Does The 70% Rule Work When Flipping a House?
·
June 23, 2023

Share

The 70% rule in house flipping estimates how much you should pay for the home you’ll be flipping.

Like a lot of easy-to-use formulas, the 70% rule works best to get a ballpark number — not as the final say on whether to take on a rehab project.

Secure your fix and flip financing.

## What Is the 70% rule in house flipping?

The 70% rule in house flipping says you shouldn’t pay more than 70% of a home’s after-repair value (ARV) minus its cost of repairs.

If you’re mathematically inclined, here’s the formula: ARV x 0.7 – Rehab costs = Maximum offer.

This rule can help investors assess, within seconds, the profitability of a rehab project. In theory, this simple math can prevent paying too much for a new property, undermining the project before it starts.

## 70% rule example

Let’s say you’ve found a 3 bedroom / 2 bathroom home in a neighborhood where similar homes that are in great shape sell for \$300,000.

You’ve estimated that \$50,000 in repairs will rehab the home.

Here’s the math:

• \$300,000 (ARV) x 0.7 = \$210,000
• \$210,000 – \$50,000 in repairs = \$160,000

In this scenario, the 70% rule in house flipping says you should pay \$160,000 or less for the home.

If the seller won’t go that low, you’d need to move on to another project — assuming you take the 70% rule at face value. Not all investors do.

## Using the 70% rule to quickly analyze deals

Like many easy-to-use rules for real estate developers, the 70% rule in house flipping can answer your question quickly. Within a few seconds, you could see whether a home is undervalued enough to consider as an investment.

To make the math faster, you can round home prices to the nearest thousand. Rounding will change the formula’s outcome a little, but that’s OK. The 70% rule isn’t part of your official balance sheet or tax records. It’s just a way to get a ballpark number to see if you should investigate a deal further.

Investigating further will mean doing more precise calculations and creating a well-planned budget. Sometimes, this further analysis will show a home that passed the 70% rule isn’t actually a very good project.

Start your fix and flip loan.

## The 70% rule doesn’t always work

The 70% rule has its weaknesses. At times, it can give a false positive, prompting you to consider a deal that probably can’t turn a profit.

Most of the time, this shouldn’t cause too much harm, beyond wasting a little time. After the 70% rule says yes, you’d do a more nuanced analysis. This analysis would show the deal’s weaknesses, and you’d avoid getting in too deep on a deal you can’t win.

What’s more troubling about the 70% rule is its potential for showing a false negative. If the 70% rule says stay away from a property, and you follow that guidance and move on, you could miss out on a potentially winning project.

## When the 70% rule doesn’t work: high-value areas

In particular, the 70% rule can mislead investors who are shopping in higher value areas — for homes with ARVs of \$500,000, for example. Let’s take a look:

70% of \$500,000 is \$350,000. Following the 70% rule opens a \$150,000 gap between pre-repair value and after-repair value — even before you subtract rehab expenses.

Most investors don’t need that much room to make a deal profitable. These flippers may be happy earning \$40,000 or \$50,000 on the project. In these cases, the 70% rule can be too restrictive. It sets the bar too low for the property’s acquisition price. (In this case, an 80% rule may create a better benchmark.)

On the other hand, for other rehab projects, 70% might be too high to ensure profitability.

For instance, what if you finish renovations within a few months, but the home sits on the market for a full year? During that year you’d be paying property taxes, homeowners insurance, utilities, yard maintenance, mortgage payments, HOA fees, and so on. Each month that passed would undermine profitability, no matter what the 70% rule said.

Submit your fix and flip scenario.

## When you might pass up a great deal because it doesn’t meet the 70% rule

Here’s a scenario: An outdated home hits the market, so you take a look. Inside you see faux wood paneling in the kitchen, pink tile in the bathrooms, and shag carpet in the sunken den. The yard’s a mess. But the plumbing and electrical are up to date. It looks like the owner replaced the roof four or five years ago. The foundation seems fine.

After some cosmetic repairs and landscaping, which should cost about \$25,000, you could sell the home at its full market price of \$400,000.

After applying the 70% rule for flipping houses to this project, you’d offer \$255,000 (70% of \$400,000 = \$280,000 minus \$25,000 rehab costs). Let’s see how this plays out.

### 70% rule for a \$400,000 ARV with light rehab costs

Along with the \$255,000 purchase price and the \$25,000 in repairs, you’d spend another \$30,000 in closing costs and commissions.

Here are your expenses:

• \$255,000 purchase price
• \$25,000 rehab costs
• \$30,000 fees and commissions

That brings your total investment in the project to \$310,000. Selling the home for \$400,000 means you’d earn \$90,000 based on the 70% rule.

What’s wrong with that? Nothing, if you’re the only investor in town. But in most markets, there’d be another house flipper who’s willing to offer \$285,000 — \$30,000 more than the 70% rule calls for — and still claim \$60,000 in profits. Yet another investor may be willing to offer \$300,000 and take home \$45,000 in profits.

In this scenario, by sticking to the 70% rule and offering only \$255,000, you didn’t make a competitive offer and missed what may have been a good investment.

### Other times the 70% rule can limit you

Along with higher value homes with lighter rehab costs, the 70% rule in house flipping can backfire when:

• Home values are rising quickly: When home values will likely be higher in a few months — when you’re ready to resell the home — you can probably afford to make a higher offer to compete with other potential buyers.
• You can keep rehab costs low: Can you do much of the work yourself, instead of paying a contractor and subcontractors? If so you may be free to offer higher, increasing your chances of buying the property.
• You won’t be paying commissions: Selling the home without a Realtor? Saving that 3% or so could help fund a more competitive offer. Keep in mind, though, that you’ll likely need to pay the Realtor that shows the house to a prospective buyer.
• It’s a seller’s market: In housing markets with high demand and low inventory, you’ll probably need to exceed a 70% rule-inspired offer in order to compete with other buyers. The good news is you can also sell the home for more once you’ve completed renovations.

## Gotchas can make a flip unprofitable even when following the 70% rule

Yes, the 70% rule can hide profitable projects, especially in higher value areas, but there are also times when the rule creates the opposite effect, giving you a false sense you’re guaranteed to profit.

If you’re counting on the 70% rule to keep you in the black, make sure you’ve planned for:

• Capital gains taxes: If you work fast, you could be setting yourself up for a higher tax bill. Short-term capital gains (on property you owed less than a year) get taxed like regular income. Work with a tax pro to best manage your tax burden.
• Agent commissions: Average Realtor commissions are 5% to 6%. This can take a big bite out of your reselling profit if you haven’t planned for it.
• Deferred maintenance: Updating the kitchen and bathrooms can add value to the home. But restoring the basics — like the plumbing and the roof — won’t pack the same punch.
• Ownership costs: Even if you own the home for only a few months, you’ll need to pay prorated property taxes and homeowners insurance premiums. Some neighborhoods require HOA fees, too.
• Closing costs: Typically, this burden falls on the next home buyer, but even when you’re selling you may want to set aside some cash for closing costs, especially in a buyer’s market.
• Borrowing costs: Unless you paid cash for the home, you’ll be making payments on a mortgage until you resell. With today’s higher interest rates, this is a bigger deal. Special fix-and-flip loans can lower these monthly costs, but it’s still good to plan for this expense.

Experienced investors know how much profit they want to earn and make sure they’re putting themselves in a position to earn it before taking on a new project.

## 70% rule: A tool of the past?

A real estate investor in 1994, back when the median price for a home was \$130,000, could probably expect reliable results from the 70% rule in house flipping.

Now, with median home prices in the U.S. north of \$435,000, the 70% rule can mislead some investors.

While quick math can still offer a snapshot assessment, the best investors assess projects based on their unique merits and needs.

Secure your fix and flip financing.

Our advise is based on experience in the mortgage industry and we are dedicated to helping you achieve your goal of owning a home. We may receive compensation from partner banks when you view mortgage rates listed on our website.

Share
Array

August 8, 2023