House Flipping Formula: What is the 70% Rule?

House Flipping Formula: What is the 70% Rule?

Real estate investing, specifically house flipping, follows certain guidelines to ensure that deals are profitable. One such guideline is the 70% rule. But what exactly does this rule mean, and why has it become the foundation of house flipping? 

This blog looks takes a closer look at the 70% rule, examining its application and the role it plays in helping investors make informed decisions about potential deals. At the end of this blog, we hope that you understand why this rule is a game-changer.

What is House Flipping?

House flipping refers to the process of buying an investment property with the intent of quickly reselling it for a profit, rather than holding onto it for long-term appreciation or rental income. 

This strategy depends on the ability of the real estate investor to purchase a home at a price that, after all costs are accounted for, allows them to sell at a profit. 

Often, properties targeted for flipping are those that can be acquired below market value, such as distressed sales or homes in need of repair or rehab.

The flipping process generally involves some level of renovation or improvement to the property, though the extent can vary. Some flippers prefer homes that require only cosmetic updates like painting and landscaping, while others take on more extensive projects, overhauling entire kitchens, bathrooms, or adding new rooms. 

The goal is to enhance the property's value and desirability in the shortest time possible, ensuring a quick sale at a higher price.

What Is the 70% Rule In House Flipping?

The 70% Rule is a foundational principle employed by house flippers. This guideline is a way to determine the maximum price or amount an investor should consider spending on a distressed property to ensure they achieve a profitable flip.

To break it down, the rule suggests that an investor should not pay more than 70% of a property's After Repair Value (ARV) once repair costs have been subtracted. The ARV represents the anticipated market value or sales price of the property after all renovations and repairs have been completed. 

By taking 70% of this value and then deducting the estimated repair costs, an investor can arrive at a purchase price or offer on a property that considers both the required investment to improve the property and the desired profit margin. In other words, they won't overpay.

One of the primary reasons this rule is commonly used in house flipping is because it includes a safety net. By capping the investment at 70% of the ARV minus repairs, the rule takes into account certain unforeseen expenses and other variable costs that might be encountered during the flipping process. 

Furthermore, this rule also aims to ensure that the investor not only recovers their investment but also secures a reasonable profit upon the sale of the property.

It's essential to understand that while the 70% Rule is a valuable tool, it remains a rule of thumb. Market conditions, the local real estate environment, and specific projects can all influence how you should price a flip so you should take into consideration all these things.

Example of the 70% Rule In House Flipping

Imagine an investor named Lana identified a distressed property in a promising neighborhood. After some preliminary research and evaluation, Lana estimated that once all renovations and repairs are done, the property could be sold on the market for an After Repair Value (ARV) of $400,000. 

This projected ARV covers factors like comparable recent sales or comparable properties in the area, the potential impact of the planned renovations, and the current market trends.

Next, Lana brings in a contractor to evaluate the property. After a thorough inspection, the contractor provides an estimate that the necessary repairs and renovations to bring the property up to market standards would cost around $50,000. 

This estimate includes essential fixes like plumbing and electrical repairs, cosmetic updates like painting and flooring, and possibly some landscaping to boost curb appeal.

Using the 70% Rule way to calculate the maximum allowable offer (MAO) for the property, Lana did the following:

Step 1. Take 70% of the ARV: 0.70 x $400,000 = $280,000.

Step 2. Subtract the estimated repair costs: $280,000 - $50,000 = $230,000.

Based on this calculation, Lana should not pay more than $230,000 for the property to maintain a good margin for house flipping profit, considering other costs such as holding costs, selling costs, and potential unforeseen expenses.

How to Determine the ARV of a Property?

Calculating the After Repair Value (ARV) of a property is crucial for anyone in the house flipping business. This value represents the expected market price of a property once all repairs and renovations are completed that help house flippers calculate the 70% rule, as discussed in recent sections. 

While determining the ARV might sound complex when flipping a house, it can be broken down into a series of steps.

Start by thoroughly inspecting the property. It's essential to understand the house's current condition before considering its potential future value. Working with a home inspector can be a wise decision as they can help you ensure that the real estate investment can still be profitable.

Once you've grasped the state of the property, you can begin researching recent sales of similar properties in the immediate vicinity, commonly referred to as comps. These are houses that have sold recently, ideally within the last six months. 

The prices at which these homes have sold will provide you a base for understanding the potential value of your house post-renovation. 

After gathering this information, focus on the renovations themselves. Once you've identified the kind of work the property needs, approach contractors for quotes on the cost of the repairs. This helps gauge what the costs can include, which will, in turn, play a significant role in determining the ARV. 

How Do I Estimate the Costs of Repairs?

Estimating the costs of repairs is the foundation of success when flipping houses. A miscalculation can turn a potential profit into a financial issue. Thus, it's essential to approach this process with a mix of diligence, research, and consultation.

Before you can estimate the costs, a quick rule to help you out is that you need to identify the extent of repairs the house requires and how long it will take to repair them. This is where a comprehensive property inspection becomes required for a property to flip. 

Hiring a professional home inspector will give you an in-depth analysis of the property's condition. Ask these professionals to get a list of issues ranging from structural problems, such as foundation cracks or roof damages, to internal concerns, like outdated electrical systems or plumbing issues, to give you an idea of what it will take the home to flip.

While there's an upfront cost to hiring an inspector, the detailed insights they provide can save you from unexpected expenses down the line.

Once you're armed with the knowledge of what needs fixing, you can break down the repairs into categories. 

For instance, structural repairs might include tasks like fixing the foundation or replacing a roof. Cosmetic repairs could range from repainting walls to replacing outdated fixtures. Each category will have its own cost profile based on the materials required and the labor involved so your budget may multiply

After categorizing the repairs, you'll also want to source quotes from contractors to get accurate numbers. It's recommended to obtain multiple quotes for each repair category to ensure you're getting a fair price. Contractors will assess the property, the extent of damage, and the quality of materials you wish to use. 

When discussing the project with contractors, it's essential to be specific about your expectations. Do you want a luxury finish, or are you aiming for something more functional and budget-friendly? Your choice will greatly impact the cost.

Additionally, it's wise to factor in an emergency budget. No matter how thorough your inspections and quotes might be, unexpected issues often arise during the renovation process. 

Costs Not Included in the 70 Percent Rule

The 70 Percent Rule is a simplification of how to calculate the maximum purchase price an investor should spend when making an offer in every flip, and there are several additional costs that aren’t covered when you use the 70 percent rule, like title insurance, property insurance, and the following:

• Closing Costs: These are expenses over and above the price of the property incurred during the transfer of property ownership. They can include title searches, lawyer fees, and title insurance.
• Financing Costs: If you're using borrowed money to purchase or renovate the property, there will be interest costs associated. This is especially true if you're not using traditional mortgage financing.
• Property Taxes: Even if you only hold onto a property for a short period, you're still responsible for property taxes during that time.
• Insurance Costs: It's essential to have property insurance from the moment you buy a home or pay for a property in cash. This protects your investment against unforeseen calamities.
• HOA / Condo Fees: If the property is in a community with a Homeowners Association (HOA) or is a condominium, there might be monthly or annual fees to consider.
• Transfer & Conveyance Fees: Some jurisdictions may charge fees for the transfer and conveyance of property.
• Utility Costs: Even if the house is vacant, you'll have bills for electricity, water, and possibly gas. Utilities might be higher than expected, especially if you're doing extensive renovations that require additional power or water.
• Selling Costs: Once you're ready to sell, there might be staging, marketing, and other related costs to make the property appealing to potential buyers. Real estate investors use certain strategies as well that may add up to the cost.
• Hard Money Loan Repayments: If you've financed your flip with a hard money loan from a hard money lender, the interest rates can be significantly higher than traditional loans. Moreover, there might be early repayment penalties.
• Loan Origination Fee: This is a charge by lenders for processing a new loan application and is usually a percentage of the loan's total amount.
• Realtor Fees: When selling a house, if you use realtors or real estate agents, expect to pay their commission, typically ranging from 5% to 6% of the property's maximum buying price. This also applies if you used an agent to sell the home.
• Mortgage Points: These are fees paid directly to the lender at closing when you sell the property in exchange for a reduced interest rate. One point is typically 1% of the loan amount.
• Carrying Costs: These are the costs of holding onto a property and can encompass many of the items on this list, from property taxes and insurance to utility costs and HOA fees. The longer you hold onto a property, the more these costs accumulate.

Frequently Asked Questions

Does the 70% Rule in House Flipping Guarantee a Profit?

No, the 70% rule in house flipping does not guarantee a profit because a seller might not accept your calculations. The 70% rule is only a guideline that helps flippers determine the maximum price they should pay. In essence, this rule states that you should pay no more than 70% of the After Repair Value (ARV) of a property, minus the repair costs, to potentially make a profit. 

Is the 70% Rule in House Flipping Accurate?

The 70% rule is a useful starting point for many real estate investors to evaluate potential deals quickly, but it is not always accurate for every situation. There are still a lot of factors you should take into consideration when buying a house to flip hard and fast. The accuracy of this rule calculation can be influenced by the specific real estate market, the nature of the property, the extent of renovations required, and unforeseen costs. 

Key Takeaways: How Does the 70% Rule Work?

While the 70% rule can help as a starting point when house flipping, it's crucial to remember that every property and market scenario is unique. The 70% rule is just a general guideline and tool — you would still need to do comprehensive research, financial planning, and other extra work to multiply that amount of money you initially invested. 

But then again, if you think you already know the ins and outs of the 70% rule, it’s time to start flipping! Connect with us at Property Leads, as we have the most motivated seller leads for your first house-flipping venture.

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