What is the 70% rule in house flipping?
The 70% rule is a staple real estate calculation, investors have on hand to be able to quickly calculate how much they should be paying for an investment property. It is also known as the 70-30 rule. Think of the 70% rule as a barometer or rule of thumb. The 70% rule states that a property investor should be aiming to pay no more than 70% of the resale, or after repair value (ARV) of their target property, minus any necessary repairs, known as estimated repair costs (ERC). The after repair value known as the ARV is the value of the property after it has been rehabilitated for sale.
Real estate investment can be an uncertain venture, but with diligence, focus and sound planning the financial rewards are highly desirable. If you desire to invest in property but are adverse to the responsibilities of a landlord, property flipping may provide accessible opportunities for tangible real estate investment returns. Property flipping when executed well is a effective way of generating substantial income. You may also have come across this practice under guise of fix and flip, buy to sell or simply, trading.
For seasoned real estate investors who purchase, renovate and sell-on properties for profit there is need to be able to know the numbers involved and make sound financial assumptions when investment opportunities (which are often at short notice) arise. Handy calculations offer a great way of testing and retesting your model for a particular property project and assess viability of your plans.
What is the 70% rule calculation?
This quick and ready tool draws from the calculations used in securing high-stakes and expensive bridging finance where a lender or financial institution may offer up to 70% of the purchase price of an asset. In this case the 70% rule can assist you in assessing whether a potential fix and flip property is truly worth it. Many seasoned property investors are using this rule without knowing its name but practical experience affords the need to be able to determine which investments are affordable and profitable. As a novice investor it is important you get your initial purchase right as this will determine the profit you walk away with at the end of your project.The 70% rule helps to create figure that is realistic for your market and leaves room for ROI.
A sample 70% rule real estate calculation.
A property with an ARV of $200,000 can be evaluated for purchase price using the 70% rule as follows:
The ARV = $200,000
The cost of repairs = $22,000
With the 70% rule the price you should pay is 0.70 x $200,000 (ARV) = $140,000 – $22,000 (the cost of repairs) = $118,000
$118,000 is the proposed purchase price of the house. To get a $200,000 property for $118,000 seems a great deal, but it is important to keep track of the costs and expenses involved in your house flipping project which will have to be paid out of your gross profit,It is by no means a hard and fast financial evaluation; you may find yourself paying more or less than this calculated value for your property investment. With the 70% rule, the price you aim to pay assures that you can walk away from your deal with some kind of profit.
The 70% rule in action – how will it work for me?
If you have a budget of $100,000, what is achievable? Well, depending on the cost of repairs, for example, $20,000, using the 70% rule you would be able to achieve an ARV of:
$100,000 + $20,000 = $120,000
$120,000 is 70% of 171,428 meaning that this is likely to be the ceiling of ARV you would be able to achieve at an initial house price of $100K.
70% is the typical percentage used but where the value of a property exceeds $200K it may be well worth tightening your numbers witha 75% rule calculation as used by seasoned investors. With the 70% your focus is entirely the cost of repairing and renovating the property as the major deductible. It is important to remember that the 70% rule over looks soft costs such as:
- legal fees
- realtor fees
- permits and inspections
- unexpected mishaps
- property and local taxes
These soft costs can eat up as much as 15% of your property’s initial cost. It is important to be conservative and as detailed and accurate as possible about the costs involved in your house flipping project to secure your profit,
So, is the 70% rule a reliable calculation?
Establishing your plans for a house flipping project, in particular the arrangement of finances, needs care and attention to detail. It is important to have as thorough a breakdown as possible of your genuine costs for property refurbishment. Think of the 70% rule as a ball-park figure or estimate and then take steps to drill down on a more accurate financial assessment of your plans. Repair costs can make or break even the most sound-seeming investments and if you are purchasing foreclosed or auctioned houses, you may encounter dilapidation or other property problems that add to your bills. Your price-point for your property investment is also a big factor in how the 70% rule will work for you. Picking up foreclosed or distressed property in a rough or run-down area may seem like a bargain, but can expose you to risks such as thefts and vandalism which will erode your margins.
Cautions for using the 70% rule.
Also avoid using this guideline literally and make allowance for real estate opportunities where you are not rigidly sticking to the parameters of this rule. Make allowance for some flexibility in getting your offers accepted or achieving your ideal price. Know the limits of the 70/30 rule which may not work for exit strategies or rental investments. The 30% will always have to bear the brunt of your costs so do not make financial decisions on your gross figures. And remember that any lenders will only be providing finance for the original price of the property.
Another disadvantage of the 70% rule is that it can never fully replace the diligence of studying the property market in which you wish to invest. Take the time to study house prices demographics news rental rates and any other information that can provide insight into how successfully you can perform your flip. In addition you want to keep your ERCs realistic with sound advice and quotation from construction professionals who are able to give as accurate an assessment as possible of the repair and renovation work necessary and its cost. what prices are well renovated properties in your target area selling for?
The 30% will always have to bear the brunt of your costs so do not make financial decisions on your gross figures. And remember that any lenders will only be providing finance for the original price of the property.
Flipping houses for real profit
Although the concept seems attractive to many, it is not easy to find suitable properties that can be flipped. Many expensive courses and learning materials exist on this topic but it well worth avoiding spending on programs and putting the capital towards your first investment. Online research and YouTube are able to provide a lot of valuable information from seasoned investors. Selecting and turning around these properties requires expertise and financial insight as well as adequate liquidity to make a definite move and buy when the opportunity arises.
You also need to be shrewd and realistic when it comes to making the necessary repairs to your property, undertaking them yourself, if competent, or with the appropriate contractor. Learn the types of structural or building problems properties typically need tackling.
Work with a reputable contractor and retain their services and goodwill for turning around sequential projects for you. Marketing the refurbished property also requires planning; confidence that the location that you have chosen has curb appeal and not overdoing property to the extent that it puts off buyers who a looking for a great deal.
When executed well your take-away profit on flips can be as much as $50K to $100K or more depending on the property. Once you are able to accurately identify and create a pipeline of suitable opportunities, you can turn around multiple flips, generating significant income as you go
Arranging finances for your real estate investment
Arranging finances for fix and flip is not as straightforward as with a traditional residential mortgage. Creative ways of financing needed, which can be mobilized rapidly along with capital and adequate liquidity to secure property when last minute opportunities arise. Real estate investment should come with understanding and comprehension that you may only break even or loose your investment and the money of your lenders. It is prudent to access professional, accredited financial advice to ensure you have been fully counselled on the pros and cons of your financing option of choice.
There are a variety of lending options that you may be able to access to assist your property flipping project Your choices include:
1) Borrowing from or making co-investors of friends and family members who may be able to assist in giving you your start. Think carefully before oing down this route as any losses may have the additional complication of stressing and souring cherished relationships.
2)Traditional bank financing If you are buying a property to sell on quickly you are in a different circumstance than those securing a standard residential mortgage. One key problem is that your repayment term, which you expect to be short is not suitable for a regular mortgage, as well as the presence of financial penalties for early repayment. However lenders are diversifying their products and you may be able to secure flexible buy to rent or flexible residential mortgages that may offer some advantage in securing your targeted property on a shorter term without incurring penalties.
3) Home equity loans are types of second mortgages which are typically secured against your home. Depending on your financial status you may able to release equity in your current property to invest in a buy to sell project. Lump sum loans or lines of credit secured on your home carry risk,; if you do not keep up with payment arrangements, you could lose your home.
4)Hard Money loans are a form of short-term lending which is secured against real property. They are used in the real estate sector and have terms of a few weeks to 2-3 years. They are expensive loans which are based on the value of the property rather than the creditworthiness of the borrower.
5) Bridge loans are another form of short term lending which preceeds the arrangement of longer-term financing. They are expensive and structured for early repayment with a wide variation in the types of loan terms that can be secured.
In addition there are a wide range of niche fix and flip loan products available from a variety of lenders. If you are considering taking out a loan it is important to do your research and search widely for the most competitive and advantageous terms for your project and circumstances.
What is LTV? (Loan to value)
When evaluating your credit and financing options for your property flip, it is well worth considering a key parameter called the Loan To Value Ratio (LTV). This financial term defines the loan amount as a proportion of the loan to the value of the asset purchased and expresses it as a ratio:
LTV = loan amount / property’s value
LTV can be used to assess exposure to risk in lending and can inform the terms of the loan and the interest rate offered. High LTV loans are perceived to expose the lender to more risks and therefore carry higher interest rates. High LTV loans secured on property are risky as there is little or no equity built up in the property, Both bridging loans and hard money lending typically carry higher LTVs and may even require the purchase of mortgage insurance. LTV can be positively impacted by providing a down payment and reducing the sales price of your target property,
Avoid making these key mistakes when flipping houses
Once you are financed and ready to make your first property investment, it is important you remain cautious and conservative in evaluating your first project, taking care to avoid these common pitfalls:
- Overlooked costs are the ones that break a good deal. Research, review and revise your figures carefully to ensure that you are not snagged by an unexpected expense that tips the balance in your deal. Keep a close eye on real estate costs and legal fees which can gradually accrue as your project progresses.
- You are more likely to be successful selling the renovated property by settling on a price that is not too high. Aim to sell quickly enough to maximize your profit and move on before costs build up.
- It may be tempting to undertake the necessary building repairs yourself, especially if the improvements are not major. Even if your are a building contractor it is well worth exercising caution in this area as your time is critical in house flipping and you want be sure you have a professional finish that truly adds enough value to attract buyers.
- House Flipping TV shows, online videos and articles make house flipping look like a quick spin of the wheel or instant cash. Nothing could be further from the truth. It can take months to even a year or so to realize the fruits of your investment. Take careful deliberate steps to turn round each stage of your investment project to ensure that you remain in control of your decision making and finances.
- Don’t be easily temped by expensive and expansive projects which appear to offer massive returns. It is better to compete smaller flips than become embroiled in large and complex projects where you may start to lose money.
Are there other ways you can identify profit opportunities?
The main focus in property flipping are the repairs and renovation work needed to increase the property’s value to achieve the optimum ARV. However, there may be ways in which you can flip a property without needed to repair it and still make a profit. Look for issues a property may have which you can invest in resolving such as extending a lease, resolving legal issues or adjusting property boundaries. You also may be fortunate and simply find a great bargain. In these cases, side-stepping the renovation costs can add to your bottom line.
Assessing buy to rent investment projects.
If you prefer to build longer term revenue on your property and accrue value over time you may prefer to go the buy to rent route. Assessment of rental investment properties also come with some key calculations which you can use to evaluate and compare buy to rent vs property flipping. The 2% rule is one such metric which applies to rental property investments.
What is the 2% rule?
This real estate rule is used to assess whether or not a rental property investment is a good deal. The 2% rule states that: the monthly rent of a property should be equal to or exceed 2% of the price of the investment property. It is a useful calculation if you are looking for a property investment with good cashflow.
2% rule example
If you invest in a $150,000 property the monthly rental income you should aim for is 0.02 x $150000 = $3,000 per calendar month.
As will other real estate investment rules, the 2% rule is not hard and fast. Rental properties not only provide the rental income, but also can appreciate in value depending on the property market where they are located, so reliance on this rule depends on your priorities as an investor. Another consideration is that the level of rent that it is possible to achieves varies greatly between different areas and the market rate in the location where you market your property. Also, this rule does not take into account your expenses in repairing or renovating the property prior to renting.
Flipping houses vs Buy to Rent
With both types of property investment having a relatively established financial model, which offers the better returns? Here are some key comparative points demonstrating the main differences between property flipping and buy to let.
Buy to rent is often tax-incentivized with tax deductibles for the expenses associated with offering your property for rent.
Over time an appreciation in the property’s value is usually but not always expected with buy to let property.
Buy to rent property investment provides a monthly income.
With buy to rent you are left with mounting costs if your property is not occupied for prolonged periods.
Buy to rent exposes you to the cost of ongoing maintenance and repairs to the rental property.
Flipping property generates lump sums of cash but provides no long term investment gains.
The increase in property value is essentially ‘forced’ by your repairs.
Flipping properties can have a massive tax exposure of up to and even beyond 40%.
There is no exposure to the ongoing costs of making the property available to rent.
Buy to rent is a true property investment, property flipping is a means of generating cash. If you are looking to diversify your range of property projects it may be well worth combining both types of real estate investment. Use house flipping to leverage cash that can be used to secure financing on better terms for a buy to rent property where you can enjoy ongoing income and appreciation. Again the emphasis of ensuring that you know as much as you can about the market you are entering and its short, medium and long-term prospects, stands.