Determining when, where, and how much funds to pump into property improvements is no easy task – even for the most sophisticated real estate investors. These determinations are not always intuitive. Installing new windows, for instance, might seem like a worthy investment. But will residents be willing to pay enough of a premium to cover the costs? It's unlikely.
Decisions about property renovations are a mixture of art and science. Some property improvements generate significantly more ROI than others.
In this two-part series, we look at some of the most cost-effective upgrades investors can make when trying to maximize rental values.
Before we get started, let's talk about the break-even concept.
The Break-Even Concept
We've said that choices about property improvements are a blend of art and science. Too many investors get hung up on the "art" part of the decision – which investments will add to the appeal of the rental property? What's the latest trend? In doing so, these investors gloss over the "science" part of the decision, usually because they lack familiarity and comfort with the math behind ROI computations.
The basic premise is this: an operator invests $X to increase rent by $Y, gaining a return of Z% in the process. If Z% is higher than the cost of capital, the overall yield is positive.
For example, renovations to your unit cost $12,000. You then increase the rent by $100 per month, totaling $1,200 per year. That's a 10% return on investment. That's a high return, assuming the rent increase lasts in perpetuity. But improvements are always time-limited; in other words, there's a set period that they can be considered "fresh" before they need to be done again. The life span of that improvement will affect the project's actual ROI.
At the core of every decision should be a reflection on the break-even point: How many months (or years) of proceeds from the investment will it take to recover the cost?
Investors should also examine how the upgrades will influence the value of the community from a cap rate viewpoint. This calculation uses the profit or added annualized rent from the investment, divided by the market cap rate. For instance, if you can raise rents by $100 per month, or $1,200 per year, this relates to about $26,000 of increased value at a 4.5% cap rate.
**Property improvements vary depending on the investor's' intentions. If they aim to boost value, then focus on how improvements will impact the cap rate. If their goal is to enhance cash flow, then think carefully about the break-even timeframe.**
Cost vs. Value
There's one other crucial caveat that we need to make before diving into specific property improvements. Investors often ask, "Which rehab efforts will give me the greatest bang for my buck?" Unfortunately, there's no perfect answer. That's because there's no magical list of exhaustive repairs and renovations, their costs, and their value as it correlates to spurring motivation to rent. In reality, there are many factors involved in weighing the costs vs. value of property improvements, including:
· The location of the property
· The age and condition of the community
· The profile of residents in the area
· Market conditions, including the comps of surrounding competition
As a result, any return on investment is likely to vary from property to property, from city to city.
That said, there are several cost-effective upgrades an investor can make when trying to maximize rental values.
Large-Scale Property Improvements
There's a distinction to be made between significant property renovations and simpler and/or more cosmetic upgrades. We'll start by looking at a few of the substantial, more expensive upgrades that may be justified. Part II of this series will look at smaller-scale investments that require less up-front capital.
Kitchen Upgrades
If you're on a limited budget and need to focus renovation dollars somewhere, start in the kitchen. The kitchen is one of the most heavily-trafficked rooms in the house, and you can tell whether capital has been deployed well or not. It's easy to gauge if the kitchen has been raised to a higher standard recently, or if it's sporting appliances and cabinets from days of yore.
When reimagining a kitchen, think functionality and simplicity. Neutral color schemes, granite countertops, stainless steel appliances, and wood floors have universal appeal. It's about improving by combining or replacing components.
Granite kitchen countertops with contemporary wood cabinetry, including under cabinet lighting is a lease closing focal point. As a general rule of thumb, budget at least $50/SF for granite with installation. Stainless steel appliance packages will start at $1,500, although some prefer Stainless steel GE Profile Series™ appliances, including washers & dryers. Pendants above kitchen islands are appealing. Smart Switches in all living areas and thermostats are the definition of modern-day apartment living. Wood flooring in the kitchen, living & dining rooms will cost between $8/SF (for engineered hardwood) to $12/SF (for quality hardwood) plus $2/SF for installation.
Kitchen renovations can get expensive and quickly. But there are ways to improve a kitchen without spending a fortune. Peel-n-stick backsplashes can go a long way in the eyes of a prospect. Decent looking backsplashes start at $8 per sq.ft. Consider resurfacing the cabinets, adding new fixtures, and repainting.
IRO's can shop around for discounted appliances (outlet stores usually have great deals on showroom models or 'scratch n' dent' appliances that have minor dings and dents). You can even look on a website like Craigslist for like-new white appliances, which can often be found at a bargain with homeowners swapping out perfectly good white appliances for stainless steel appliances in advance of selling their home.
Bathroom Renovation
If budget allows, consider upgrading bathrooms. Renters appreciate having bathrooms with porcelain tile and back-lit mirrors above vanities. LED lighting in entries, kitchens & baths. High-end Kohler sink fixtures and hardware tend to draw the eye. Luxury spa shower/tub combinations are bound to be a hit. Some opt for white quartz countertops and large rainfall showerheads in the bathrooms. Steam showers, heated floors, and double vanities will help your rental unit stand out from its competition.
Bathroom with white quartz countertops and large rainfall shower head.
Whereas kitchens should be remodeled with an eye to functionality, bathrooms should be renovated with an eye toward luxury and amenities.
It's vital to examine market demand before taking on a project of this scale (a local property manager should be able to give you insight). Some conversions will make sense, and others will not—it all depends on the community.
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There are other large-scale investments that IRO's may contemplate, like the addition of a swimming pool, that seldom generates positive ROI. If you're going to invest a significant amount of money into property improvements, then you're best served by investing in kitchens, bathrooms – the spaces of the unit where residents spend the most time.
In Part II of this series, we'll look at the smaller-scale investments that require less up-front capital but still generate positive ROI for investors looking to maximize rental values.