A Guide to Calculating Maximum Allowable Offer (MAO formula real estate)

Flipping houses has become a popular investment strategy for real estate enthusiasts looking to generate substantial profits in a relatively short period. However, to succeed in this competitive market, it is crucial to understand the 70% rule and how to calculate the Maximum Allowable Offer (MAO Formula). In this article, we will delve into the intricacies of this rule, discuss the importance of knowing your comps, reveal effective methods to find properties, and highlight the pitfalls of over rehabbing.

Understanding the Impact of Purchase Price and Market Conditions on the 70% Rule

The 70% rule is a popular guideline among real estate investors, helping to determine the maximum price to pay for a property flip. However, the application of this rule can vary depending on both the purchase price and market conditions.

Low Purchase Prices

When dealing with properties on the lower end of the price spectrum, say around $100,000 or less, investors often need to buy at a steeper discount, approximately 65% of the After Repair Value (ARV). This is primarily because the margins are tighter, leaving little room for errors. A lower purchase price demands a strategic cushion to cover all potential expenses involved in the transaction.

High Purchase Prices

On the flip side, when investing in properties valued over a million dollars, the scenario shifts. The dollar amount of potential profits increases, allowing for a slight adjustment in required margins. Here, investors might accept a smaller buffer percentage since the absolute profits are substantial enough to absorb transfer and holding costs.

Adjusting the 70% Rule in Real Estate Investments

When considering real estate investments, the 70% rule is a common guideline. Yet, several factors may require you to tweak this rule to ensure a profitable venture. Here’s how:

Lower Purchase Price

If you’re eyeing properties with a lower after-repair value (ARV), typically $100,000 or less, consider buying at a deeper discount, maybe around 65%. The narrow margin for error in these cases demands cautious spending due to less flexibility for covering deal-related expenses.

Higher Purchase Price

For high-value properties, where ARVs exceed a million dollars, the absolute profit can be significant. This scenario might allow you to accept a lower percentage margin since the sizable profit can cover higher transfer and holding costs.

Minimal Effort Flips

A mid-priced property needing few repairs can warrant a higher purchase price percentage. If comparable properties sell quickly and the renovation is straightforward, a lower overall profit might actually be more lucrative in a quick turnaround scenario than a lengthy project with potentially higher returns.

Critical Components of the 70% Rule Formula

The accuracy of the MAO calculation hinges on two critical numbers: the After Repair Value and the estimated Repair Costs. Both must be as precise as possible to ensure the resulting offer aligns with your investment strategy.

Calculating Maximum Allowable Offer (MAO):

To calculate the MAO accurately, investors must first determine the ARV, which is the estimated value of the property after it has been fully repaired and renovated. Conducting thorough market research and analyzing recent sales of similar properties in the area will aid in establishing a realistic ARV.

For a detailed understanding of ARV calculation, consider following a step-by-step guide that includes:

Assessing Market Comparables: Look at recent sales data of comparable properties in the same area to gauge potential value.
Evaluating Necessary Repairs: Identify and estimate the cost of repairs and upgrades required to bring the property to its full potential.
Calculating Potential Value: Combine insights from market analysis with repair estimations to forecast the property’s future value.

This approach ensures that the ARV is derived from a blend of current market trends and specific property conditions, offering a comprehensive method for accurate valuation.

After Repair Value (ARV):

The ARV is your estimation of what the future sales price of your distressed property will be after repairs and upgrades. This involves conducting a detailed analysis of comparable properties and understanding market trends. For those seeking a more structured approach, a step-by-step guide can be invaluable in accurately calculating the ARV.

Example: ARV x .70 – rehab = MAO or maximum allowable offer.

However, it is essential to remember that the estimated cost of rehab must be subtracted from the ARV to arrive at the final MAO.

Estimating rehab costs can be challenging, especially for novice investors. Seeking advice from experienced contractors or utilizing online resources can help in accurately assessing the expenses associated with the renovation.

If you’re new to this, you might find that your estimates are either too low or too high. To safeguard your investment, consider using the higher end of your estimated range as a buffer to cover unexpected expenses. This conservative approach aligns well with the 70% rule, ensuring you maintain a profitable margin.

For a more structured approach, explore educational primers on evaluating rehab projects. These resources often provide detailed steps and considerations that can improve your estimation accuracy. Additionally, leveraging construction cost databases can offer nationwide averages, helping you ground your figures in reliable data.

By combining expert advice, structured learning, and data-driven insights, you can enhance your ability to estimate repair costs effectively, making informed decisions that align with your investment goals.

Repair Costs:

If you are not experienced at estimating rehab costs, you could arrive at a much lower or much higher value than is accurate. It’s advisable to include a buffer by considering the high end of your value range. Reviewing primers on how to evaluate rehab projects and estimate costs can provide a solid foundation for these calculations.

By thoroughly understanding and accurately calculating these components, investors can confidently utilize the 70% rule to make informed decisions in the property-flipping process.

What Does the Leftover “30” Part of the 70% Rule Account For?

When using the 70% rule in real estate investing, the “30” in the equation is far from straightforward profit. Instead, this percentage must cover a range of costs associated with flipping a house. Here’s a closer look at what it really accounts for:

Purchase Costs: These include any expenses incurred getting the property into your hands. Think of closing costs, title inspections, and necessary legal fees.
Holding Costs: While owning the property, you’ll have ongoing expenses. These can range from property taxes and utility bills to potential homeowners association (HOA) fees.
Selling Costs: Once it’s time to sell, expect to pay for realtor commissions and additional closing expenses. Marketing costs might also be necessary to attract buyers.
Financing Costs: If you’re using loans to finance the purchase, interest and lender fees quickly add up, especially if you’re working with hard money lenders.
Profit Margin: The aim of any flip is profit, of course. However, once all these expenses are deducted from the available “30%”, the actual profit margin often shrinks, commonly settling around 15%.

It’s crucial to account for these factors to avoid overestimating potential earnings. The 70% rule serves as a guide, helping investors gauge a property’s potential, but requires careful analysis to yield successful flips.

Exit Strategy Considerations

Your chosen exit strategy is pivotal in determining the ARV percentage. More unconventional strategies provide flexibility in adjusting this percentage. For instance, purchasing for rental rather than resale might justify a higher purchase price since long-term gains like appreciation and rental income come into play.

Moreover, access to cash without the need for hard money loans can further influence the discounted purchase price, providing room to buy at a slightly lesser discount compared to flips involving significant financing costs.

Market Conditions

Real estate margins vary significantly depending on location, down to specific neighborhoods or zip codes. Thus, it’s crucial to familiarize yourself with local market conditions to adjust the rule effectively.

Each of these factors plays a part in fine-tuning the 70% rule, ensuring your investments remain sound and profitable.

Influence of Market Conditions

Market conditions play a crucial role, sometimes dictating variations in how the 70% rule is applied. Different regions, even specific zip codes or neighborhoods, operate under various margin expectations. These localized market variances mean that what works in one area may not be suitable in another. Investors need to tailor their strategies to align with local economic landscapes and market trends.

In summary, understanding how purchase prices and market conditions influence your investment strategy is essential. Adapting the 70% rule to accommodate these factors can significantly affect the profitability of your real estate endeavors.

To understand how the 70% rule compares to a more detailed analysis, it’s important to look at each approach separately.

The 70% Rule

The 70% rule is a quick and straightforward method often used by real estate investors to estimate the maximum allowable offer (MAO) on a property. This rule suggests that an investor should not pay more than 70% of the After Repair Value (ARV) of a property, minus the costs of necessary repairs. By using this rule, investors ensure they leave enough room for potential profit after accounting for all expenses related to the purchase and renovation of the property. However, this method provides a generalized estimate and may not always reflect local market conditions or other specifics that can impact a deal’s profitability.

Detailed Profit Margin Analysis

On the other hand, a more detailed profit margin analysis allows for a comprehensive evaluation of a property’s value and potential profitability. This involves using a specific formula:

MAO = ARV – Repair Costs – Purchase/Sale/Holding Costs – Your Desired Profit

This formula requires you to take into account all potential costs and expenses, including purchase, sale, and holding costs, rather than just focusing on repair costs. By integrating these detailed figures, you can arrive at a more precise offer price that is tailored to your financial goals and market realities. This approach is particularly beneficial when beginning in real estate investing, as it helps avoid relying solely on generic percentages and instead provides a customized financial strategy.

Comparison

While the 70% rule offers a fast, easy-to-apply guideline, it lacks the nuance and specificity of a detailed analysis. The detailed method, though more time-consuming, provides a thorough understanding of all influencing financial factors. Investors can use the 70% rule for quick assessments and then employ a detailed analysis to make informed, precise decisions that align with their financial targets and the intricacies of their local market.

Pros of the 70% Rule

Quick Calculations: The main advantage of the 70% rule is its simplicity. This rule provides a straightforward formula that helps investors calculate a reasonable offer quickly. By taking into account potential profits and expenses, the 70% rule allows for swift decision-making.
Built-in Profit Margin: This rule is designed to include a profit margin and cover various costs, such as repairs, closing fees, and holding costs. By sticking to this guideline, investors can potentially safeguard their profits from unpredictable expenses.
Structured Approach: For new and even seasoned investors, the 70% rule offers a structured approach to evaluating deals. This can help reduce the emotional aspect of investing and focus on numbers.

Cons of the 70% Rule

Accuracy of Estimates: One significant drawback is that the rule relies heavily on accurate estimates of the After Repair Value (ARV) and the cost of repairs. Beginners might struggle with these calculations, leading to inaccurate margins.
Market Variations: Real estate markets can vary drastically. In high-demand areas, sticking rigidly to the 70% rule might result in missed opportunities because sellers may have more competitive offers.
Not Comprehensive: While the rule offers a quick calculation, it isn’t comprehensive. Factors like location, market trends, and unexpected repairs can impact the actual profitability of a flip and may require more detailed analysis.

By understanding both the advantages and limitations of the 70% rule, investors can make informed decisions that align with their financial goals and market conditions.

Calculating Maximum Allowable Offer (MAO Formula):

Example: ARV x .70 – rehab = MAO or maximum allowable offer.

However, it is essential to remember that the estimated cost of rehab must be subtracted from the ARV to arrive at the final MAO. Estimating rehab costs can be challenging, especially for novice investors. Seeking advice from experienced contractors or utilizing online resources can help in accurately assessing the expenses associated with the renovation.

Here is a real life example:

Property Type: Single family home

The ARV for the property is $193,000 and the investors renovation costs are estimated at $80,000.

Using these numbers, we can now calculate the Maximum Allowable Offer.

Crunch the Numbers

Our Formula: Max Allowable Offer = (ARV x 0.70) – estimate repair costs

Max Allowable Offer = ($193,000 x 0.70) – estimated repair costs
Max Allowable Offer = $135,000 – estimated repair costs
Max Allowable Offer = $135,000 – $80,000
Max Allowable Offer = $55,100

Know Your Comps:

Knowing your comps, or comparable sales, is vital in determining the ARV and ensuring a successful house flip. Analyzing recent sales of similar properties in the neighborhood will provide valuable insights into market trends, demand, and pricing. This information will enable investors to make informed decisions and avoid overpaying for a property.

Why Understanding Your Market’s Typical Percentage is Crucial in Real Estate Investing

Grasping the typical percentage in your local real estate market is essential for several reasons. It allows you to set realistic expectations and make informed decisions that directly impact your investment’s success. Here’s how:

1. Aligns Investment Strategy with Regional Norms

Every market is unique, and understanding the typical percentage gives you insight into regional norms. By knowing what local fix-and-flip investors consider a standard profit margin, you can tailor your offers and strategies accordingly. This knowledge is typically gathered by conversing with seasoned investors at real estate meetups or seminars.

2. Informs Financial Planning

Having a handle on the typical percentages helps you better plan your budget, especially when purchasing properties below the After Repair Value (ARV). If you’re navigating this as a wholesaler, asking cash buyers about their preferred percentages gives clarity on how aggressively you can negotiate deals.

3. Enhances Negotiation Tactics

When you understand the typical margins, it empowers your negotiation tactics. You can present data-driven arguments to sellers, ensuring that your offers are competitive but also maintain profitability.

4. Aids in Risk Management

Recognizing what other flippers are achieving helps you manage risk by not overpaying for properties. If you’re unable to gather insightful data from local interactions, you can still evaluate your market by analyzing recent cash sales compared to their resale values post-rehabilitation.

5. Guides Compliance with the 70% Rule

The well-known 70% rule in flipping serves as a guideline, suggesting you should pay no more than 70% of a property’s ARV, minus repair costs. However, understanding your market’s unique dynamics may justify deviations from this rule to maximize potential returns.

By adopting these practices, you’ll not only stay informed but also positioned for success in the ever-evolving landscape of real estate investing.

Discovering the Percentage Discount in Your Market

Understanding the percentage discount in your real estate market is crucial for maximizing your investment potential. Here’s a step-by-step guide to uncovering these figures.

1. Engage with Local Investors

To pinpoint the typical discount percentages, start by connecting with local investors actively involved in house flipping. Attend real estate networking events, workshops, or seminars. These gatherings provide a platform to ask seasoned investors what discount rates they typically apply in the area.

2. Consult Cash Buyers

If you’re a wholesaler, it’s beneficial to know what cash buyers are willing to pay. Engage them and inquire about the percentage of After Repair Value (ARV) they target for their purchases. This dialogue can give you insights into the prevailing discount rates.

3. Analyze Recent Sales Data

Should direct insights be scarce, turn to data analysis. Examine records of cash sales in your neighborhood. Compare these purchase prices with the subsequent selling prices post-renovation. This method allows you to calculate an approximate discount rate that local flippers are achieving.

4. Adapt to Market Trends

Remember, strict adherence to fixed rules like the 70% rule isn’t always necessary. Instead, be responsive to evolving market conditions and adjust your strategies accordingly. This flexibility ensures you remain competitive and well-informed about your market’s practices. By leveraging these methods, you can accurately identify the discount percentages in your area, enhancing your investment strategy.

Finding Properties:

Finding suitable properties to flip is a crucial step in the house flipping process. Real estate investors employ various strategies to identify potential opportunities. Networking with other investors, attending local real estate meetings, and building relationships with real estate agents can uncover off-market deals. Additionally, online platforms, such as MLS listings, auction websites, and foreclosure databases, offer a vast array of properties for consideration.

Avoid Overrehabbing:

One common mistake made by novice investors is overrehabbing the property. While it may be tempting to add extravagant finishes and amenities, it is crucial to remember that the goal is to generate a profit. Overrehabbing can lead to increased expenses and extended holding periods, ultimately reducing the potential return on investment. Striking a balance between necessary repairs and cosmetic upgrades is key to maximizing profits.

In conclusion, mastering the 70% rule is essential for real estate investors looking to succeed in the competitive world of house flipping. By understanding how to calculate the Maximum Allowable Offer (MAO), analyzing comps, effectively finding properties, and avoiding overrehabbing, investors can increase their chances of achieving substantial profits.

The 70% rule streamlines the process of making quick and informed decisions. This formula inherently includes a margin for profit and costs, which simplifies calculations for both newcomers and seasoned professionals. By accurately determining the After Repair Value (ARV) and estimating repair costs, investors can confidently make offers knowing that their calculations will likely lead to profitable outcomes.

For beginners, this rule offers a straightforward method to assess potential deals without extensive experience, while experienced flippers benefit from its efficiency in evaluating multiple properties. The 70% rule is a valuable tool in any investor’s toolkit, ensuring that house flipping ventures are both calculated and rewarding.

Once you have figured out that your target fix and flip property meets the MAO formula, contact us and get financing from Preferred Capital Investors today!