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