Regardless of what you may have read or heard about what rate of return you can expect to receive from a remodeled rental unit, forget it.
You might have heard, for instance, that a remodeled kitchen will pay back, say, 75 percent of its cost, or a remodeled bath maybe 150 percent of its cost. This is not necessarily true. To make money at real estate investing, you should never rely on any of these specific payback figures, and instead, learn to evaluate every rental property and every remodeling project on its own merits.
Remember, your profits relate directly to how much your tenants or buyers value your units. In other words, how much value your property improvements add are only as good as the price someone is willing to pay for them; and these relative comparisons differ in time and place.
Therefore, before you make any improvements to your rental income property, research competing properties and tenant (buyer) preferences. Learn what you need to do in order to achieve competitive advantage. Think twice about making any property improvement unless it’s sure to attract tenants willing to pay higher rents or buyers willing to pay your desired higher price.
Make Your Budget
Start by developing a cost/income estimate. Study resale prices and rent levels inside your local real estate market. Figure out how much you can increase the sales price or rents resulting from each project you undertake, decide on a rate of return, and then compute your budget, which, of course, can vary enormously depending on who does the work, what materials are selected, and the skill with which the job is undertaken.
Let’s assume you want to achieve a 20 percent overall rate of return on the capital invested for the remodel. In this case, as a rule of thumb, every $1,000 you invest in improvements should increase your net operating income at least $200 a year.
Naturally, real estate investors can choose whatever rate of return they desire. Some investors might be pleased with a 10 percent rate of return, for instance, whereas others may aim as high as 50 percent. What matters most is that you look realistically at the amount of increased rents your investments of time, effort, and money are likely to produce before you renovate.
Okay, let’s consider an example and then make the calculation.
First, survey the local rental market for the top rental rates in the neighborhood relative to the size and quality of units you intend to remodel, then apply your rate of return and compute.
Assume that after renovations you expect to raise rents enough to pocket another $150 a month per unit. By applying the 20 percent rule, you would determine that you must limit costs to no more than $9,000 per unit.
$1,800 (12 X $150) / .20 = $9,000 cost of improvements
Of course, you have the option of plugging in whatever rate of return you desire. The important thing is to run through your numbers thoroughly enough to be satisfied that your local real estate market actually supports the selling price or rent level you intend to ask.
The bottom line is this: No universal rule applies. Not unlike other aspects of real estate investing, always analyze the financial details of the deal in front of you before you do anything.
