Thursday, February 18, 2016

Why the 70% Rule is Dead

After moving to Tampa, FL - the real estate guru capital of America - from San Antonio, I keep running into people quoting the 70% rule, I believe coined by Ron Legrand.  But after examination of more than 10,000 transactions our company has conducted nation wide I must say, I think this rule is out of date.

I'm sure this was extremely applicable back in the 80's and 90's before MLS was a thing in the real estate world.  I remember my dad's big binder full of all the active listings and the fax coming in every morning with the listing updates.  He'd spend an hour going through his binder, removing the old listing, and placing the new one in it's place.

You used to really be able to make a killing investing in real estate back then.  Information just wasn't accessible to anyone, even real estate brokers.  In a non disclosure state like Texas where the sales price of real estate is not recorded it must have been absolutely impossible for anyone to conduct any type of real estate business without the consistent help on an agent.  At least the local board of realtors kept records of what houses sold for in their market.

I remember the first iteration of MLS in San Antonio which ran of MS DOS.  With an AOL trial CD and no one picking up the phone in your house you could quickly research what was happening in your area.  Before mapquest (remember that one) you had to have one of the large Mapsco books that gridded the city over and flip between pages trying to find what street you were going to.]

But that's over.  Margins are becoming tighter for real estate investors.  The reason is the ease of access to information.  Moving to Florida is like getting in a DeLorean and shooting thirty years into the future from small town San Anton.  The amount of information available here is staggering - and if you have a real estate license and pay for MLS access you can do some pretty incredible things.

The profits you can make in residential real estate aren't shrinking because the market is hot or cold.  The tools available are making consumers - sellers - more informed than ever before.  It's becoming more difficult to tell someone selling their home to you that you can only pay $50,000 when they know it's worth $120,000.  Of course their are deals out there but because of mass marketing tools such as Zillow, Hubzu, Auction.com, and now even county auction websites, more eyes are on the limited amount of deals out there.

Good ol' Texas... I miss you.  I used to read the actual MLS feed constantly throughout the day and when I saw a deal I'd usually be the first person at the house, the first person with an offer in, and the person who ultimately got the deal.  Tampa seems to have 100 times as many people doing the exact same things I do.  If you think that 70% deals are still out there, I beg to differ.

To the people who tell me, "I only buy houses 70% of value less repairs," I say, "And how many of those deals are you actually doing?"  I can't walk into the grocery store, pick up a sack of potatoes that's advertised for $8.99 and tell them, "I only pay $6 for sacks of potatoes."  The high school cashier is going to look at me like I'm out of my mind.  It just doesn't work like that.

This guy named Adam Smith wrote a book before Legrand called An Inquiry into the Nature and Causes of the Wealth of Nations a few years earlier, 1776 I believe.  What I was beginning to describe earlier was the basis of the efficient-market hypothesis, something most business majors dabble in during college.  To break it down, the more information consumers have in the market place the more efficient the market and thus, the more difficult it is for investors to achieve a sale price of less the actual value (ARV - repairs).

The other factors effecting the market rate for real estate investments are things such as number of competitors, average availability of capital to those parties, the availability of credit, etc.  "The 70% Rule" really has to change depending on what market you're buying in.  Truly buying at 70% of a houses actual value less the repairs will basically always yield you a profit.  Something seriously catastrophic would have to happen for you to lose on that deal.

But the reality is, people aren't paying that.  In super desirable areas such as South Tampa you're paying around 81% of a houses value less repair work.  In wildly undesirable areas such as  South St. Pete, you can't even really get an ARV as all purchases in the area are investor purchases looking to rent the house out to a Section 8 tenant and is focusing more on cap rates than resale values.

In a nation wide study examining our offices in the markets of Atlanta, Austin, Dallas, Denton, Ft. Worth, Houston, Las Angeles, Philadelphia, San Antonio, and Tampa we haven't found a place that's selling a true 70% deal.  Sure, you can inflate the ARV on it ten or twenty thousand dollars, that will get you there.  I love deals where I'm told that a 1,500 sqft house only needs $10,000 in work, something I've never been able to pull off even on my rentals.

In summary the 70% model of buying houses teaches you something in the end.  You need to be careful that you're building enough room into your offers for profits, holding costs, realtor commissions, and closing costs.  You do need to remain competitive however.  If you're constantly getting beat out in multiple offers the market may be bearing less margin for profit than you're trying to achieve.

https://www.biggerpockets.com/renewsblog/2014/02/14/70-rule-bible/
https://www.biggerpockets.com/renewsblog/2012/11/03/flip-houses-formula-math/
https://www.youtube.com/watch?v=JpfnAMRj-2Y

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