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 VALUE 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.
There are times when remodeling might create lots of value. Here are three examples:
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.
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.
PROPERTY EXPANSION FOR 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.
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Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Updated for 2019 and beyond.