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.

by Roselind Hejl

A decade ago subprime mortgages were an alternative for borrowers who did not fit standard guidelines. Maybe they just started a new business or had some past credit problems. These borrowers paid a high interest rate or put more money down to compensate the lender for making a risky loan. Private investors who would accept higher risk for higher returns funded these loans.

In recent years we began to see a new type of subprime loan. It was intended to enable a lot more people to buy homes, and indeed it did accomplish that. It achieved such popularity that, from 2005-2007, this subprime loan accounted for one-third of all mortgage loans issued. Borrowers often did not fit the standard qualification profile. They had issues such as: minimal job history, debt repayment problems, low FICO scores, previous bankruptcy, sketchy documentation, or little cash on hand.

A typical scenario was to start with a very low rate for the first two or three years. Or, the payment may have been artificially low, so that the loan balance went up each month, absorbing the unpaid interest. After two or three years a very high rate would begin.

How was it possible to make loans such as these? What made them work? The underlying strategy was this: Instead of relying on the credit worthiness of the borrower, the lender expected to refinance the loan after a short period of rapid appreciation. The refinance requirement was the feature that distinguished these loans from prime or old subprime loans.

The low initial rate was not profitable to the lender. The loan needed to reach its refinance phase to become profitable. A hefty pre-payment penalty discouraged borrowers from paying the loan off early. Squeezed between a pre-payment penalty and an impending high interest rate, the borrower had no choice but to re-finance after the initial two or three years. At that time the borrower could apply for a prime loan – if payments had been made on time, and if their financial condition improved, and if the house had good appreciation.

In fact, most borrowers did not get a prime loan at refinance time. They got a new subprime loan, doubling the requirement and the cost of refinancing. Refinance fees could be added to the loan balance. The lender had a lot of control over the borrower at refinance time. For subprime borrowers, refinancing was not a choice made at their discretion, as it is with prime loans. It was an integral part of the subprime loan.

One could say that this subprime loan was, in effect, an agreement to allow mortgage lenders to play the real estate market – betting all their chips on appreciation.

Why did borrowers agree to this? Borrowers saw their neighbors buying houses, using subprime loans. And it is true that home values were rising, from about 1998 through 2006. In many parts of the country homeowners saw 25 – 50% escalation in their home values. So it seemed to be a safe bet. However, one could say that it was, in effect, a massive pyramid scheme. The more people who participated, the more the early players were rewarded. Demand for houses raised prices, and higher prices stimulated more people to get subprime loans.

Why did investors buy these loans? Subprime loans were financed through complex securitization structures, with multiple levels of risk spread over many parties. Insurance protection could be purchased, shifting the investor’s risk to other entities. The layers of complexity were astounding. The investment bankers who created the structures were the only ones who seemed to understand them.

Unfortunately, investors did not know very much about what they were buying. They trusted rating agencies and investment bankers to protect their interests. Yet, no one at any level seemed to understand how dependent subprime loans were on market appreciation. They did not recognize the need to refinance under better market conditions that was implicit in the loan. It was this need for rapid market appreciation that made their investment a very high risk – in fact, doomed to failure.

When the potential downside became apparent to investors, the ownership of risk within complex mortgage securities was very hard to figure out. There was confusion, and then the worst possible reaction – panic. Investments in mortgage securities abruptly ended, investment banks closed, and related financial institutions were harmed. The panic spread, as people pulled their money out of other investments.

Real estate roulette was possible because the borrowers who accepted money, and the investors who supplied money, were not at all clear about the high level of their risk. Had they understood the impending downside, they might have left the table before the game got out of hand.

About the Author

Roselind Hejl is a Realtor with Coldwell Banker United in Austin, Texas. Her website – http://www.weloveaustin.com – offers homes for sale, market trends, buyer and seller guides. Austin Texas Real Estate Guide

Forget what you may have read or heard about what rate of return a remodeled rental property unit may give you.

Perhaps you’ve been lead to believe, for instance, that a remodeled kitchen will pay back, say, 70 percent of its cost, or a remodeled bath, say 100 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 project on its own merits.

Foremost, your profits relate directly to how much your tenants (buyers) value your rental property units. In other words, improvements are only as good as the price someone is willing to pay for them, and these relative comparisons differ in time and place.

In this case, research competing properties and tenant (buyer) preferences. Learn what you need to achieve competitive advantage. Think twice about making any property improvement that will do little to attract tenants willing to pay higher rents or buyers willing to pay your desired higher price.

In other words, smart real estate investing requires you to know what rate of return you will achieve for any modifications you make to your rental properties.