Renovations - Profitable or Not?

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Renovation projects are one way to increase the market value of a property, whether your personal residence or a rental property.  However, you should usually not undertake a renovation for that reason alone.

      Major renovation projects are almost never a good idea if you're getting ready to sell the property.  While many improvements provide a significant return on investment over a number of years, the return on investment for various renovation projects due to immediate increased value are typically as follows:

• Kitchen or Bathroom remodels
        Upgrades in these areas or addition of a bathroom are generally considered the wisest choice and will definitely increase the property's value.  The typical return on investment is 65 to 75 percent.
  
• Home Office
        A home office addition or conversion can return 60 to 70 percent on your investment because more people, whether owners or tenants, are working from home these days, either as a telecommuter or in their own business.  There can also be tax advantages for a home office, for either an owner or a tenant.
  
• Finished Basement
        A finished basement can provide  play space for the kids as well as extra storage space for items that can't be left in an unfinished basement or in the garage.  This can bring a return of up to 50 percent.
  
• Energy Efficiency Improvements
        Installing a central air conditioning system or replacing windows with more energy-efficient ones typically provides a return on investment of only 30 to 40 percent.  The return for a heating system upgrade is a little better, typically returning as high as 50 percent.  Keep in mind, though, that new highly-efficient heating and cooling systems are excellent long-term investments because they can often pay for themselves within a few years due to energy savings.
  
• Cosmetic Improvements
        Cosmetic improvements generally make more sense where a near-term sale is contemplated because they are usually lower cost, provide an immediate obvious visual improvement, and can often be handled by the owner himself.  While a new coat of paint (neutral color) may return only 60 percent of your cost.  The other 40 percent is a relatively small number which may be made up several times over simply because the property attracts more interest and because buyers sometimes overlook more important issues due to the fact that the property is so attractive.  The same factors apply to other cosmetic improvements, including having the floors buffed or planting flowers in the front yard.

      In general, all deferred maintenance items should always be taken care of before putting the property up for sale.  First, buyers will usually discount the offering price by significantly more than the actual price of making the repairs because they tend to overestimate the costs of repairs and reduce offers accordingly.  Second, buyers may assume that deferred maintenance of minor items means that there may be deferred maintenance of major items and they will discount significantly for that risk.  Third, a lot of obvious minor problems will be a turn-off to the buyer before he's had a chance to consider the property in total.  A sticking front door, a patio door off its track, a cracked window, a yard in serious need of mowing, and similar items will cause some potential buyers to eliminate the property from consideration and encourage other potential buyers to make low-ball offers.

Long-Term Considerations
      The fact that a particular major renovation is not profitable if immediate sale of the property is being contemplated doesn't mean that it should not be considered if the property will be held for a number of years.
      For the owner-occupied property, one must consider the enjoyment potential and other personal benefits.  Years of enjoyment from a new kitchen or improved bathroom has a personal value and the cost per month averaged over several years will not be much.  For example, a $6,000 improvement enjoyed for 5 years cost only $100 per month.  And with a 70 percent return on investment upon sale, that was actually only $30 per month.  A new home office not only provides personal enjoyment at a relatively low cost per month, but the profit potential and tax benefits of operating a business may far exceed the net value (sales value increase less cost of improvement). 
      For the rental property, major improvements may actually return a significant profit over the long-term.  First, an improved property should allow higher rents.  Second, an improved property should attract a better quality tenant, one who can afford a higher rent, one who is more likely to pay the rent on time, one who better maintains your property,  and one who is less likely to do damage or cause other problems.  For example, a $6,000 improvement that allows a higher rent by $50 per month generates additional income of $3,000 in 5 years.  So if the return on investment upon sale is 50 percent, the increased sales price was $3,000 and the net cost was only $3.000, meaning that improvement was free.  Also, the expenditure produced additional tax write-off that further increases the real net profit.
      A new high-efficiency heating/cooling system can result in substantial savings in energy costs.  In many areas of the country these savings can be as high as $100 to $200 per month during the peak winter and/or summer.  Accordingly, the cost will be amortized within only a few years.  So, this particular improvement, a bad investment just before a sale, can be very profitable over a longer term.
      For the owner-occupant, the benefit is obvious and the profit is real.  The cost is paid within a few years by reduced electric bills, the owner can spend the savings on other things during the remaining years of occupancy, and the 30 to 50 percent typical return on investment upon sale will be pure profit.
      For the rental property, a high-efficiency system should allow higher rent in areas where there are extreme hot or cold temperatures.  And, again, the tax benefits provide additional net profit to the landlord.  Finally, after the cost has been paid by the higher rent, the 30 to 50 percent typical return on investment upon sale will be pure profit.  These considerations also apply for larger multi-unit rental properties.  If the landlord is paying for energy, lower expense will amortize the cost over a number of years, varying from area-to-area, depending on climate and energy costs.  If the units are separately metered, increased income should result from higher rent and/or lower vacancy because the tenants' total housing costs will be lower.

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