Investors often use the 70 percent rule when calculating the maximum purchase price they are willing to pay for a property that needs repair and improvements. Seventy percent is the amount of the ARV (after repair value) that an investor may be willing to spend to acquire a property. But the formula also subtracts the cost of needed repairs from the 70 percent of the calculated ARV. It sounds complex, but it is relatively straightforward:
Suppose you are considering purchasing a property that has an ARV (we will discuss making that calculation below) of $300,000 after you spend $50,000 on repair and remodeling. 70 percent of $300,000 is $210,000. Subtract the $50,000 needed for improvements, and you have the maximum reasonable purchase price of $160,000.
Sometimes investors will loosen the 70 percent rule to 75 percent with mitigating circumstances. In the example above, the calculation would change slightly. With an ARV of $300,000 multiplied by 75 percent, you use $225,000 minus the repair cost of $50,000 to arrive at a maximum purchase price of $175,000. Increasing the percentage of ARV reduces the potential profit and margin for error.
How Can I Calculate the ARV?
Determining the future value of a building that needs significant repairs can be challenging. In traditional real estate purchases, the value of an asset is often calculated by comparing the property to similar properties nearby. If the house next door is virtually the same layout, size, and condition as the one you are looking at, then it’s reasonable to look at the recent sale price for that home. By aggregating several comparable sales, you can arrive at a fair price. But if the house next door is in perfect condition and the one you are buying needs substantial work, the calculation becomes more difficult.
There are a couple of ways to bridge the gap, and getting an official appraisal is an excellent way to start. One option is the cost approach, which considers the cost of rebuilding from the ground up. This method can help if there are no comparable properties available.
Don’t Forget About Carrying Costs
If you are pursuing a buy, repair, and hold strategy, you can take a longer-term approach than if you are seeking a short-term gain by investing in a property, making improvements, and selling for a profit. Also, keep in mind the difference between long and short-term capital gains because the tax rates are different, and the distinction depends partly on the holding period. Either way, owning the real estate comes with expenses in addition to what you will spend on any repairs and improvements. The carrying expenses include financing, maintenance, utilities, insurance, property taxes, and HOA fees.
Why Limit the Offer to 70 Percent of ARV?
Using the 70 percent rule allows an investor to build a margin into the calculation that should provide room in the budget for accomplishing their goals with the remodel and repair, maintaining the property in the interim, and selling it for a reasonable profit. If you can obtain the targeted asset for less than 70 percent of the ARV, that is a plus. Keep in mind that the ARV is an estimate based on your calculations or the assessment made by an appraiser. Real estate markets and prices are volatile, and conditions can change even during a brief remodel. Therefore, it's wise to have a cushion built into the equation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
