Convert 2 BR to 3 BR - Payback Period -

[Tom Lipps]

Hi BP!

I'm curious about your thoughts/recommendations here...I have a 2 bedroom unit with two tenants with declining health.  I mention this only to say they are relatively high maintenance. I'm averaging at least 1 call per week to make minor repairs (admittedly these are things that need to be repaired). I think I can "train" them to be less needy in the long term.

I inherited these tenants, and they're currently paying a 1 BR rate of $600 for a 2 BR unit. Their lease expires in October. A 2 BR rents for about $755. I can convert the basement to a 3rd bedroom, which has a market rate of $986.

Once their lease expires I have two options:

1. Raise rents to the 2 BR rate of $755 ( I may use a gradual increase to make it hurt less)

2. Request the tenants leave, flip to 3 bedroom, and rent to new tenants at $986

If I convert from  2 BR to a 3 BR, I've calculated a payback period of 2.3 years... here's the high-level of how I came to that number:

Annual Opportunity Cost:

• 3 BR vs 2 BR Rent = $2,790
  
• My Time (expect less needy tenants) = $1,183
  • TOTAL OPPT COST= $3,973 <-- This is a favorable number

Cost to get unit ready as 3 BR

• Total to flip = $7,551 (includes paint, new floors, converting basement to bedroom, etc)
•   2 Months lost rent = $1,510 
  
  • TOTAL UPFRONT COSTS $9,061 <-- This is an unfavorable number

Payback Period 

• =  $9,061 / $3,973 = 2.3 years (Note if I'm conservative in my nubers, this becomes 3 years)

Couple more things to note, they're set up on re-occurring payments and have not missed a payment. They're a bit much but in general, pretty decent folks and they keep the unit in pretty clean shape. (This is a B minus neighborhood in Cincinnati, OH).

So my question to you BP is:

1. Am I missing anything in my analysis?

2. If you were me, based on the given info, would you:

                 A. Keep the tenants and raise rents to a 2 bedroom rate? 

                               OR

                 B. Ask them to leave, convert to 3 BR, and raise rents to 3 BR rate with new tenants?

Thanks as always for the advice!

- Tom

[Jim Goebel]

@Tom Lipps

We've done an egress project to add a bedroom I think 3 times now to add value to a house and the payback has been phenomenal every time. A lot of investors overlook the deals/opportunities that are already easily within grasp of their existing portfolio.

Your analysis seems apt to me, obviously the 'your time' is hard to quantify - I'm not sure that the jump from 2 to 3 bedroom would enable getting less needy tenants - at least with what we're doing - I think this would actually typically be the reverse if I had to generalize.  So I'd dig into that assumption.

Seems like a good payback.

Few words of caution and thoughts------ may or may not be relevant for you:

• Make sure you get the water thing nailed when doing those egress projects.  It's easy to mess that up by not digging deep enough, putting in proper rock and possibly tying to a drain tile (easier said than done), oh and sealing the new hole in foundation properly.  Consider a well cover over your well, as well.
• Consider doing the project with the tenants there.  What we did on one of these was to do the project after we learned that they were already utilizing the bedroom as a bedroom anyways (against the rules) - we didn't increase rent right away but gave them a year at current rent, and gave them visibility into what we thought market rent was going to be after some time and the option to stay at the increase...  That way they get the benefit/functionality but don't feel like they're getting penalized in rent increase.  Benefit obviously is that if you can do this, you don't lose rent while they're there.  Also, many basements this works well because it's kind of easy to section it off from the rest of the house while work is going.
• It seems like your costs are pretty high to be honest but I don't know what you're dealing with.  Best candidates for adding bedrooms downstairs for us have been basements where there is NO/MINIMAL risk of water intrusion as-is, and where there's already some finish (or mostly finished space), but just not the official bedroom.