Are you thinking about remodeling your home in this hot real estate market? What you must realize is that often times, remodeling does not pay off. In other words, remodeling does not recoup 100% of the cost of remodel. Therefore, you need to be strategic.
I've remodeled seven times before across multiple properties I own in San Francisco. Let me give you some perspective on remodeling so you can get maximum profit.
The Remodeling For Profits Fallacy
In “How To Make A Lot Of Money In Real Estate: Focus On Expansion,” one of the questions was on whether remodeling really recoups the cost and provides such a large return.
One of the biggest fallacies homeowners have is thinking whatever they spend on remodeling will automatically bring them great returns when it comes time to sell. I used to think this way as well until I started remodeling and property expanding myself.
Let's be clear. Almost all property remodeling does not recoup the cost spent remodeling based on national averages. Only in super expensive cities does remodeling sometimes bring in extra value to a sale because time is more valuable to higher income buyers. In such cases, home buyers in places like San Francisco, London, or New York may be willing to pay a premium to avoid the hassle of remodeling.
In order to create more value, remodeling (renovation) must include expansion. Do not confuse remodeling with expansion!
Remodeling Cost And Return
As you can see from the chart above, at no point since the year 2003 has Value exceeded Cost when it comes to remodeling. The trend has actually declined from a high of around 80% in 2005 to just 65% in 2015. In other words, the average total renovation recoups only 65% of the total cost it takes to renovate. A negative 35% is a bad investment!
One of the reasons for the decline in returns is because input costs have increased faster than sales price (Value). Everything from wood, copper, and steel have all shot up in price, whereas housing went through a tumultuous time in 2007-2011. I suspect the recovery percentage will start flatlining and then rise as home prices continue to rebound nationwide.
The Cost Approach for property appraisers is one of the keys to assessing the value of a home during a refinance or a purchase where a mortgage is required. I just got my Uniform Residential Appraisal Report back for my latest mortgage refinance and the 22-page report uses three methodologies: 1) Sales Comparison Approach, 2) Cost Approach, and 3) Income Approach. The very fact that input costs keep rising is a big reason why property prices can't get too cheap. Once input costs (including labor) reach selling prices, builders will stop building and prices will rise again due to lack of supply.
Despite the decline in returns for remodeling, remodeling is not primarily about making a return. Remodeling has more to do with living a nicer lifestyle. Do you want that nicer porcelain tile? Do you want some new fixtures or a white marble slab? How about a steam shower with nice brush nickel finishes?
In essence, remodeling can be deemed a “want” and not so much an investment to make money.
Times When Remodeling A Home Can Create Big Value
1) Layout improvement. In my other house, I used to have three bedrooms on the top floor and only one full bathroom. I decided to blow out a hallway closet and take a corner of a bedroom to create a second full bathroom. To the majority of the people out there, having a second full bathroom vs. a hallway closet is more desirable. Improving an existing home's layout based on existing market trends can improve resale value, e.g. creating an open kitchen or a family room off the kitchen.
For more, see: The Ideal Layout And Size For A Home
2) When the house is just too old. Renovating a fixer is also a great way to create value if you buy at the right price. If a house is still living in the 1940s, but is in a great location, it's probably a good idea to renovate from top to bottom. Most of the money is made before purchase. In other words, know your price and walk away if it's not met.
3) You've got a fancy designer. Some people pay up for a name brand designer to remodel their entire house with different materials. Maybe purple fuzzy walls behind glass pocket doors that lead to a wood floor kitchen are in. Who knows. At the very high end, those who are paying for famous designers typically have so much money that they can pay for superfluous things. It's kind of like buying fine art. There are designer showcase events at multi-million dollar San Francisco homes every year, for example.
Remodeling With Permits
If you plan to remodel your home and one day say, I highly recommend you remodel with permits as well. Getting permits will go on your home's 3R report, its report card. Future buyers can see that your remodels were done by licensed professionals and inspected multiple times by city inspectors.
Remodeling with permits adds tremendous value to your home if you plan to sell. Remodeling with permits also provides peace of mind for safety.
Check out the post, Remodel With Permits Or No, for more insights.
Expand Your Property For Maximum Profits
Property expansion is about increasing livable square footage. When a home is marketed for sale, the most common metric is the home's size. Increase the livable square footage of the home and you increase the home's selling price. It's that simple. Make sure you get all permits so that the legal work can be documented in your home's 3R report (home's report card). That 3R report is a very valuable piece of paper when it comes time to sell.
It's a much better use of funds to build a new bathroom that never existed before, rather than remodel an existing bathroom. In my case, I'm expanding an existing bathroom, which lands in the middle of the two. I wish I could just build a third bathroom, but that project will have to wait until I get the expansion plans approved for the back of the house.
Please don't confuse remodeling with expanding if your primary goal is to make a return on investment. Remodeling is a lifestyle choice with generally negative returns. Property expansion can also be a lifestyle choice, but with a much higher probability of earning a profit when it comes time to sell.
People ask me all the time what I spend my money freely on because of my frugal habits. The answer is property. I love being able to spend money on living in a nicer place that also has the potential to appreciate in value. That's a two-for-one special, aka a “twofer.” As someone who gave up the daily grind in 2012, I spend a lot more time now at home.
Related: How Much To Spend Remodeling For Maximum Profit
Investing In The Real Estate Boom Wisely
If you don't have the downpayment to buy a property, don't want to deal with the hassle of managing real estate, or don't want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you're looking for strictly investing income returns.
Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It's free to look.
Refinance Your Mortgage Today
Check the latest mortgage rates online through Credible. Credible has one of the largest networks of lenders that compete for your business. You can get free, no-obligation quotes in minutes. The more lenders compete for your business, the lower your rate. Mortgage rates continue to be near all-time lows. Take advantage.
Remodeling can be extremely exciting, which often leads to a fast planning process so that the project can get underway, this practice can also result in costly changes when certain aspects of the ongoing project don’t meet expectations. Lessons I’ve learned was: don’t start the project until you have made well your final decisions.
Nicely done. It’s good to understand the difference between a remodel and an expansion.
On the chart…is this the immediate value vs. the cost of the re-model? Or over several years?
If its all in the same year you do the remodel, I wonder how many years it takes on average to break even?
We bought our house first and foremost to live in, so we do remodeling because it improves the quality of our life, not because it will necessarily increase the value of the house. It’s nice if it does both of course, but we have no short-term plans to sell so that’s not at the forefront of our mind.
You raise some good points. I think the main difference is whether people renovate for themselves or for an investment. This is the major factor in determining whether there is a return or not.
If someone renovates for themselves, they can go and spend money on fancy fixtures and tiles because it’s what they want and can enjoy it. This is done for enjoyment and not return, so the cost often outweighs the increase in value.
If someone renovates for an investment, the analysis should be done at the start to get AT LEAST one dollar back for every dollar you spend. Improvements are done in areas where the cost to value ratio is better – painting, rendering, kitchen and bathroom, yards. If this is done right, you get a positive return.
Also, there is much more to consider when measuring a house’s value than the square footage. How many bedrooms does it have? Bathrooms? Car parking? What comparable sales have been made? Nearby amenities? Size of the house and block is only one factor :)
I think it is true that square footage is only one factor, but the thing is that factor (and nearby sales $/ sq ftg) has a way of being *the* factor, more than it should be. I have noticed that in a lot of different situations where quantification is difficult (e.g., assessing school performance) people tend to overly fixate on the few things that can be quantified easily and objectively. I think that is how it works with home sales price and square footage. We have noticed that in our area nicer homes do sell for more per square foot than less nice homes, but provided both homes are livable (everything functions and isn’t gross) the difference isn’t that much–not anywhere close to what you would have to spend to get similar benefits yourself. I do think nicer homes tend to sell faster around here if the price is just a bit above average. But the people who try to recoup much of their investment at all tend to languish on the market like the people with the run-down homes. (I am thinking of one nicely redone home in our area that sat for 2.5 years before finally going for just a little above normal for the square footage). As a buyer trying to figure out what is a fair offer, it’s just hard to get that square footage number out of your head. In the buyer’s mind, yes, the house is nice and all, but everyone upgrades their home some so it all sort of comes out in the wash. Not true (there are huge differences in how much people invest, it doesn’t all come out to about the same), but if that’s what buyers are thinking, then it’s going to influence what they offer, which is going to make for lower sales prices. (In our case, when we were on the market we both had that thought at times and also realized based on sales data that it seemed lots of other buyers had that thought, which in turn told us something about what sort of offer was likely to be competitive).
I do think the one thing you can say in favor of a true renovation (as opposed to fixing an obvious problem) is that you are likely to get some of your money back, and even if it’s just 30%, that still brings down the overall cost to you of living in a nicer place.
I agree. After a certain bedroom count, livable layout, etc… the size is THE factor that makes the biggest difference in selling price.
I see your point, but my experience has been different. I bought some foreclosures in 2009 and 2010, remodeled them and eventually sold them between 2012-2013 for a decent return. I also have bought 2 houses that I lived in for just over 2 years each that were run down when purchased, but in a great neighborhood, and they were easy to remodel and resale. Finally, I work for a private real estate fund and we do typically upgrade apartment units to drive up the price of rents (which ultimately affects the sale price). I think you have to be smart about it, but adding value can definitely improve your returns, either as a landlord or as a seller.
The ability to buy foreclosures itself in 2009-2010 is the biggest reason for your gains. Nice job.
As we look FORWARD, buying a property with expansion potential in a high cost area is the best way to go imo.
I did a lot of updating last year but did not spend on high end finishes. A gross basement shower stall was replaced, a new laminate kitchen counter top was installed and a few new vinyl floors went in. It makes the house look clean and fresh and less 80s. I am not handy and had to pay to have all the work done except the painting. I broke my own rule and put all the work on my HELOC and it will take 3 years to pay off.
The purpose of the reno was to replace all of the bad plumbing and the money spent on that is where I will really make the money back on the renos. I won’t be selling for 7 or 8 years but the house will sell for more when the time comes. I will also enjoy my time here more without worrying that I may come home to a plumbing leak every day.
I hear you on the plumbing work! I’m trenching my garage now to install a new bathroom and I was shocked to see the cast iron pipe from the kitchen to the main drain have so many holes in them! I might as well replace the pipe now while there’s a hole in my garage.
How much is your HELOC?
Great post. Do you have any thoughts on expansions versus tearing down and rebuilding? We are in a high-cost-of-living neighborhood where rebuilding is a trend – three houses within three blocks are all being rebuilt right now. Ours is a small, older, single family home, and we have talked about upgrading in 7-8 years. We’re open to moving but we’d prefer to either rebuild (to fit in with neighborhood trends) or build a second-story expansion (assuming high quality, but still probably half the price of the rebuild). It’s far enough down the road that a lot could change between now and then, but I’m curious to hear whether one generally produces a higher return on investment.
That’s an interesting dilemma! One of the benefits of remodeling or expansion is that you can often live through the project and not pay for double living arrangements.
I’d ask your friendly neighbor or ask the general contractor who is working on the tear down and rebuikd the cost for your home and then run the numbers. I bet it is still cheaper to tear down and rebuild than to buy.
Sounds like my grandma’s neighborhood in Arcadia, CA. It is common for a developer to buy up 2-3 older homes on big lots, level them, and put in a small cul-de-sac with 4-5 homes 2x-3x the size of the originals.
Zillow estimates her 1950’s 1365 ft^2 3Bed 2Bath on 0.25 acres at $924k. The neighbor’s house built in 2001 on a cleared lot is 3957 ft^2 5Bed 5Bath on 0.19 acres and it sold last year for $1.79M.
Couldn’t agree more. Make your money on the front end. Whatever house you buy, get it low.
I did a major rehab a while back, literally got my money back out (maybe minus a little), but the countless unpaid hours.
One thing about remodeling is you really don’t know what style a potential buyer might like (maybe with the exception of the high end designer remodeling). So while some styles are generally more attractive, your idea of a beautiful space might not match someone else’s. We did open our kitchen and significantly improved the aesthetics and functionality, so I’m hoping it’ll provide some return, though I don’t expect we’ll recoup the entire cost. One advantage is we did a lot of the work ourselves and got discounts from a friend’s remodeling business, so it cost about one third what it would have to hire someone.
Bingo, that is exactly right. Good luck when it comes time to sell!
Hi Sam,
New Subscriber here. I like your articles, thank you!
Even though you might not earn the money spent on remodeling when you sell the house, wouldn’t you be able to rent out the place for a bit more $ since it’s looks nice? what are your thoughts?
Hi CRW – Yes, theoretically, you should be able to rent for more and get more interested tenants to choose the best tenant possible.
The downside is that after the expansion + remodel, your house will look the best it will ever look until the tenants go to town on the place. Hence, once should strongly consider selling as soon as the expansion is done.
I’m thinking of expanding my existing home, and then my rental in a year and then selling my rental after the expansion is done. But gosh, I hate to let go of SF real estate. I know in 20-30 years I’ll be kicking myself for selling, especially if I don’t reinvest the proceeds into something that makes 10% a year.
Dollars per square foot is just about the only metric. Unless you are at the very high end of the market. We moved last year from a house we thought we were going to spend 20 years in. So we had been updating, not for a return, but because we wanted those things in our house. When it came time to sell the buyer didn’t care about what we had spent, it was only $/ft^2 on the other side. Adding square feet to your dwelling will add value, everything else? Not so much.
A’int that the truth. People may have different tastes and won’t like what you’ve remodeled at all. If no expansion, then layout improvement and specifically highlighting what has been done with a record of cost will help.
My sister is always talking about adding on two additional bedrooms. I think in her case, it would add value into her house if she every decided to sell.
Great article, Sam. In my life I have remodeled once, and it was to update a foreclosed home that I purchased three years ago. Since I did all the work myself and found cheap materials, the house definitely increased in value by more than the cost of the remodel.
Like you said above, one must know the cost of the remodel before the purchase and build that into the buying price. I definitely did and came out on top because of it.
In the future, I’m looking to buy some more foreclosed properties that I can fix up and rent out for passive income! Should be later this year. Can’t wait!
That’s very awesome you were able to pick up a foreclosure three years ago. Hope it brings you big bucks when it’s time to sell!
I am eyeing property in two to three years after a CD comes due. I wonder how the market will be then. Good luck on your foreclosure hunt!