Real estate investors, whether looking to purchase a rental property or determining how to put a long-term rental back on the market, can anticipate reaching into their pockets for renovations. While most renovations will require some capital expenditure, not all dollars spent are equal. Investors should understand how to measure a renovation’s return on investment to make smarter improvement choices.
Contemplate, Then Renovate
Prior to beginning any renovation project, it is important to consider the financial impact renovations can have on a property from a rental perspective. Every renovation choice by a property owner has to make financial sense. It is not smart to put in more than you are able to get out.
Renovations can affect rental rates, vacancy and the long-term performance of your investment property. Here are three big items to consider at the outset:
- Improving the property to meet municipal and building code standards. Before dreaming about the returns you may garner post-rehab, make sure you are covering the basics. Can you legally lease your investment property? If a property is uninhabitable or lacks a certificate of occupancy, then renovations are necessary prior to a tenant moving in. This is particularly the case when it comes to complying with applicable laws, regulations and building codes that may have changed since the property was initially built.
- Improving the property to a condition desired by the local market. Maybe a property is in decent shape, but it’s outdated compared to available rental properties in the neighborhood. In this case, renovations are optional as you may be able to find a tenant at a lower rental rate. But in order to charge market rent and drive solid rental demand, making improvements consistent with local comparable properties may be a good idea. Conversely, sometimes investors rehab a property far beyond what is necessary because they make the false assumption that all improvement dollars can push rents higher. If all of the homes on a street have carpet and tile countertops and rent for around $1,500 per month, do not expect that investing in hardwood floors and granite countertops will increase rent to $2,500 per month. The market may be unwilling to agree with your expectations of rent and the result may be that you have a very nice, very empty house until you decide to adjust your rent to what the market will bear.
- Understanding the ROI and lifespan of renovations. As a rule of thumb, you should consider renovations that yield at least 20 percent in initial annual return on your renovation investment and have a life span long enough to last well beyond returning the initial cost. For example, if you renovate all of the bathrooms in your rental for $12,000, you should make sure those improvements will allow you to increase the rent at least $200 per month ($2,400 annually = 20 percent of renovation cost). Bathrooms generally have a lifespan of 20 years, so by the time you need to do another renovation, your $12,000 renovation costs would have grossed you $48,000 in additional income. That means you made $36,000 on your initial investment of $12,000 over 20 years. That is a 300 percent ROI over 20 years and a simple annualized return of 15 percent. To put this into perspective, the Standard & Poor’s 500 index annualized return for the past 20 years was 6.1 percent.
While the situation described in item 1 tends to be a matter of following the applicable laws and regulations to comply with standards, items 2 and 3 fall into a gray area since there is no clear roadmap to determine what type of renovations should be done or how extensive they ought to be. This really comes down to you, as an investor, to understand the local market and work with local resources that can assist your renovation efforts.
Renovations require weighing the costs against the benefits. Holding off making renovations to a property that needs them may mean that to get a potential renter in the door you may have to price the home below market rent. While you did not have to make that initial spend, devaluing your investment could mean that you might lose out on potential long-term upside from rental cash flow.
The overarching solution may be to improve a property to meet market standards in order to charge market rent and create consistent demand for your investment property.
Consider the Renter and the Next Owner of Your Property
Property owners must understand and analyze not only how renovations may impact rent but how they may impact the overall value of the property as well.
There may be many reasons why you may want or need to sell your investment property, so it’s important to consider the potential value of those improvements relative to their cost on a retail basis. If you improve certain aspects of the home that are less valuable to a potential buyer than what they cost, you run the risk of losing money and reducing your equity in the property.
Here is a brief snapshot of how the numbers shake out when it comes to the value versus cost of renovations. The National Association of Realtors highlights how renovations resulted in value for homes in their 2015 Remodeling Impact Report. Keep in mind that these numbers are averaged, so the percent of value recovered may be substantially higher or lower on an individual property than indicated in the report.
|Type of Renovation||Remodelers' Cost Estimate||Realtors' Estimated Cost Recovered||Percent of Value Recovered|
|New Roofing||$7,600||$8,000||105 percent|
|Insulation Upgrade||$2,100||$2,000||95 percent|
|Wood Flooring||$5,500||$5,000||91 percent|
|Vinyl Windows||$15,000||$12,000||80 percent|
|Kitchen Renovation||$60,000||$40,000||67 percent|
|Bathroom Renovation||$26,000||$15,000||58 percent|
Data sourced from National Association of Realtors.
These numbers can be staggering when thinking about the investment in time and money that renovations require. It’s clear that certain renovations may not deliver the added value you might anticipate at the outset. Don’t waste time getting frustrated. Get smart.
In order to get the most of your investment, it’s important to do your homework. Make sure you truly understand your market so you can take the right action to meet neighborhood standards, get the home occupied quickly and charge the right rent so your investment can pay off.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of Investability Real Estate Inc. or Altisource.
Clarified on July 29, 2016: This article was updated to note that the views expressed are those of the author, and not necessarily of Investability Real Estate Inc. or Altisource.