How to Compute Rental Property Improvement Budgets to Prevent Overspending
It’s never sound real estate investing practice to do a remodeling project for your rental property simply because you read somewhere that property improvements will always payback some (if not more) of the costs you invested to make the improvements. Or that any improvements to your rental property are better than none and therefore sure to increase your rents and/or property’s market value.
Some magazine articles and gurus might suggest that a remodeled kitchen will pay back 70-80 percent of its cost; a remodeled bath maybe even 110 percent of its cost; updated fixtures possibly 35-40 percent of its cost; and so on.
But this is not necessarily true, and worse, might not even be close in your case.
Why? Because your profits are directly related to the price your tenants or buyers are willing to pay for your property improvements. If tenants or buyers attach enough value to your property improvements that they will pay you a higher rent or sale price relative to what other owners offer than great, you could profit; on the other hand, if they discount the value and aren’t willing to pay you more relative to what other owners offer, than you needlessly spend your money and waste time and effort.
How do you prevent that real estate investing disaster from happening you? Foremost, never rely on any set of generic payback figures that dictate rental property improvements and learn to evaluate every remodeling project you are considering on its own merits.
Start by researching competing properties so you can discover tenant and buyer preferences. What do you need to do to achieve competitive advantage and get tenants and buyers knocking on your door rather than your competition?
Next, study market rental property sales prices and rent levels in your local market area. Will the property improvement for each project you undertake for your rental property increase the sales price or rents according to realistic numbers in your local market, or are they pie-in-the-sky?
Next, determine how much you can increase the sales price or rents for each property improvement. A good rule of thumb is to want every $1,000 invested for remodeling to increase your net operating income by at least $200 a year. Why? Because this will yield you a 20 percent rate of return on your time, effort, and remodeling expenses. But of course, you can choose whatever rate of return you want to aim for.
Okay, let's make the calculation.
Let's say after researching the rental rates in the neighborhood relative to the size and quality of units provided by your rental property, you conclude that after remodeling you can safely raise your rents enough to collect another $100 a month per unit. What you want to determine is the amount you must limit costs to per unit in order to achieve your 20 percent return. Here’s the formula.
$1,200 (12 X $100) / .20 = $6,000 cost of improvements limit per unit
This intends to illustrate the method, however, not a hard-fast rule because budgets for property improvement projects can vary enormously.
On some occasions, in fact, you may want to invest more in your improvements than what rent increases might justify. Perhaps your renovation would attract a better quality of tenant, reduce tenant turnover, cut losses from bad debts and vacancies, and give you the greater pride in ownership you are longing.
But don’t get carried away. You still must work the numbers. Good tenants and pride of ownership are a worthwhile blessing only if you're collecting enough rents to pay your property expenses and mortgage payments.
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