Is the 70 percent rule really necessary?
You have probably heard of something in real estate called the “70 percent rule.” Here’s what it says: In order to acquire a property, a real estate investor should pay 70% of the ARV (after repair value) minus the cost of repairs. The formula looks like this:
(ARV x .7) – Rehab
For example, let’s say a house has an ARV of $100,000, but needs $20,000 in repairs. First you would calculate 70% of the ARV, then you would subtract the cost of the rehab. In this case, the investor should not acquire the property for more than $50,000.
(100,000 x .7) – 20,000 = 50,000
The question then becomes, how critical is this rule?
Some would say this formula is more of a suggestion or guideline rather than a rule. I’d say those people won’t be in business very long, and if they are, they won’t be in a growing business.
The 70% rule is there for a reason. You need margin in order to grow your business. Once you calculate closing costs plus the cost of holding a property from the time you purchase it until the time you sell it, you’re going to find that your profit margin will dwindle pretty quickly.
What if permits take longer than expected? What if something goes wrong during rehab? If you buy a property right at 70% less repairs, you can afford to screw up a rehab and still be okay. We don’t recommend doing that of course, but that wouldn’t work well at 85% because your margin is too tight. You can’t afford the inevitable visits from Murphy’s Law (“Whatever can go wrong, will go wrong”).
Working backwards, let’s imagine that you sold a property at 100% ARV. Right away, you had to take 10% off the top for closing costs. If you held the property for six months, you paid around 1.5% per month in holding costs. That covered insurance, taxes, HOA, utilities, lawn and pool maintenance, etc. and means you were out another 9%. Of course you still needed another 3% for things like title insurance and attorney fees, so the bottom line is that even when you sold your property for 100% ARV, you really only received 78% because 22% went to cover all of those costs.
If you had purchased the property according to the 70% rule, you’d be free and clear because you’d still have 8% margin left. But what if you had purchased the property at 85%? Where would that extra 7% in costs come from?
Your pocket, that’s where.
If you'd like to learn more about the importance of the 70% rule, click here to see information on our upcoming events.
If you break the 70% rule, you’re putting your own money into the deal, and that’s not running your real estate business like a business at all. That’s running it like a hobby. If you’re trying to build a business, you’ve got to grow. That means buying more and more properties year after year.
The people who tell me that the 70% rule is not important are the same people whose businesses have not grown since we started Houston House Buyers four years ago. They’ve bought the same five, eight or ten houses year after year while we’ve built a business that buys ten times that in the same amount of time.
When you buy things for the right price, you can afford to hire people, spend more on marketing, and do all of the things you need to do to allow your business to flourish. But if you don’t have enough margin, you can’t afford to grow your business.
The only mistake you can make in this business is paying too much for a piece of property. That’s it. Outside of that, it’s pretty hard to screw this business up.
Respect the rule. It’s there for a reason.