouth watering already… but this is a lot of hype. Let’s talk about reality.

Here’s the downside of the 70% ARV rule in Houston – No one will sell you a 70% ARV deal when they can sell it to someone else at 75%-82% all day long. Houston has been and continues to be a very hot market and deal-sellers (wholesalers) know what they’ve got. There are plenty of flippers and landlords that have no problem spending 75%+ to not have to waste a bunch of their time (and money through their own marketing budgets) looking for 70% deals because they are very challenging (and time-consuming!) to find. (As an aside, 70% deals are typically much easier to find in bad parts of town. They’re cheap because you’re going to have to spend a lot more of your time dealing with problem tenants and crime-ridden areas. Your rental is vacant and now your air conditioner is gone. Good luck with that. You have a problem tenant that likes to flush diapers down the commode and doesn’t ever pay her rent on time. Good luck with that too! Again, it’s going to come down to you spending your time versus money.)

The real question here is can you make money with an 80% deal or not? Or is real estate investing just a big scam where everyone shows up to sell you “The Dream”? Let’s look at it by the numbers:

Assuming a $100k ARV, Lender finances at 70% and now you’re buying at 80% Minus Repairs ($60k Price and $20k Rehab Financed + $10k Closing/Financing/Holding + $6k Commissions). If you are financed up to 70%, your total out of pocket would be $26k. That means there’s only $4k left on the bone for profit potential: ($100k ARV - $60 price - $20 rehab - $10 C/F/H - $6 Commissions) For the risk and headaches you’re taking on, if you make the $4k profit expected then you’ll reap a 15% cash on cash return ($30k/$26k-1) in a 2-3 month time period. Unfortunately, everything would have to go perfectly in that example for you to make that return and in real estate there are too many unexpected surprises that come up in a rehab project to take on that risk and deal with the headaches just to make $4k. The trick here is to keep a close eye on minimizing the financing costs and sales commissions. If you have lower costs than your competitor, you’ll be able to do deals that others can’t. In general, I would pass on that deal though because I think the net profit margin is too thin. If I don’t pass on it, the lack of profit margin as a flip here may lead me to consider holding onto it as a rental or owner-financing it out but you need to choose that exit strategy before you buy into the deal, not after!

So far, not so good. It sure doesn’t sound like I can make any money with what we just went over! So how are people making money on flips at 80% of ARV? Consider these numbers from an actual deal that was done recently: $215k ARV - $45k Rehab - $127k Price = $43k Gross Profit Margin - $10k in Closing/Financing/Holding Costs = $33k. Here’s the part that makes a big difference: the 6% in sales commissions can 1) be negotiated down with a Realtor or 2) you can get your own real estate license to sell your rehabbed properties yourself or 3) you can use a flat-fee listing service that will put your property on the MLS for $500 instead of $13k. Yes the flat-fee only covers the sales side of the transaction so what happens if the buyer uses a buyer’s agent? Not all buyers do but if a buyer does use one, it’s completely valid to not pay a whole 3% to a buyer’s agent. Again, that’s negotiable. I can see the Realtor’s pitchforks coming out for me at this point but if I’m a buyer’s agent, then I’d rather make 1% then no percentage and it’s up to you to negotiate with your clients to create a deal that makes sense for both of you.

If you’re flipping houses, you’re either going to spend your time hunting for deals at 70% of ARV… or buy them very easily at 75%-80%, fix them up, and then market them yourself. You can also simultaneously hunt for 70% ARVs and market rehabbed listings as well. Again, what is your time worth?! Either way, flipping houses is really a j-o-b that will require your time and sweat equity which will lead to larger returns over the long run compared to other asset returns. You will notice that the gross profit margin is larger on this deal versus the $100k house example because this was a $215k ARV. You will have financed $150.5k (70%* $215k) and come out of pocket $32k ($45k Rehab + $127k Price + $10k Closing/Financing/Holding Costs + $500 Flat-Fee Listing Cost - $150.5k financed). If your net profit was $32.5k ($215k ARV minus costs) and your out of pocket cost was $32k, then your cash on cash return is over 100%!!! (($32.5k net profit + $32k out of pocket) / $32k out of pocket)

In conclusion, ARV %’s are important to understand as a gauge/range of value but they don’t make or break a deal and you don’t have to buy as low as 70% to make money in this business. There are bigger profits in bigger deals while some of the costs can be either fixed or not increase much as the size of the deal increases. While flipping houses is great, it’s still a job and if you’re not doing it then you’re not getting paid. Rentals require expertise as well but are definitely a more passive activity where a lot more of the work can be put on auto-pilot. Hence it is treated differently as passive income by the IRS (please confer with your CPA; I am not a tax advisor.) Deals need to be analyzed from your unique individual standpoint. I tend to focus on what my net profit potential is in total dollars and what the cash on cash return is expected to be. For example, if I made $40k and 30% in 3 months, I’m pretty happy! That’s almost the average annual family income in the U.S. and it’s 2-3 times the average annual return for the stock market made in 1 quarter. What may be a deal for me may not be a deal for you and while rules of thumb are good to know and understand, do not accept rules at face value… It’s the investor that makes a deal successful, not the other way around! This is a controversial post. There are people out there that will scream that 70% is the only way to go. However, I know for a fact that you can come up off of that a bit and still be fine. As an investor, you have to figure out what your own risk tolerance is and what you’re comfortable with doing and outsource the rest to professionals!