When you spend $4,000 to renovate a unit, are you looking at how much more per month you get, say $50, and deciding it will take you over 6 years to get back that investment? Or – are you looking at market cap rates, where $50 a month, $600/year, in a 6% cap rate market, produces $10,000 of additional value?
You like the property because it’s in a great area and the rents are below market. Fantastic. But what does it take to get rents up. I’m ignoring how to be sure of what “market” rents are, a topic for another discussion, but you have to know what you can spend. That’s what helps you decide whether to buy the property or not.
First, some quick math. (Want to invest in real estate? Learn the math! ☹) Capitalization rates tell you how much the property costs in relation to the income it produces, Net Operating Income (NOI) / Purchase Price. It also gives you an idea of what you can sell the property for, and therefore the value of your property. If it’s your goal to increase value you want to know what kind of value you’ve created.
If I bought my property at $1,000,000 and it produced NOI of $50,000, that’s 50,000 / 1,000,000 = 5% cap rate. Let’s say your broker told you other properties in the same area also sold recently for cap rates of 5%. That means if you increased your income from $50,000 to $60,000 and your market cap rate stays the same at 5%, and if NOI / Price = cap rate, then Price = NOI / cap rate, your new value is 60,000 / .05 = $1,200,000.
You added $200,000 to your value by increasing income by $10,000. But what did you have to do to increase income by $10,000? You raised rents by making the property nicer and the units newer. If you have 20 units you increased rents an average of $42, because $10,000 a year is $833 a month, divided by 20 units is $42.
This helps you decide what to spend. Remember you have $200,000 in greater value, not just $10,000 more in income. If you want your renovation to pay off in, say, two years, you’re allowing yourself to spend just $1,000 per unit, because $20,000 / 20 units = $1,000. $1,000 might pay for a new countertop or a couple of new appliances but will that bring $42 in higher rent?
Focus on what tenants love. Flooring, kitchen, bathroom. Do you need carpet replaced? With what, new carpet or LVT? Does the bathroom have a sink or a vanity? Is the tub area pretty gross? Is the kitchen countertop chipped? Are the light fixtures straight outta the 80s?
What would you pay? Make it nice but keep in mind the location. When you’re sure there are tenants who will pay the premium for a nicer unit then invest with confidence. One spending guideline is 50% of the improvement in value. For example, if you increase rent by $50, that’s a $600 increase in annual income, or $12,000 in value. You might only need to spend $2,000 but if you have to spend $6,000, you should still be in good shape. If your estimate for bringing that unit to the level it needs to be is $10,000, you better have more than a $50 rent increase opportunity.