The purpose of the property-flipping industry is to buy a rundown property at a bargain price, fix it up, and sell it profitably. To reap a profit, flippers spend money to rehab and repair their properties before putting them up for sale. After repair value (ARV) is an important metric that lenders use when financing flip properties. It is especially important when hard money lenders finance projects. Let’s dig into the ARV meaning, understanding what is ARV, its calculation, and its importance within the industry.
What is ARV?
Technically, the acronym ARV stands for: After Repair Value. ARV in real estate is a property’s value after an investor has conducted repairs. It is the basis of the property’s selling price, comprising the purchase price plus the total cost of repairs. The key to the profitability of property flipping is that repairs more than pay for themselves.
For flipping to be profitable, investors must understand local market dynamics. They know the profit available from flipping as opposed to alternative investment opportunities. Flipping is unique within the real estate industry for its reliance on sweat equity. It’s a way to turn expertise and hard work into significant profits. Flippers need sales experience to decide how much to invest in property repair. Owning a real estate license can be a great help to property flippers.
Flippers may also have a background in general contracting, whether they perform the repairs themselves or hire out contractors. Although not strictly necessary, having contracting experience is useful in calculating ARV and therefore forecasting return on investment (ROI).
ARV in real estate is not merely book value, but rather an informed opinion about how much to spend on purchases and repairs.
How to Calculate ARV
The formula for ARV is:
ARV = Property’s Current Value + Value of Renovations
The current value is how much you paid to purchase the property. The value of renovations may be a pre-repair estimate or post-repair actual costs. The pre-repair estimate is important for lenders who finance a flip project.
You may be able to find an online ARV calculator. However, it’s easy to construct an ARV calculator in Excel. In fact, you can download ARV calculator spreadsheets via an internet search.
The 70% Rule is popular among flippers:
Maximum Purchase Target = (ARV x 70%) – Estimated Repairs
This rule supposedly tells you the maximum you should spend on a flip property. However, it is only a general guidance and you should not consider it an ironclad rule.
The ARV Formula in Real Estate
Hard money lenders use a different lending paradigm than banks do. Typically, a bank lends an amount that is a percentage of the current value. That percentage can be 80% or higher, depending on the loan’s equity requirements. For example, imagine a flipper buys a property for $200,000 and expects to spend another $100,000 on renovations. If the bank requires a 20% down payment, then the loan amount will be $160,000, which is 80% of $200,000. The flipper will have to provide $40,000 for the down payment and $100,000 for the renovations, or $140,000 in equity. That means the entire project is about 53% financed by debt (that is $160,000 / $300,000).
By comparison, a typical hard money lender will lend up to 70% of a property’s ARV. In this case, that is 70% of $300,000, or $210,000. Clearly, the flipper will have to pony up $90,000 in equity for this project, which is $50,000 less than the bank will lend.
According to the 70% rule, the property in this example is grossly overpriced. The maximum price should be (70% x $300,000) – $100,000, or $110,000. That’s $90,000 less than the indicated purchase price. The example illustrates the mistakes a novice flipper can make when entering into a deal.
A flipper might prefer to borrow from the bank because it has a lower interest rate. But the higher interest rates of hard money loans may be of secondary importance compared to the equity differences. A bootstrapping flipper might not be able to supply all the equity required by conventional lenders.
In addition to the difference in equity requirements, other considerations may be in play:
- Loan Approval: Banks require borrowers to have good credit. That means a relatively high credit score and a clean background regarding foreclosures and bankruptcies. The bank will underwrite the loan based primarily on your creditworthiness. On the other hand, a hard money lender will focus more on the property’s ARV. It will usually OK a loan if the numbers add up properly. The lender might or might not consider the borrower’s past financial experience. But in most cases, the borrower’s credit history is of lesser importance than the financials of the deal and the property.
- Transaction Speed: A bank might require 6 to 8 weeks or longer to approve a real estate loan. That’s the time it takes underwriters to perform due diligence on the borrower and the deal. By way of contrast, a hard money lender may be able to close on a loan within 2 weeks or so. That’s extremely important in the flipping industry because flippers compete for newly available properties, often at auction. A delay in financing could hamper a flipper’s ability to compete.
A flipper’s ability to value a property is vital. First, a flipper must evaluate a property’s current value. That requires the flipper to fully understand the property’s current condition. Furthermore, the flipper must underpay the current value in order to maximize the profitability of the deal. Therefore, the flipper must either be an expert at property assessment or rely on an expert third party.
The estimated cost of renovations is even harder to assess, since there may be hidden damage discovered during repairs. Underestimated repair costs will reduce the flipper’s profits. If the hidden damage is severe, the flipper may take a loss. In the worst case, the flipper will walk away from the deal, saddling the lender with the property.
For example, imagine that a repair plan calls for laying down a new floor. In the process, the flipper discovers an extensive mold issue that requires structural repairs. This increases repair costs and ARV. Had the flipper understood the problem before borrowing, it would have been able to seek a larger loan. Even so, buyers might balk at the higher after repair value because they don’t understand the dollar value of the repairs.
Another issue is the limit on the property’s value imposed by comparable properties. It may not be possible to price the property high enough to make the desired rate of return on the flip. Therefore, you may have to adjust the asking price and the renovation plan.
Limitations on ARV
One ARV limitation is that it’s a snapshot in time. The ARV in real estate depends on the current real estate market and the perceived state of repair. These factors may change during the repair cycle. A pandemic might send property values plummeting as foreclosures rise. On the other hand, property values might rise if the economy strengthens. Miscalculation of repair costs can also disrupt a flip deal’s economics. All of these factors can result in an after repair value significantly different from that at loan closing.
In addition, an appraiser might value properties differently than would a realtor or investor. Lenders depend on appraisals, which could lead to a lower pre-repair property value, exposing the flipper to a possible loss. Flippers must also be good negotiators when they buy a distressed home and then sell it after repairs. A flipper good at estimating repairs but poor at negotiations may not receive the property’s ARV at sale time. Of course, a flipper can hire a real estate agent to negotiate the sale. However, that will typically cost a fee of 5% to 6%.
In sum, a property’s after repair value requires accurate estimations. Project ROI will suffer when an appraiser misunderstands local market conditions and/or property condition. An investor should prepare ahead of time for possible losses due to unforeseen circumstances.
How Assets America® Can Help
Assets America® offers acquisition and renovation loans starting at $10 million. We have access to a network of funding sources built over greater than three and one half decades! We can fund deals that other lenders cannot. And, we can fund a project in in as little as two weeks rather than months. If you have a large project, turn to Assets America® for the best of both worlds. Please call us to discuss your funding needs.
Frequently Asked Questions
Which related metrics are important for commercial real estate appraisals?
Important metrics include capitalization rate, net operating income (NOI), lease terms, rental rate, TI allowance, and rent escalations. You also must look at return on investment, loan-to-value ratio, and debt service coverage ratio when asking for financing.
What is the 70 percent rule?
This is a rule stating that flippers should pay no more than 70% of a property’s ARV minus the cost of required improvements and repairs. If you pay more, you might not turn a profit on the deal.
How do you calculate the ARV for wholesaling?
The calculation is usually moot because wholesalers typically do not perform repairs on properties. The calculation is the same, and it affects the sale price according to the 70% rule.
Is 2020 a good time for flipping commercial properties?
Yes, there are many foreclosures and interest rates are rock bottom. Now is a great time to take the plunge. Contact Assets America® for timely advice on projects starting from $10 million.