Two school of thought.. which are you?

Question

Was just pondering this idea, which I think may be a real thing for myself and probably has been for you guys as well.

When you buy a rentable place for B&H, that has the basic necessities but is overall older. Do you:

a) Rent it out right away for a lower rent, or

b) Upgrade it, then rent it as a standout unit for a higher rent

I will also provide a hypothetical example. You purchase a place for $120-160k. You can immediately rent it for $1500, or you can put an additional $20,000-25,000 in upgrades and can rent it for $1900-2000. Lets say you have a day job and are not doing REI full time.

Marcia Maynard · Answer

Are you assuming you buy it "ready to rent"? It would depend on the cash flow potential, as many upgrades do not translate into that much higher rent. Also, holding costs accrue when a place sits empty, so I would want to see it rented quickly.

I would also take into consideration the location, the current condition of the unit, the market and many other factors. We aim for safe, clean and functional first. Comfortable and good looking second. Our market is "affordable housing" so we would not do upgrades for the purpose of commanding higher rents.

Elizabeth Colegrove · Answer

Are you sure you could get $1900-$2000? In the areas I operate fully renovated places for "oldness" and not additions only get an extra $100-$200. Plus your pushing market value. I probably would rent it out for the higher value possible and than increase the rent when their are natural breaks or when my tenant was going out of town and I could get in their for 2 weeks.

Ned Carey · Answer

In your example the extra $20,000 will get you $400 extra a month or $4,400 a year allowing for vacancy. That is a 22% return on your money.  That is the appropriate way to think about it. However only you can decide if it is worth it given your finances, and goals.

Rob Gribben · Answer

Another reason I hesitate to improve more, the higher the rent, the more likely you are (at least in Canton), to have 3-4 roommates sharing the house.  I like to target singles or young couples who can afford $1,500, but at $1,900, it's too much for many.  If I add another bath and finish the basement into a BR, sure I get more rent, but more people living in the house = more potential for headaches (potentially anyway).

Andy Gross · Answer

Without adequate market studies of your specific neighborhood, you may over-improve the dwelling. I think that before sinking cash into a unit to upgrade it (vs. using the cash to acquire additional units), your rental comps have to be solid, taking into account the actual vacancy losses incurred by higher-cost units.

As @Rob Gribben  pointed out, you might get more money, and even a better tenant, but will you have more turnover and is the cash worth the downtime? Canton is a funny market, and I don't think you have too many folks renting for more than 2-3 years because it's a young crowd there for their first job before they get married/sick of the bar scene/enough money to buy a place. I'd personally be weary of improving beyond the B range of rentals in that neighborhood. In Oahu, your place has to radically overpriced or a total dump not to rent within a weekend. When we were looking for places, our application was usually in a stack of 4-5 fully qualified, great tenants, and 10 more "ok" tenants.

Andrey Y. · Answer

Keep in mind guys, since I hear a few of you mentioning vacancy, that the vacancy on Oahu, Hawaii is 0%. Myself and Bob B. on here can attest to. Typically, cash flow % is dismal here compared to the mainland, but I usually have a line of 15-20 people to rent my studio the day I put a craigslist ad out.

Rob Gribben · Answer

I would run the numbers, lots of variables.  How long to renovate (i.e. lost rent).  I have a house in the Canton area in Baltimore.  It rents for $1,500.  I could put another $15,000 into it and get maybe closer to $1,900, but to me, it rents at a good rate (it's already paid off) and it rents fast, so hard for me to justify putting $15k into it.  I think gradual upgrades (between tenants) is the way to go.  It limits downtime, and you increase rental rate and market value over time (sometimes slow and steady does win the race!!)

James Wise · Answer

I think that you can better use the $25k by pputting it into another deal as opposed to spending it on renovations that will take 5 years or so to get your capital back.

Aaron Montague · Answer

Yeah, I'm with @Paul C. on this one.  Your hypothetical is going to be tight any way.

I'm assuming 20% down, ~4000 in closing costs and for that you'll pay renovation expense out of pocket.

Here is your property as I see it somewhere were taxes are low and insurance is medium:

Mortgage Rate 5.00%Length of Mortgage in years 30Monthly Mortgage payment $515.35Taxes $100.00Sewer and Water $-Trash $-Heat/Utilities $-HOA $-Cap Ex and Ops $150.00Insurance $100.00Mgmt Fee $150.00Vacancy $120.00Total Expenses $1,135.35Total Revenue $1,500.00Cashflow/month $364.65Cash on Cash Return 15.63%

Same place after renovations:

Mortgage Rate 5.00%Length of Mortgage in years 30Monthly Mortgage payment $515.35Taxes $100.00Sewer and Water $-Trash $-Heat/Utilities $-HOA $-Cap Ex and Ops $150.00Insurance $100.00Mgmt Fee $190.00Vacancy $152.00Total Expenses$1,207.35Total Revenue $1,900.00Cashflow/month $692.65Cash on Cash Return 15.68%

You get the same return on both properties but MUCH nicer cash flow after renovations.  Assuming it takes 6 months to complete the renovations, you'll be behind $15,810 (9k rent, 6.8k expenses) so you'll pull slightly ahead in month 49 of renting.

15810/(692-364) = ~48.2 months

So the value of this project depends on your length of investment.  If you plan on holding the place for 48 months or less, @James Wise is correct, you'll make more (assuming you make $0 on exit).  If you plan on holding it 49 months or longer, you'll put more cash in your pocket by doing the renovations.

You should also be wary of your exit strategy.  Will the fixed up place give you a significantly high resale value for the property in X months?

Two school of thought.. which are you?

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