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Should you use 70 per cent rule when house flipping? Is it a realistic rule to follow when buying a fix-and-flip property?
With the recent property boom, a lot of people are looking to dip their toes in the real estate market.
One of the most common strategies used by investors to make money is house flipping, in which a property is bought not to be used, but with the intention of selling it for a profit after renovations and repairs.
The 70 per cent rule is a common term used among many real estate investors when flipping houses. It’s a way to determine what price to pay for a fix and flip to make money.
How does this rule work? And is it realistic when flipping houses?
What is the 70 per cent rule?
The 70 per cent rule is a way to help investors calculate the maximum purchase price they can pay for a fix-and-flip property in order to turn a profit.
This rule states that a house flipper should pay 70 per cent of the after-repair value (ARV) of a property, minus the cost of necessary repairs and improvements. As such, it can be a quick and simple way to determine a ballpark purchase price.
By using the rule, you are effectively building a 30 per cent profit margin into the deal. However, remember that closing costs, lender fees, mortgage points and carrying costs factor into that 30 per cent.
How do I use the 70 per cent rule?
On paper, applying the 70 percent rule is easy. Simply multiply the property’s ARV by 0.7 to determine your maximum all-in cost.
Here is the formula:
after-repair value x 0.7 – repair costs = maximum offer price
For example, if a home’s ARV is $500,000 and it needs $50,000 in repairs, then the 70 percent rule states an investor should pay $300,000 for the home. Here is how we applied the 70 per cent rule:
$500,000 x 0.7 = 350,000
$350, 000 – $50,000 = $300,000 (maximum offer price)
* (Please note that the figures used above were selected for calculation purposes only and may not reflect real/current valuations).
Buying a house for $300,000 that will be worth $500,000 may seem like an awesome deal, but you have to remember all the costs involved in a fix and flip.
How accurate or realistic is the 70 per cent rule?
The main purpose of the 70 percent rule is to prevent you from paying too much for a fix-and-flip property.
If you look at the rule from this perspective, it should serve as a good starting point for most property investors.
However, there are major downsides to using this rule as your only way to estimate how much you should pay for a fix-and-flip property.
Some of the downsides include:
1. It’s hard to find a property with the 70 per cent rule in a hot market.
The 70 percent rule can be a decent guideline in certain markets, but it does not work everywhere. Given the inexorable rise in prices in the country in recent months, it is much harder to find flips that meet the 70 per cent rule.
In today's hot and competitive marketplace, and especially in capital cities such as Sydney and Melbourne, many investors are seeing their profit margins shrink as they bump up that 70 per cent to 80 or even 85 per cent.
When you determine the percentage of ARV on high-dollar flips, the profit dollar amounts are much higher so you may be able to reduce the margin required for transfer and holding costs.
Additionally, in areas where property values are soaring, the housing boom can also end abruptly, leaving you with a home that is worth less than what you paid for it.
2. Not all costs are accounted for by the rule.
As we’ve mentioned, the main goal of the rule is to create a profit margin that can cover all the costs for flipping a house, while still reaping a sizable net profit.
With that said, it is important to remember that the following costs are not taken into account by the rule and must be factored in when doing an in depth analysis of the property:
These are some additional costs that you will incur when flipping houses. It is your responsibility to keep these extra costs in mind when estimating the net profit that is likely to be made during the deal.
3. You will need to have close-to-reality estimates.
Even if you use the correct formula, you need to ensure that all of your numbers are correct. This means that you have to be able to correctly assess your property’s ARV and the estimated repair costs.
To have an accurate estimate of the ARV of your property, you need to have a good understanding of your local market and know how to compare homes of similar size, style, age and condition that have been taken off the market in nearby areas.
Meanwhile, to accurately account for the rehabbing, you will need to know a thing or two about the local material and labor costs or to get multiple estimates from experts in these areas.
All of these points are critical to keep in mind since, if your calculations are wrong, there is no known rule that’ll salvage a bad deal.
4. It fails to factor in the location of the property.
As any seasoned property investor will tell you location is important when you’re buying, renovating, and selling houses for a profit. If houses aren’t selling in a particular neighborhood, for example, then it’s not going to matter what percentage you’re at.
If your property is on a rougher side of town, you may not be able to sell it for much more than you bought it – even if it is the nicest property on the block. This will result in your profit going down the drain.
5. The rule does not guarantee profit.
On the surface, the 70 per cent rule may sound foolproof. However, the rule is only designed to ensure that you have wiggle room in your budget for unexpected costs.
Simply put, the 70 per cent rule is in no way a guarantee that you will turn profit when house flipping, so it's still important to do an in depth analysis, run the numbers properly and have a clear exit strategy.
6. Your bid may not be competitive enough.
By overestimating the repair costs, your maximum purchase price may end up being too low for the seller to take your offer seriously. While it's practical to be conservative with repair costs estimates, they still need to be realistic.
As mentioned, there are also other investors that are willing to lower their profit margin to seal the deal, so you may need to adjust your profit margin as needed.
The 70 percent rule can be a good starting point for estimating your maximum purchase price. However, it should not be the only formula you should use when buying a fix-and-flip property.
Rather than use one rule of thumb when trying to figure out the ideal price of buying a property, consider all of the elements that might affect your numbers. And, when it comes to those figures, consider the cost of miscalculating them – then, go out and get access to some of the best tools to make sure that you don’t.
Closing cost refers to the fees and expenses associated with the purchase of a home, paid at the closing of the transaction or when the property title is transferred to the buyer.
An investment property refers to a land, condo unit or building purchased to earn profit through rentals or capital appreciation.
A real estate agent is a licensed professional authorised to act as a representative for buyers or sellers in a property transaction.