Purchasing homes to renovate and flip is a common real estate investment strategy. So, too, is home buyers purchasing an inexpensive property that needs some rehab or customization, or even a mortgage refinance when your existing property needs renovations. However, just because you have the desire to purchase a home and then renovate it does not mean you might have the cash resources to do so. This is, of course, where mortgages come into play, as many investors and buyers will finance a property purchase.
Banks will only offer a certain amount of lending to borrowers based on a specific formula known as loan to value (LTV). If the LTV of a property isn’t within acceptable parameters, a bank is unlikely to offer mortgages to prospective borrowers, as anything over 80 percent is considered a poor risk. However, there’s another ratio that comes into play when talking about purchasers seeking mortgages for homes they want to renovate. This ratio, which is called “after repair value”, is related but has some important differences. Here’s what you should know.
As mentioned above, the LTV is a ratio that lenders use to determine the balance between the amount of money being lent to the overall value of a property. Meanwhile, an after-repair value, or ARV, is the estimated value the same property after renovations have been completed. This differs from LTV as ARV is not calculated using the current condition of the property.
ARV is commonly used by real estate investors who plan on flipping a home as a way to gauge the worth of the property they plan on rehabbing. There are a couple of factors that go into calculating that worth, which include the purchase price of the property, the cost of repairs, and then the price it can be resold for after those repairs, whatever they may be, have been finished.
Calculating an ARV is slightly more complicated than calculating an LTV. For example, the loan to value ratio for a property is the value of the mortgage being sought divided by the total cost of the house, as expressed by a percentage. An example would be how buying a home that’s valued at $100,000 with a $20,000 down payment would require an $80,000 mortgage with an LTV of 80 percent.
Calculating ARV also has to take into account other factors, like repair cost and estimated resale price, according to the following formula.
Most house flippers and investors use a simple formula to calculate ARV. You begin with the cost of the property, and then you add the cost of renovations. A property that costs $195,000 that will cost an estimated $55,000 to repair has an ARV of $250,000.
This is different than an LTV, as the result isn’t a percentage that lenders then use to determine suitability. Instead, it’s a more concrete number (albeit an estimation) of total costs to the real estate investor.
Knowing your ARV lets you then determine what you should be selling that property for once you’re done renovating it. Resellers don’t want to end up spending so much on a property that they won’t make a profit off it, after all. The maximum offer price of a property, or the most an investor should pay for a property, is 70 percent of the ARV minus the repair costs. To follow the example above, the maximum offer price for a home with an ARV of $250,000 and estimated repair costs of $55,000 would be $120,000. This 75 percent rule is common in the industry, but some resellers may go as high as 75 percent or even 80 percent when making offers on properties they wish to flip. This can help them outbid others but can result in higher risk factors – especially if repairs run over budget.
Once you have decided on the percentage ARV you’re going to use, it’s time to put it into practice. Doing so requires knowing what constitutes a good ARV in the context of what you can resell the home for once you’ve done renovating it. This process is much more complex, as it involves looking at comparable properties in the area that will match the property after renovation. The ideal comp for such a property would be homes that are built in a similar style, are within the same neighborhood or subdivision, have a difference of less than 250 square footage of the subject property, and were constructed within 5 to 10 years of the property. Looking at the sale prices for these comps can tell a reseller what price their own property is likely to sell at after putting it back on the market after renovations.
The process of flipping a property – which is buying a home in need of repairs, renovating it, and then selling it at a profit – is one way to invest in real estate. There are, of course, plenty of risks involved in such an investment, which is why real estate investors and house flippers use the after-repair value of a home to determine the possible profit they could stand to make after a sale – provided they keep their purchase and repair costs in line with their estimations. It’s a complex dance that involves choosing a property with an ARV that is in line with comparable properties, being able to purchase that home for 70 to 80 percent of its total ARV minus its repair costs, and then being able to find a buyer for their renovated property. It can be risky, but as all investment carries risk, understanding the math behind the risk is a helpful tool in managing that risk.