You’ve seen TV programs about house flippers who buy properties in poor condition, fix them up and resell them at a profit. To do this on a profitable basis, you need reliable data. For example, knowing the after-repair value (ARV) of a property will help you know how much money you should pay for a property and whether the renovations required are worth the investment.
Have you ever seriously considered becoming a house flipper? Is it as easy as it seems on TV? How do you make the numbers work? Could you make money? As we will see, knowing how to calculate the after-repair value, or ARV, of a property is often a key requirement to make money as a real estate investor. It’s also important when you’re shopping for a renovation mortgage.
What is the after-repair value (ARV) in real estate?
ARV or After Repair Value is an estimate of the market price of a property after it has been renovated. It’s part of a statistical calculation used by people who intend to buy, renovate, and — sometimes — sell properties, better known as house flipping. You need to get the calculations right (and have some luck) to make house flipping work. A popular rule of thumb among house flippers is the 70% rule. This rule states that you shouldn’t buy the “as-is” property for more than 70% of the after repair value minus the repairs’ cost.
What is a good ARV?
A good after repair value is one that’s much higher than the “as-is” value of a property that only requires modest repairs. In other words, a good ARV provides a large profit margin and only require a little work to get it back on the market.
How do you calculate ARV?
Here’s how you calculate After Repair Value or ARV. It’s pretty straightforward. The ARV is the value of the property once you make the necessary renovations.
The formula is the average price per square foot of comparable homes x your property’s square footage = ARV. If the average price of comps is $200/sq.ft and you have a 2,000 sq.ft home, your ARV is:
Here’s how it’s calculated.
1. Find similar properties (comps) in the neighborhood
You’ve heard the saying: “Buy the worst house on the best block.” At this point, you may be considering buying that “worst house.” You and your real estate agent are looking at recent sales of houses in good condition in the same area. Your logic is once your house has been renovated and looks like those others, it should sell for a comparable price.
You need to do an apples-to-apples comparison. The houses used as comparables or “comps” should be in the same neighborhood, not the nearby more expensive neighborhood. They should be of a similar age and square footage. The renovations you are planning should be also similar to what is available in those houses. Put another way, you can’t put in a bargain basement kitchen and bathroom when nearby houses look like they were featured in design magazines and expect to get a comparable selling price.
2. Calculate the average price per square foot of the comps
Divide the market value of the comparable homes by their square footage. So a house with a market value of $400,000 and 2,000 square feet would have a price per square foot of $200.
Do this for as many comps as possible and then get the average by adding the prices per square footage and dividing by the number of comps. So, if you find five comps in your area with prices per square foot of $200, $220, $180, $240, and $160, the average price would be $200 ($1,000/5).
3. Apply the average price of comps to your property
Now you have the average price per square foot of your comps multiply it by your property’s square footage. Following with our example, if you have a 2,200 square-foot property, the estimated ARV would be $440,000 ($200 x 2,200). Of course, these are just estimates. Determining the market value of one property, never mind multiple comps, is more of an art than a science. Home prices depend on multiple factors, such as local trends, market conditions, local schools, amenities, and so on.
ARV is not just for house flippers
ARV is not just for real estate investors. Although ARV is often associated with people looking to buy and sell properties, it is also important for people who apply for a renovation mortgage.
Renovation mortgages, such as FHA 203K. and Fannie Mae HomeStylejust allow homebuyers to include the cost of repairs in their mortgage. Search for lenderst that offer these loans using SuperMoney’s comparison tools.
Consider getting the property professionally appraised
Before attempting to buy the home (or start work on a property you own) it is often a good idea to hire a professional, particularly if you are new to real estate investing. Consider hiring a professional appraiser to value the property. Ask her to value the property as-is and also take into account the renovations you are planning. The factors determining the value include the location (often the most important factor in real estate), square footage of the property, number of bedrooms and bathrooms, and other factors like overall condition, age, and the home’s “curb appeal.”
Estimate the value of repairs
Knowing the ARV is only the first step. You also need to know what it’s going to cost to get the work done. You’ve seen this process on plenty of house remodeling series. The buyers talk to the contractor and tell him what they want to do. The contractor then gives them a price. They make it seem so easy on TV! It’s a lot more complicated than you imagine.
Your appraiser might be able to give a ballpark estimate of what the work will cost, however, they aren’t doing the work! Ideally you have a trusted general contractor with their own team providing an estimate. Bear in mind estimates are just that, estimates. No one knows what they will find once they get the walls opened up. It’s the time the contractor gives the designer the bad news and the designer needs to ask the homeowner for more money.
Another aspect to consider is gaining the necessary permits and approvals for the work. This is especially important if the house is in a historic district. This paperwork costs money. There may be restrictions on what you can and cannot do to a property. This adds to the cost of the renovations.
The assessment for the cost of repairs needs to include a contingency fund for problems that develop. You are also expecting your contractor to start the job and keep working on it until the job is completed, not juggling several jobs at once. Why? Because you are paying interest on the money used to buy the house and fund the repairs. You want the job done as quickly as possible.
What does loan-to-ARV mean?
The term loan to after repair value looks at the ratio not involving the value of the property in its current condition, but the future value of the property after renovations are completed. It asks the question: “Will banks lend based on something that might happen?”
Some lenders will take into consideration the ARV of a property when determining eligibility and calculating financial ratios. For example, some lenders offer renovation mortgages, which bake the cost of repairs into the mortgage. Not all lenders Most banks won’t, but some institutions might. It’s been said the ratio might be 65%. Logically you should expect to see higher interest rates and fees because not all banks make this kind of loan.
Things to consider when estimating the ARV of a property
After repair value seems pretty straightforward. It’s the cost of the average price per square foot of comparable homes times your square footage. What could possibly go wrong? A lot.
ARV represents only a moment in time
The after repair value is only “true” at that moment. The appraiser put a value on the house you are considering buying. What if you put this project on the back burner for six months? Circumstances can change. Several months ago the newspapers were talking about the price bubble in lumber. Suddenly it was more expensive. Your contractor will be paying current prices for materials, not selling out of inventory he has stacked in his garage.
Value change within the real estate market
The real estate market moves up and down. Supply and demand are major factors. If property prices in that neighborhood shoot up, that unrenovated house should move up with it because “a rising tide lifts all boats.” If plenty more unrenovated houses hit the market, prices may weaken.
Results based on appraiser’s opinion
Your appraiser has offered their considered opinion, based on their experience. They selected several comps. A different appraiser might select different comps. Your appraiser’s price estimate was valid at that moment in time.
Where does ARV fit within the house flipping business?
The concept of after-repair value is a core principle when people are buying homes to renovate and resell, also known as house flipping.
There are people who want to buy a house in “move-in” condition. Then there are people who will buy old house with the intention of restoring them. There is a third group of people who will buy a house in poor condition, restore it, and then sell it to the first group. If you’re not buying a move-in-ready home, you should probably calculate your property’s ARV.
Many real estate investors buy a property with the understanding they won’t be holding it that long. However, there are lots of unknown factors going into the equation. Investors have to bear additional costs, such as the cost of financing the project or the opportunity cost of tying up their assets until the house is sold. They may also be paying real estate taxes on the property, and there might be cost overruns on the renovations.
The good news is there are ways to account for the risk involved in flipping homes. Enter the 70% rule.
What is the 70% rule?
People who buy, renovate, and resell properties often try to buy unrenovated property using the 70% rule. This is a rule of thumb that recommends you only bid for properties that are valued at 70% (or less) of the ARV price MINUS the cost of renovations. The formula looks like this:
So if you are looking a multifamily property with an ARV of $1,000,000 that will cost around $200,000 to fix, you should probably not bid more than $500,000.
The 70% rule helps you avoid projects with a narrow profit margin by giving you an estimate of what your maximum bid price should be. Remember these are just estimates. There are many unknown variables and things could change at any moment. The market price of comps could drop. The cost of repairs may be higher than you anticipated. So, if possible go for properties that are below the 70% rule.
- People who buy to renovate and resell are known as house flippers.
- Do your homework and not let the costs get out of control when investing in real estate.
- You need data before going into a project, specifically the value of the property in “as is” condition, the value of similar properties in good condition and the cost of renovations.
- Calculating the after-repair value (ARV) of a property is important if you’re interested in a renovation mortgage or want to flip a home.
- ARV is the estimated value of a property after you make the planned renovations.
- The 70% rule provides a good estimate of what your maximum bid should probably be when purchasing a home that needs substantial work.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.