How to calculate ARV in real estate, how to use it to analyze potential investments, and what are the limitations of this metric?
ARV stands for after repair value. As the name suggests ARV in real estate is the calculation to determine the value of a property after repairs have been completed. This is an important metric for real estate investors as it allows them to determine the potential value of an investment property after repairs and calculate the maximum price they can pay for the property and still make a profit.
In order to calculate ARV, you must factor in local market conditions and the costs of the repairs that need to be undertaken. However, you won’t necessarily know exact costs and, due to external factors, the market can fluctuate significantly the resultant estimate isn’t always accurate.
In this article, we take a look at how exactly to calculate ARV, how you can use it to analyze potential investments, and what these limitations are.
If you want to purchase a “fixer-upper” property, one that requires renovations before selling or renting, you need to have an idea of the value the property will achieve after all the work is completed. You can hire an appraiser to do a comparative market analysis or you can do your own rough calculation.
Thankfully, the calculation itself is pretty straightforward if you want to do it yourself. Here’s what you need to do:
The first step is to get an accurate estimate of the property’s value by comparing it with like properties in the area. You can do this by analyzing five or six comparable properties (comps) in the area.
Look through multiple listing services or talk to local realtors to determine recent property sale prices. The properties you look at should be near to the property you’re analyzing and either still be on the market or have sold within the last 90-120 days. Prioritize properties that have similar features to the property’s projected state after repairs and renovation (rather than looking at properties in a similar state to the current condition).
Once you have a selection of similar properties, divide their sale price by their square footage to get a price per square foot of your comps. Do this comparison for each comp and then average the results by adding them all together and dividing by the number of properties. This will give you an average price per square foot of comparable properties in the area.
The formula for calculating ARV is pretty simple.
ARV = avg. price per sq. ft. of comps x your property’s sq. ft.
For example, if the average price per square foot that you calculated was $150 and the property was 2000 square feet the ARV would be $300,000.
Once you have the estimated ARV of the property you can use it to estimate the maximum amount of money that you can pay for the property and still make an acceptable profit. This is where the 70% rule comes into play.
Estimating the potential cost of repairs and renovations can be a challenging thing to do. It’s a good idea to get several different independent contractors to survey the property.
By consulting with a few different contractors you can get several written estimates for the cost of the work and average the estimates to hopefully come to a realistic spend. Be sure to get an itemized list of each repair that includes both labor and material costs.
Related: Rental Property Accounting 101: Capital Improvements vs. Repairs
House flippers and property resellers often operate with a 70% rule. Again, this is just a general estimating tool, but as a rule of thumb investors only buy a property if it is priced at no more than 70% of the after repair value minus the cost of the renovations.
The formula for the 70% rule including the ARV is
(ARV x 0.7) – estimated repair costs = maximum bid price.
A real estate investor locates a potential property. They calculate the ARV to be $400,000 after all the designated repairs and renovations are concluded. They then estimate the total for all the repairs will cost $50,000. Using the above formula investors can calculate that the maximum amount they should pay for the property is ($400,000*0.7) – $50,000 = $230,000.
There are a few limitations to using this metric. First and foremost, it is only an estimate, the two major inputs, the property value and the cost of the repairs are often inaccurate and can change over time depending on various factors. Additionally, whilst comps can help inform you of the property’s valuation after repairs, estimating repair costs is more subjective.
ARV also doesn’t include unforeseen expenses. One thing that is especially true for older properties that are in need of significant repairs, is that there may be hidden issues. For example, there might be water damage that escapes the surveyor’s notice. Serious repairs may only be discovered once work has begun which will dramatically increase your repair costs.
Finally, markets change. House prices can fluctuate from year to year or even month to month. If the market takes a turn for the worse, you may find that you need to hold on to the property for a while longer than planned, or you may end up selling the home for less than you anticipated.
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