Real estate can be a great investment – if you do your homework and know what you’re doing. You can’t just invest in any property and assume it will turn a profit. That is not how it works. Investing in real estate requires a significant investment of time and money, which means that if your investment fails, you could stand to lose a lot.
A key factor in determining whether or not a real estate opportunity will be a profitable investment is by identifying the potential return on investment (ROI). In order to calculate the ROI, you need to know two things: the purchase price of the property and the estimated future value of the property.
The purchase price of the property is self-explanatory – it’s how much you paid for the property. The estimated future value of the property is more difficult to determine. If you’re investing in a fix-and-flip, then one of the essential components of calculating the estimated future value is to identify the property’s after repair value (ARV).
What Does The ARV Mean In Real Estate?
The after repair value (ARV) is the estimated market value of a property after repairs and renovations have been completed. Investors use the ARV to determine whether or not a fix-and-flip investment is worth pursuing. If the estimated ARV is lower than the purchase price plus the cost of repairs, then the property is likely not worth the investment.
The ARV is also commonly used to secure loans for repairs and renovations. Lenders want to make sure that your investment will turn a profit to help mitigate the risk that they are taking on. By including the ARV in your loan application, you can show lenders that your investment is a sound one and that you have a plan to make a profit.
A Basic After Repair Value Formula
The basic ARV formula is as follows:
ARV = Property’s Purchase Price + Value Of Renovations
The formula may seem straightforward, but you have to remember that the “value” of the renovations is not the same thing as the “cost” of the renovations. The cost of the renovations is what you actually pay out of pocket –e.g., materials, labor, etc. The value of the renovations is determined by the market once the repairs and renovations have been completed.
How To Calculate The ARV
To be able to use the ARV formula, you’ll need to know how to calculate the value of the property you’re investing in, as well as the value of the renovations that you plan on doing. As such, the following are the steps you’ll need to follow to accurately calculate the ARV of a property:
1. Assess Your Competitors
By comparing your property to other similar properties (known as “comps”), you will get a better idea of how much your property is worth after you’ve made all of the necessary improvements.
To do this, there is a simple formula to follow. When you identify your comps, divide the selling price of those properties by their square footage to get the average price per square foot. Take that number and then multiply it by the square footage of the property you are planning to invest in. This will give you a rough estimate of the ARV. Try using around three to six comps to get an idea of what the average ARV will be.
Although you can use the resources available to you to make the necessary comps (by looking at listings online), assessing your competitors is much easier if you work with a real estate agent. Real estate agents have access to the Multiple Listing Service (MLS) and will have a better understanding of the local real estate market.
With that being said, the following are a few essential elements to look for when searching for comps:
- Comps should be in the same neighborhood
- Comps should be similar in size and style
- Comps should be similar in age
- Comps should be upgraded to a similar extent
2. Obtain An Appraisal Of The Property
The list price of a property may not represent the actual value of the property. When it comes to fix-and-flip houses, it’s not uncommon for a seller to list a property at a price under the current value because of the amount of renovations needed to make the house livable. Either way, you’ll want to obtain an official appraisal of the property to identify its actual value.
An appraiser will take into account a wide range of factors in order to calculate and assign a value to the house. This includes:
- The overall condition
- The property size in square feet
- The number of amenities, bedrooms, and bathrooms
- Curb appeal
Appraisers can also do post-renovation appraisals, which will give you a better idea of how much your property will be worth once the planned repairs and renovations are completed.
3. Evaluate The Cost Of Repairs
Once you’ve identified all of the necessary repairs that must be made, you’ll need to come up with an estimate for the cost of repairs. The best way to do this is by speaking with a reputable contractor who can provide you with accurate estimates.
The last thing you’ll want is to encounter unexpected costs after you’ve already calculated and presented your ARV. As such, be sure to do a careful and comprehensive evaluation of your property’s renovation needs when determining the ARV.
Limitations Of The ARV
The ARV can be very useful when it comes to estimating how much you could potentially make from a fix-and-flip investment. Additionally, it can be helpful in demonstrating the potential profit of the investment to lenders. However, there are some limitations to using the ARV that you should be aware of. These limitations include the following:
The ARV Shows Specific Time Window Estimations Only
The ARV only represents the potential value of a property if it’s sold in the present. There are a lot of things that can change after you’ve calculated your ARV. For example:
- There may be a sudden shortage of materials, resulting in the estimated cost of renovations going up
- New local laws could be passed that affect the value of properties in the neighborhood you’ve invested in
- The announcement of a new construction project in the close vicinity of your property could affect its value
These are all unforeseen events that can affect the ARV. The bottom line is that the ARV should only be used as a general guide when estimating how much you could potentially make from fix-and-flip investment. Remember that there are many factors that can impact the value of your property over time.
Market Value Fluctuations In Real Estate
Just like any other type of investment, the real estate market is subject to market fluctuations. The real estate market can be very volatile, which means that the value of your property could increase or decrease significantly over time.
For example, let’s say you purchase a fixer-upper for $150,000 and sell it for $230,000 after you’ve made all of the necessary repairs and renovations. However, by the time you actually list the property, the real estate market in your area may have taken a turn for the worse and home prices may have decreased significantly. As a result, you may only be able to get $200,000 for it.
Depending on whether or not you spent a lot on remodeling the property, you may not make much of a profit if any at all.
Appraisers May Value A Repair Differently Than Investors
Appraisers are not fix-and-flippers or investors. As such, they may not have the same opinion as you when it comes to estimating the value of your property.
For example, you may think that a certain repair will add a lot of value to your property, but an appraiser may not agree. In their opinion, the repair may not be worth the money you’re spending on it. This is why it’s important to have a clear understanding of what repairs and renovations are most likely to add value to your property before making any decisions.
How The ARV Fits Into The House Flipping Business
House flippers use the ARV to know how much they should pay for an investment property because it tells them the maximum amount they could potentially make from selling the property. This is useful information for house flippers because it allows them to know how much they can afford to spend on a property without losing money.
Essentially, the ARV gives them a better idea of whether any given fix-and-flip investment opportunity is worth their time and money.
The 70% Rule
The 70% rule is a guideline that house flippers use to determine how much they should offer for an investment property. The formula is as follows:
(ARV x 70%) – Estimated Repair Cost = Maximum Purchase Target
For example, let’s say you’re looking at a fixer-upper that has an ARV of $250,000. Based on your estimate of the repairs needed, you believe the total cost will be $40,000. Using the 70% rule, you would calculate the maximum purchase target price as follows: (250,000 x 70%) – 40,000 = 140,000
This means that you should offer no more than $140,000 for the property. Doing so ensures that you’ll be more likely to turn a profit after you’ve purchased the property and have made all the required repairs. Additionally, it will give you financial wiggle room in case unexpected expenses creep up.
At the end of the day, it’s up to you to decide how much you’re willing to offer for an investment property. However, using the 70% rule is a good starting point when making an offer.
Ensure A Healthy ROI With A Properly Calculated ARV
If you’re thinking about getting into the fix-and-flip business, it’s important to make sure that you have a clear understanding of ARV and how to properly calculate it. Knowing the ARV of a property will help ensure that you’re making sound investments that will give you a healthy ROI.