After repair value (ARV) is the expected market value of a property after construction, repairs, refurbishment, and other improvements. A realistic ARV takes into account the local market rather than simply looking at the cost of the work and materials. Understanding ARV is key to deciding if a project is viable and suitable for financing.
ARV is a simple but valuable concept. It’s an estimate of how much a property would fetch on the open market after specific changes. Most commonly this involves renovations, as in a “flipper upper” property. An ARV could also cover the value of a property after an extension, adding extra rooms, or even a completely new construction on currently empty land.
ARV is important both for the people carrying out a project and for anyone financing it. It’s reckless to begin a project without:
- Assessing an ARV.
- Comparing it to the purchase price of a property.
- Making sure the difference is big enough to cover the cost of materials and any contractors.
- Ensuring it leaves enough profit to justify the time and energy of running the project.
Calculating the expected profit margin using the ARV also shows how much leeway you have for unexpected delays, cost increases, or changes in the property market. This in turn lets you assess the balance of risk and reward as well as whether you need to negotiate the purchase price downward to make the deal viable.
Similarly, private lenders who specialize in fix & flip properties and similar projects will want to know your expected ARV for two reasons. First, they’ll want to know the profit margin is high enough to justify the risk in the project. Second, they may look at whether your ARV is realistic, which may affect their confidence in your understanding and ability to run the project.
Calculating an ARV is a specialist skill and it’s often best to hire a professional appraiser. However, it’s useful to know how calculating ARV works, both to work out your initial figures (perhaps highlighting that a project is a complete non-starter) and to understand the reasoning behind the professional appraisal.
Some assumptions people have about ARVs are completely wrong. The appraisal does not simply take the purchase price of the property or its current market value, then add on the expected costs and a “going rate” for profits on such projects. Neither does it take the current market value and add on a particular percentage.
Both of these methods are about the inputs and process: ARV instead looks solely at the outcome. An appraiser will take the plan for the “finished” property, including size, rooms, facilities, and state of repair, then compare it with similar properties already on the market. In particular, they’ll look for recent sales in the same neighborhood to get a fair comparison.
Looking in the same local market is particularly important as the comparison between properties before and after improvements can vary wildly. For example, two-bedroom houses in fair-but-tired conditions may fetch similar prices in a suburb near a school and in a rural community favored by retirees.
When upgraded to a pristine three-bedroom property, the ARV may be very high near the school where such houses are in demand by growing families. However, the ARV may be lower in the rural community, with retirees not having as much need (or buying power) for the bigger and fancier houses.
The key to remember is that ARV isn’t based on the cost of the repairs, but instead assesses the value added by the repairs.
In principle, it’s a straightforward process to compare an ARV to the various costs in a project and work out the profit potential. In practice, people often overlook some important factors. Just some of the questions to ask include:
- How much will the property cost to buy?
- How much will contractors cost? Are lower estimates realistic, and is there a risk of the contractor going over budget or past the schedule?
- Will raw materials be available, and could the cost change? (Supply chain issues make this particularly important at the moment.)
- What are the likely costs associated with both the purchase and sale of the property?
- Are you responsible for any costs such as local taxes or homeowner association fees while you own the property?
- Have you taken account of utility costs while you are working on the property?
- Do you need to insure against damage to the property or liability during renovations?
- Does your anticipated profit margin adequately reward your own time and efforts on the project?
The 70% Rule
People in the property investment business frequently cite the “70% rule” when talking about ARV. It’s a rule of thumb rather than an unbreakable formula, but it’s based on sound logic and experience. It’s often the starting point for potential financers deciding whether to offer a loan.
The rule sets a maximum amount you should pay for a property that you buy solely to improve and sell. This amount is calculated as 70% of the ARV, minus your estimated repair costs.
To give an example, imagine you expect to spend $75,000 repairing a property and your expected ARV is $400,000. Under the rule, the maximum amount you should pay is: (70% of $400,000) – $75,000 = $205,000.
Another way to understand the rule is that your total costs (including both the purchase and the costs of repairs and improvements) should be no more than 70% of the ARV. Some home loan companies follow the rule by having a policy to not lend more than 70% of the ARV.
In each case, the theory is that this leaves a big enough profit margin to mitigate many of the risks (e.g., unexpectedly high repair costs or a disappointing sale price), leaving a project that will still be worth the time and effort.