Convert from 2 family to 3 or remodel and just rent out

[Bin Chen]

Hi all,

I am currently working on a two family house in the riverdale part of the bronx, I went the route of converting the property to a 3 family house but am now wondering if it was worth it.

Scenario 1:

The house is a two family house where the 1st and 2nd floor are part of 1 unit and the 3rd fl is the second unit.

The 1st floor has a garage, living room .5 bath and kitchen (400 sf)

The 2nd floor has 3 br and a living room 1.5 bath (900 sf)

The 3rd floor is a 2 br 1.5 bath (1000sf)

The house was not in a move in condition but if I made some minor design changes and renovated the place I could have updated the house, kept the layout for the 1st fl the same and made the 2nd floor a 4 br 2 bath. I would have made the 3rd fl a 3 br 2 bath. This would make this house a 2 unit house with a 4br 2 bath and a 3 br 2 bath. I can probably rent the 4 br for 3.2k and the 3 br for like 2.8 and the garage for another 200.

The renovations would cost me around 130k.

Total rent 6.2k I would have to pay for gas and water.

Scenario 2

Eliminate the garage and add space to the 1st floor and also redo the layout to get rid of a lot of dead space.

Convert the 1st floor to a 2br 1 bath (750sf)

Convert 2nd and 3rd fl to 3 br 2 bath (900/1000 sf)

Renovation cost 230k the huge cost increase is due to adding a sprinkler system into the house, separating the gas and electricity for each unit, seperate heating system for each apartment, and increasing the water service line into the house.

Total rent would be around 8k and the tenants would pay their own gas and heating. I still pay for water.

Since I am making a lot more changes to the house in scenario 2 it took 3 extra months for dob approval and probably 2 more months for construction. 5k mortgage payment and 6.2k lost rent if I went with scenario 1. 

100k extra renovation and 56k extra holding cost.

So a total of 156k cost difference.

Was it worth it to do the conversion or would it have been smarter to keep it 2 fam and move onto the next project.

Thanks for you time.

[Gerold Koch]

Hi Bin,

That's an interesting mind game!

If you were a company and this was an expansion project, you would take the additional future income of the project and convert it into a present value by discounting the future cash flows with a risk-appropriate discount rate (which should be your average equity returns).

I did that and to simplify things, I assumed your equity returns are 10% and you will get the additional rent and savings on gas (I assumed $100 per month) for eternity.

Your annual incremental cash flow is $22,800; (monthly: $1800 in additional rent + $100 in savings).

Turning that into a present value, you divide the annual amount by the discount rate. That gets you a project value of $228,000 which is higher than your cost. The net present value (present value - cost) of your project is $72,000. It is positive and thus the project was worth it. You can play a bit with the discount rate; it has a huge impact. But unless your equity returns are higher than 14%, the project was still worth doing.