How To Compute Income Property Improvement Rate Of Return

By Author: James Kobzeff
Total Articles: 44
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Ignore what you may have been told about the rate of return you can expect to receive from a remodeled rental unit.

For instance, maybe you were led to believe that a remodeled kitchen will pay back, say, 70 percent of its cost, a remodeled bath 110 percent, and updated fixtures around 60 percent of its cost. This is not necessarily true. You must never rely on any of these specific payback figures. If you want to make money at real estate investing you must learn to evaluate every investment property and every remodeling project on its own merits.

Bear in mind, your profits relate directly to how much your tenants or buyers value your units. In other words, your property improvements are only as good as the price someone is willing to pay for them, and these relative comparisons differ in time and place.

Therefore, before you make any improvements to your investment property, research competing properties and tenant (buyer) preferences. Learn what you need to do in order to achieve competitive advantage. Think twice about making any property improvement unless you're sure to attract tenants willing to ...
... pay higher rents or buyers willing to pay your desired higher price.

How to Make Your Budget

Start by developing a cost/income estimate. Study resale prices and rent levels inside your local real estate market. Figure out how much you can increase the sales price or rents resulting from each project you undertake, decide on a rate of return, and then compute your budget, which, of course, can vary enormously depending on who does the work, what materials are selected, and the skill with which the job is undertaken.

For our purposes, we'll assume you want to achieve a 20 percent overall rate of return on the capital you invest for the remodel. If so, then every $1,000 you invest in improvements should increase your net operating income at least $200 a year.

Real estate investors, naturally, are free to choose whatever rate of return they desire. For instance, some investors might be pleased with a 10 percent rate of return, whereas others may aim as high as 40 percent. What matters most is that you curb your enthusiasm with a realistic look at the amount of increased rents your investments of time, effort, and money are likely to produce before you renovate.

Likewise, creating a budget helps prevent you from over-improving your property. The last thing you want to do is to spend money for improvements that are not relative to the neighborhood and relative to the prices and rent levels your buyers or tenants are willing and able to pay.

Okay, let's consider an example and make the calculation.

First, survey the local rental market for the top rental rates in the neighborhood relative to the size and quality of units you intend to remodel, then apply your rate of return and compute. Let's say you feel after renovations that you will be able to raise rents enough to pocket another $150 a month per unit. By applying the 20 percent rule, you would determine that you must limit costs to no more than $9,000 per unit.

$1,800 (12 X $150) / .20 = $9,000 cost of improvements

Again, you have the option of plugging in whatever rate of return you desire. The important thing is to run through your numbers thoroughly enough to be satisfied that your local real estate market actually supports the selling price or rent level you intend to ask.

An Exception to the Rule

Real estate investing is about making the greatest return on your real estate investment as possible and therefore explains the purpose for writing this article about returns on improvements. Still, on some occasions you may want to invest more in your improvements than rent increases justify for other reasons.

To attract a better quality of tenant, for example, or to reduce tenant turnover, cut losses from bad debts and vacancies, or just because you want some pride of ownership. In these cases, real estate investors simply have to weight tradeoffs.

The important thing is to work the numbers, regardless. Remember, good tenants and pride of ownership benefits you only if you're collecting enough rents to pay your property expenses and mortgage payments. You don't want to have to feed your property just so you can pound your chest whenever you drive by it.

One Last Word

It's probably a good idea to categorize property improvements into those you can do, and those you would never want to do.

For example, whereas it might be okay for you to tackle some cosmetic improvements such as painting, landscaping, carpets, and light fixtures, you must exercise extreme caution when it comes to roofs, foundations, wiring, and plumbing. These types of renovation can be inundated with hidden costs, and unless you buy the property favorable enough to make these types of improvements, you might discover the amounts you spend to improve the property aren't profitable.

No universal rule applies. Smart real estate investing requires you always analyze the financial details of the deal in front of you before you do anything.
James Kobzeff is the developer of ProAPOD - superior real estate investing software since 2000. Create a cash flow analysis for rental properties in minutes! Go to => www.proapod.com