Is it worth keeping refinancing in mind when remodeling?

[Tim Coppola]

Does going "bigger" when remodeling a rental unit make much of a difference if you plan on refinancing? Is it worth it to spend an extra $7-10k above your budget now to get hardwood floors throughout instead of using carpet in the bedrooms, or getting granite countertops instead of formica, or using more expensive cabinets and tiles?

[Moses Kagan]

When considering how much to spend on a re-model, you must focus on two things:

1. How much will your proposed improvements increase the rent. You can think of this in terms of yield or in terms of valuation. 

With respect to yield:

Assume that any additional rent falls straight to the bottom line (eg that an increase in rent does not increase expenses)... You should only spend if the return on the expenditure is satisfactory. For example: If spending $5k on a new bathroom increases rent by $200 / month, which is $2400 / year, the yield on the expenditure is $2,400 / $5,000 = 48% / year, which almost anyone would think worthwhile. If the additional rent were $25 / month, or $300 / year, the resulting $300 / $5000 = 6% / year would be much less tempting.

With respect to valuation (most relevant for refinancing): 

Assume properties in your area are valued at 11x annual rent. In the bathroom example above, the $2400  / year in additional rent equates to $26,400 in additional value... so you're very happy to spend $5,000 to get it. If you're planning to refinance, and the bank is looking at the cashflow, then you're likely to be able to get back more than $5,000 in tax-free refinance proceeds.

If, on the other hand, the incremental rent from your bathroom remodel is only $300 / year, then you're spending $5,000 to get $3,300 in value... a bad deal.

2. How much will your proposed improvements decrease expenses.

This is an under-appreciated factor in the rehab business. Certain improvements can dramatically decrease operating expenses. 

For example: We always repipe our buildings and give each unit its own water heater. The results are (1) to move the cost of heating water for the building from us to the tenants, which can reduce our expenses by thousands per year, all of which falls to the bottom line (eg the cashflow); and (2) to reduce repair costs (for leaks, clogs, etc.)

Say that this kind of re-piping costs $50k on a 5 unit building (ouch). Say the result is to save $3,500 / year on gas plus avoid $2,000 worth of leaks and clogs, for a total savings of $4,000 / year. That's an 11% yield on the cost... not a home-run, but not bad either.

One final note:

Beware of over-improving. Even if you can justify each expenditure on the basis of increased revenue or decreased costs, you can still run into trouble. If your spending takes your all-in price / sq ft (cost of buying plus cost of renovating) way above the current market rate, it's going to be very hard to convince a bank (or, for that matter, a buyer) to give you full credit for the increased value.