Investing in real estate can be a tricky proposition. Whether an investor plans to flip properties or rent them, there is always the question of how much to pay. One of the tools used to determine purchase price is known as the 70% rule. Investors have used it for generations.
For the record, the word ‘rule’ may be too strong. What we are talking about here is more of a guideline than anything else. As you’ll see in this post, the 70% figure is somewhat arbitrary. It can be adjusted as needed.
Also note that real estate investors relying on hard money and bridge loans generally employ some version of the 70% rule. They have to be especially careful about how much they pay with the understanding that they are going to incur higher interest and more points on hard money loans.
Determining the Purchase Price
Actium Partners, a Salt Lake City firm that specializes in hard money lending, explains that the 70% rule is essentially a tool for determining the maximum purchase price on a distressed property. Investors can only afford to spend so much and still realize an acceptable level of profit. But how does one know how much to spend?
The 70% rule proposes a purchase price calculated as a portion of a property’s value after renovation value (ARV) and estimated repair costs (ERC). In theory, the rule is pretty straightforward. You multiply the ARV by .70, then subtract the ERC. You are left with the maximum amount you should pay to acquire the property.
Let’s say you have a property with an ARV of $100,000. Your ERC is $25,000. Multiplying ARV by .70 reduces the price to $70,000. Subtract your ERC and you are down to $45,000. That is the most you should pay for that property.
Hopefully, your hard money lender bases its decision on the property’s ARV rather than its current market value. Otherwise, the LTV could put the property out of reach.
Applied to The Market
As previously stated, the 70% rule is more of a guideline than a hard and fast decree. It can be modified depending on the market. Let us say you are planning to buy property in the Salt Lake City area. It is one of the hottest markets for real estate right now. You may have to adjust up to 80%. Just remember that ARVs are also going to be higher in that market.
Detroit is the opposite side of that coin. Property values are comparatively lower there. If they are low enough, you could adjust your 70% down. Perhaps 60% is not off the table. The point is that the rule has to be applied according to the market.
Buying Distressed Properties
One last thing to remember is that all of this is predicated on purchasing distressed properties. Real estate investors make money on distressed properties, not turn-key properties selling at full market value. This is an important distinction that cannot be overlooked.
Distressed properties are properties being sold at below market prices due to certain circumstances. They include foreclosures, short sales, auction properties, etc. They can be had at much lower prices because their owners are looking to dispose of them as quickly as possible.
Whether you are looking to flip or become a landlord, the 70% rule acts as a good starting point to help you determine appropriate purchase prices. Remember that the rule can be adjusted. Also note that there are other formulas for determining purchase price. You may find that the 70% rule doesn’t work for you at all. That’s okay because there are other options.