What is the “70% rule” of house flipping?

Last Updated on November 17, 2021

What is the “70% rule” of house flipping?

 

If you’re looking into flipping a house, you’re probably wondering how to make sure your investment turns out to be profitable. There are a wide variety of approaches to answering that question, and we would recommend performing a house flip market analysis in any case. You can never be too thorough when making a major financial decision. However, there’s one principle that underlies all house flipping scenarios, and it’s incredibly simple: the 70% rule.

You should spend no more than 70% of the property’s ARV (After Repair Value) on the property.

In other words, your anticipated profit margin should be at least 30% of the final sales price.

The ARV, short for After Repair Value, is the estimate of a given property’s value after all repairs and upgrades are completed. It is used to determine the margin between a home’s current value, and the value it will have after renovations.

We call this a “rule”, but it isn’t a totally rigid one. It should serve as the basis for a thorough market analysis, but it can be a very powerful tool in your decision making process.

There’s an important caveat, though…

A 30% anticipated profit margin does not necessarily mean you walk away with exactly 30% in profit, as some may imagine. Part of the reasoning behind the 70% rule is that you need a cushion to cover any expenses left at the end of the day; these could include agent commissions, title inspections, lender fees, and any other miscellaneous expenses included in closing.

So, why the 70% rule?

Buying a property, especially a house to flip, is never easy. There are always many different factors to keep in mind when making your decision. It goes without saying that how much you’ll pay is the number one factor among them.

When you’re planning on investing more in the interest of making a property more viable on the market— that is, renovating and flipping the property— you’re always going to need to account for the costs incurred by repairs and upgrades.

Your profits all rest on the relationship between your expenses and the final sale price, and the 70% rule serves as a simple way to determine how much you’re willing to invest, and whether those investments will be worth it.

The genius of the 70% rule

The 70% rule works so well because it is so simple: there’s very little to complicate your calculations. It forces you to consider the two most important numbers in house flipping, those being the ARV and the repair costs.

None of this is to discount the significance of other numbers, such as the soft costs you may face during the renovation process. However, you really do need to keep the ARV and your repair costs in mind every step of the way, even before you embark on a more thorough analysis.

If anything, the 70% rule can be thought of as the first preliminary step of that analysis, a simple way to determine whether investing your time and money is likely to pay off in a given case.

An example: the 70% rule in practice

The 70% rule is really quite simple, no matter how intimidating it may seem. You just need to multiply the property’s ARV by 0.7 to determine the price ceiling for that property.

Take, for instance, a property which you anticipate to be worth $200,000 after repairs. You should pay a maximum of $140,000 right? Well, keep in mind that repairs are a significant expense too. You always want to be conservative with your estimates, accounting for further expenses than may appear on the surface.

Let’s assume the expense of repairs comes out to about $30,000. You’ll need to subtract that from the previous value, which in turn means that you shouldn’t buy for more than $110,000. Here’s a quick formula for those of us who like to see it in mathematical terms:

((ARV of property) x 0.7) – Cost of repairs = Maximum amount you should pay for the property

Simple enough, right?

70% rule versus market analysis

Applying the 70% rule is an important step, but it does not make for a complete market analysis in itself. For an accurate house flip market analysis, you’ll want to be thoroughly familiar with expenses beyond just purchase and repairs. Make sure to keep in mind that the 70% rule on its own does not account for the following:

• Settlement costs
• Carrying costs
• Financing costs
• Any other unforeseen expenses you need to budget for

So, although the 70% rule is a simple, versatile way to quickly assess a property, you shouldn’t base your decision on the rule alone.

When should you use the 70% rule?

Being that the 70% rule is a useful tool, but not a comprehensive solution, there are always cases where its use makes more sense than others. It may make sense to offer only 65% of the ARV. It could also be that 80% is justifiable in some scenarios. It is designed to be applicable in a broad context, but no tool is ever perfect.

Below, we’ll discuss a few factors to keep in mind. This list is by no means comprehensive, but it should offer some basic insight into the different kinds of decisions you could be making as a real estate investor looking to flip a home.

Making your exit

The 70% rule is most useful when flipping houses, which is likely your intent in reading all this. However, keep in mind that if your plans are subject to change, the 70% rule may not be a perfect match for your needs. If you’re holding onto the property over the long term, such as in the case of a rental, you should consider annual yield and income rather than just ARV.

Likewise, if you already have a buyer who you know will pay a certain amount, ARV may be insignificant. In that case, you’ll want to base all your decisions on the predetermined buyer’s intentions.

Market price point

Some markets are more difficult to work in than others, especially lower-income property markets. Your renovations could be seriously disrupted by trespassers, vandals, thieves, or even con artists.

In some areas, the underlying process of renovation can also vary significantly in terms of price. Labor could be much cheaper in an area with an abundance of workers in relevant trades and relatively few jobs available in those areas, but such an area may not be a very profitable market to operate in. The costs of doing business in general can also vary from state to state, city to city, or even neighborhood to neighborhood.

Keep in mind, as well, that settlement costs are fixed and do not vary based on the purchase (or sales) price. Lenders can charge a minimum fee. For that matter, your title-related fees are also likely to be fixed, rather than responsive to sales price. In a less profitable environment, these expenses could really add up.

On the other hand, higher end markets take more capital to approach, but also tend to make for more reliable investments with fewer headaches. Choose your markets carefully!

Target profits and labor

One deal may take more work on your end than another, and some investors expect more profit per deal than others.

A deal that requires minimal work and offers a quick turnaround with a buyer already in place may justify a lower profit margin than the 70% rule would suggest, not that such deals are easy to come by.

Always keep in mind, as well, that your repair costs and ARV estimates should be conservative. These are the numbers that divide loss from profit, and you really don’t want to take any unnecessary risks. Overestimating your expenses could leave you with more money left over, at the end of the day; underestimating could leave you facing a serious loss, or even in debt.

Closing remarks

The 70% rule is perhaps less of a rule than a guideline, but it can be an incredibly valuable guideline. If you need a quick calculation to provide a rough ceiling figure, it’s hard to go wrong with the 70% rule.

However, you shouldn’t let it dictate your decision entirely. You’ll want to look into a potential flip in more detail before making any purchases.

Perhaps the most important thing to keep in mind when using the 70% rule is to be very cautious with your repair cost and ARV estimates. It can be very dangerous to be too optimistic in these regards; always account for some overhead.

If your access to the property is limited such that you can’t inspect it in detail, always use worst-case scenario numbers. These properties can be especially risky.

Remember: you always need to protect your resources, both time and money. Be precise, be conservative, and don’t be afraid to perform a more detailed follow up analysis when using the 70% rule in real estate.