House flipping, when done correctly, can be an extremely lucrative way of generating market-beating profits in a very short time frame.
Like most real estate investing decisions, the investor must act with precision and a scrupulous dedication to expense management.
Believe me, making a 15% or better return in a 6 month timeframe is nowhere near out of the question. All you need to do is abide by the holy grail of house flipping - the 70% Rule.
The 70% Rule is a rule of thumb that helps real estate investors find attractive real estate investments, appropriately budget their costs, and ensure they make a substantial profit along the way. It’s a great rule for a house flipper to implement throughout their investment process.
The 70 percent rule states the following:
After Repair Value x 70% - Repairs = Maximum Allowable Offer
Here’s how it works:
Step 1. Assess the ballpark After Repair Value (ARV) of the potential project.
This can be done primarily by scoring the local market and determining the fair value of houses in the area. If comparable houses - both in size and amenities - are selling for $100,000 expect to sell your house for a similar price.
Understanding the market is key to understanding the maximum amount of money one can make as an investor on a flip.
Step 2. Come up with an appropriate budget.
It’s very hard to pinpoint the exact costs of repairs. You can inspect the house and walk around the interior and exterior hundreds of times, but once the keys are yours and you actually take a peek underneath the hood, loads of issues can emerge.
It is essential you come up with a budget and be very conservative.
Very very conservative.
Step 3. Make an offer.
After looking at some comps and penciling in a conservative renovation budget, it’s time to reach out to the Realtor or listing agent and make an offer on the house.
By using the 70 percent rule, you’ll ensure, excluding associated fees, a handsome profit.
For example, You notice 3 bedroom, 2 bathroom houses in your market can sell for $200,000 (the "after repair value"). You’d like to update the kitchen with new countertops and appliances, modernize the bathrooms with sleek looking vanities, and repaint the interior. You believe your estimated repair costs for a job like this will cost $30,000 (the "repairs"). What should the offer price be to make this a successful house flip?
70% Rule Example: $200,000 x 70% - $30,000 = $110,000
With a maximum price of $110,000, a rehab budget of $30,000, and a sale price of $200,000 you’d generate a $60,000 profit - or a 43% return on investment (excluding other associated fees).
Thoughts on the 70% Rule
Although the 70% Rule is a great way to get started analyzing a potential investment, it isn’t - nor it shouldn’t - be the end-all and be-all of your price point analysis.
The 70% Rule is akin to a back-of-the-envelope workup. It’s the beginning of a journey, but that’s all it is - a beginning.
At Real Estate Skills, we believe using the 70% Rule can produce great deals, but it shouldn’t be a substitute for a deep dive into the investment.
Be sure to ask the important questions before diving into a deal and lay out all the options in a clean, well-researched spreadsheet.
It sounds daunting, but with a little education and a couple of rounds of trial and error, you’ll be able to walk into a house and immediately assess the scope of work that needs to be done.
Before diving further, let’s take a step back and explain what 70% of ARV truly means for house flipping and why it’s important.
Determining the appropriate repairs needed on an investment property is - for the most part - in the eyes of the beholder. Two investors looking at the same house can look to bring the ARV up substantially using very different renovation tactics.
That’s why, when looking to get financing or to realize value through a sale, the end all and be all is that 70% ARV figure, not the 70% Rule. A lender will only finance 70-75% of the property's ARV and a purchaser will only pay whatever that ARV is.
So, we at Real Estate Skills encourage honing in on that ARV first, then diving into what repair options are out there.
Check out this short video to better understand the investment process and the various options an investor has as an owner of real estate.
The 70% Rule has many useful applications in the world of house flipping and renting. It hones in on the time in which a deal can be evaluated, the amount of money one can offer on a property, and the BRRRR Method - an investment style essential for those looking to churn investments.
House flippers - whether in a full-time or part-time capacity - need to act fast when they see an opportunity. The minute a real estate agent posts a house on the real estate market, many like-minded investors will be ready to pounce.
In order to differentiate yourself, it’s essential you act swiftly and with precision.
One great way to determine if an investment is viable is by performing the 70% Rule. By quickly crunching the numbers you’ll be able to determine if you can afford the investment.
Acting swiftly can truly make or break an investment.
The MAO is the highest offer price an investor should make while still making a respectable return. Often in the heat of the moment when dealing with competitive bids, investors can lose sight of the appropriate offer price needed to turn a profit. The MAO formula will keep you in check when that happens.
Sticking to the MAO will undoubtedly result in some missed opportunities. However, walking away from an investment is far better than making a mistake.
The BRRRR Method is the Buy, Renovate, Refinance, Rent, Repeat Method - an essential method to learn and implement for the aspiring new investor.
The way it works is that an investor buys a below market deal at the MAO, renovates the property, and then refinances to recoup the entire initial investment. By refinancing the property with a traditional fixed rate 30-year mortgage, the investor is able to essentially rent out the house and own a cash-flowing property with zero money down.
Banks and hard money lenders typically offer financing at 70%-75% of the home’s value. If investors are disciplined enough to abide by the 70% Rule, the value of the home will increase enough above the purchase price to ensure all capital invested in the property is returned once refinanced.
The BRRRR method provides the practitioner with a great exit strategy and the much-needed liquidity to keep the ball rolling into other flips, wholesaling, or rental property opportunities.
It’s imperative, when analyzing a flip opportunity, to understand all the associated costs and variables involved in the process.
Before reaching out to contractors and estimating a renovation budget, investors need to first determine what the likely sale price of the project will be.
You cannot walk into a neighborhood, buy a house, renovate it, and hope to sell it for 2x the price of all other houses on the block.
Be realistic and don’t overestimate your cash flow potential. You’ll end up getting burned if you think the ARV is well above the surrounding market.
Investors need to budget accordingly.
Reach out to local general contractors and keep an eye on people offering their services on Angie’s List or Task Rabbit. By putting the effort into researching the variables, you’ll be able to come up with a more accurate budget.
However, give yourself some leeway. Once you peek under the hood, tons of unexpected issues can emerge. If you think renovating the house will cost $20,000, budget for $25,000. You’ll be happy you saw the issues coming and still turned a profit.
Closing costs are all the fees associated with selling or refinancing a property. These typically include title company fees, attorney fees, appraisal reports, real estate agent commissions, etc. These fees, although not typically greater than a few hundred basis points, can eat up profits.
Make sure your back of the envelope calculations and excel spreadsheets take into account some of these one-time fees.
If you are looking to fix and flip the property, you’ll have to account for some of the financing costs.
If you are getting a short-term hard money loan, you’ll likely be paying anywhere between 6% - 15% interest. These loans are typically flexible and can close quickly, but not without a price. Lenders will typically charge origination fees and exit fees that can range from 0.25% to 1% of the loan amount.
Holding costs are a major aspect of the flipping process. Although the costs might not be insurmountable, they can throw a wrench into the process.
These costs are the carrying costs of holding the investment during the renovation and sale process. They can include, Homeowners Association (HOA) fees, real estate taxes, insurance, and utility costs.
The longer the house is being renovated or marketed, the greater these costs will become. Keep a close tab on the timing of the project and make sure these costs are budgeted for.
Profit margins are the percentage gain in an investment sale over the costs associated with the investment.
If you spend $130,000 on the purchase of the property, $30,000 on the renovation, and $10,000 on holding and closing costs, your total investment cost would be $170,000 ($130,000+$30,000+$10,000).
If you sell the house for $200,000, your profit margin would be 17.6% - or ($200,000-$170,000)/$170,000 x 100. Not bad at all!
In our opinion, the 70% Rule is a great rule of thumb to stick by, however, depending on your investment appetite, you can orchestrate a higher or lower profit margin by shifting the rule slightly.
By taking on a 60% Rule, the opportunities will be harder to come by, but they’ll turn to be more profitable. By taking on an 80% Rule, you might hit more bids, but you’ll likely achieve a lower return on your investment.
The choice is yours, it all depends on the investor’s preference.
A profit margin of 10-15% is respectable for the risk an investor takes on by flipping a house.
Finally we arrive at the purchase price.
When computing the 70% Rule - or any rule for that matter - the purchase price is the ultimate determinator of the flipper’s potential profitability.
If an investor exceeds the Maximum Allowable Offer and purchases a home without a large enough margin of safety, he or she will be doomed to failure.
Be conservative on the offering price and don’t chase investments that fall out of your circle of competence.
So, you are ready to take the plunge - should you use the 70% Rule?
Believe it or not, at Real Estate Skills, we recommend not using the 70% Rule.
We find that although the 70% Rule will result in an attractive risk-adjusted return, it will generally price investors out of a good deal.
If an investor is looking to jump into an investment, using a deal calculator pricing each expense and possible ARV is the best way to go.
Even if the offer price is a little higher than the MAO, an investor can still make a significant amount of money if they pay attention to the various expenses going into the project. It might be worth it - from a competitive standpoint - to make an attractive bid above the 70% Rule and worry more about budgeting the project to hit that ARV rather than being priced out of a deal with a low-ball offer.
Keeping a deal spreadsheet and maintaining close relationships with general contractors are far more important than simply abiding by the 70% Rule.
The 70% Rule is a great way to ensure a house flipper will turn a profit on the project.
If the investor is determined to stay at - or below - the Maximum Allowable Offer (as calculated by After Repair Value x 70% - Repairs), he or she will certainly have a higher likelihood of success.
However, we at Real Estate Skills believe the 70% Rule is just the beginning. If you can hit a bid by abiding by the rule - great. If the bid isn’t competitive - which it typically isn’t - be sure to sharpen up your deal spreadsheet and model out a detailed analysis taking into account all the variables.
Trial and error is the best educator, but until then check out our educational content on the Real Estate Skills blog and our free house flipping training. Before you know it, you’ll be making a killing in the industry.
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