Remodeled homes will sell for bigger premiums going forward because it has become so much more costly and difficult to remodel today. In the previous article, I focused mostly on the negatives of remodeling. However, this article will focus on the financial benefits of remodeling. Namely more rental income and a higher property value.
The home I bought and began remodeling in 2019 turned into a rental in October 2020. Here's a case study on how much money I ended up spending on the remodel and how much additional rental income it now generates. I'll also calculate how much potential value the remodel created if I were to sell.
Remodeling Your Rental Property For More Rental Income
After remodeling the kitchen and three bathrooms on the top two floors, I ended up renting out the space for $6,700 a month. I also refinished the floors and painted the walls. The top two floors consists of four bedrooms, an office, dining room, kitchen, living room, and three bathrooms.
The ground floor was uninhabitable because my general contractor blew everything open in order to more easily rewire the house with modern ROMEX wiring. Therefore, I lost a half bath and a room. If both those rooms were kept, maybe I could have rented out the house for $6,900 a month. The rooms were just really run down.
I was hoping to spend $100,000 gutting and remodeling the ground floor. Unfortunately, the project ended up costing me about $130,000 due to delays and rising labor and material costs. I thought the remodel would take 10 months to complete. Instead, it took more than two years!
With the downstairs remodeling project done, I'm now renting out the entire house for $8,000 a month, a $1,300 a month increase. Luckily, I found tenants the very next month after my previous tenants moved out. Hence, full occupancy.
Let's do the quick math on the remodeling return. One of my consistent goals is to keep building more passive income to remain free. And one of the easiest ways I've been able to do so is by rehabilitating properties and renting them out at market.
Gross Return On Remodeling Project
Charging $1,300 more a month in rent means earning $15,600 more in rent a year. Therefore, to get an annual return, I would simply divide $15,600 by $130,000 (cost of remodel), to get 12%.
A 12% annual return is great compared to the 10-year bond yield (~3%), the average stock market return of ~10%, and the average bond market return of ~5%.
Obviously, in a down market, a 12% annual return is even better. However, a 12% annual return is not the true return on the remodeling project. Let's calculate further.
A More Conservative Calculation On The Remodeling Project Return
Did my $130,000 downstairs remodel really enable me to generate $1,300 more a month or $15,600 more a year in rent? Probably not.
Thanks to inflation, rents would have increased slightly anyway from the existing $6,700 a month in rent charged from October 2021 through May 2022. The rent from October 2020 through October 2021 was $6,550. Upfront, they agreed to the $150 increase after one year.
Realistically, the market rent would naturally go up by 4-5% after one year, starting in October 2022. The San Francisco rental and property market never got too crazy during COVID. Whereas property and rent prices in San Francisco rose by ~20% over two years, heartland cities like Austin and Memphis saw a 40%+ increase in prices.
Hence, with the power of inflation, my original $6,700 rent would probably have naturally increased to $6,900 – $7,000 by October 2022. Hence, the real rental power increase for my downstairs remodeling project is closer to $1,000 to $1,100 a month ($8,000 a month minus $6,900 to $7,000 a month), or $12,000 to $13,200 a year.
Therefore, the real annual return on my remodeling project is closer to 9.23% to 10.15%. Still a solid real return compared to all other asset classes. However, it's not the initial 12% annual return I had calculated.
If only I could have kept the remodeling project cost at $100,000, my real annual return would now be 12% – 13.2%! Oh well.
An Easy Way To Further Boost Remodeling Project Returns
Charging a real $1,000 – $1,100 more a month is not bad after spending $130,000 on remodeling. But if I wanted to make an even greater return on my remodeling project, I could simply find a separate tenant for the downstairs unit. Although it doesn't have an official kitchen, the new laundry room has space for a kitchen, microwave, and stove top.
I could easily charge between $1,600 a month for the downstairs space alone. If so, my return on my remodeling project would therefore rise to 14.8% a year.
Making a 14.8% return in this market would be a home run. Alas, the additional absolute dollar amount I would be making of $600 a month isn't worth the hassle for me at this stage in my life. Having to deal with two sets of tenants for an additional $7,200 a year isn't a good tradeoff. What if the two tenants have a conflict?
As a landlord, you're always comparing the value of extra rental income versus more work and potential damage to the property. Two sets of tenants creates bigger liability issues.
The more people who work from home on your property, the more wear and tear there will be. There are also liability issues to consider as well. Hence, fewer tenants is usually better.
Another Consideration That Drags Down Remodeling Returns: Time
The longer it takes to remodel your property for greater rental income, the lower your returns. Sometimes, your contractor may hold you hostage given he found a more lucrative project to work on. This has happened to me many times before.
In a perfect world, my downstairs rental property would have been remodeled with a snap of my fingers. Instead of charging $6,550 a month in rent starting in 2020, I could have charged $7,550 a month in rent.
Hence, every month I spend remodeling is like losing out on $1,000 a month in rent. And if my expectations were to finish the remodeling in 12 months and it lasts 24 months, then that means I actually lost $12,000 in rental income.
One positive I can think of regarding my delayed remodeling project is that it might have taken me longer to find tenants in 2020 at $7,550. Although it's not six figures in rent, as I profiled in another post, spending $90,600 a year in rent is still a lot of money.
Back then, I might have broken down and just accepted multiple roommate tenants to obtain the higher rent. If so, I might have had to deal with a lot more turnover. I did come close to renting to a group of four techies relocating from India. But they were extremely nit-picky. Two of the roommates said they only planned to stay for a year.
Whenever you take on a remodeling project to boost rental income, you must have as realistic a timeframe as possible for when the project will be completed. Always expect your remodeling project to take longer and cost more than expected.
Unfortunately, COVID delayed project completions by 50% – 100%. Thanks to inflation, costs also rose with the delays. At least the delay also delays my property tax increases given I remodeled everything with permits.
Calculate The Payback Period
Getting an annual return on your remodeling project is one benefit of expanding your property. The other benefit is making “infinite returns” once the cost of your remodeling project is paid off.
For example, if you earn a 10% annual return on your remodeling project, your remodeling project will be paid off in 10 years. 10 years is your payback period. After 10 years, any return over the cost of maintaining that portion of the property is gravy. Of course, you will still have to maintain the property.
If your annual return on your remodeling project is 5%, then your payback period is 20 years. The payback period is simply calculated by dividing the cost of the remodeling project by the extra annual rental income generated.
One good rule of thumb is to hold onto your rental property for as long as the payback period. By doing so, you ensure capturing the returns on your remodeling project. While you're earning higher rents, your rental property may also be appreciating as well.
Once the payback period is over, you can then decide whether to earn infinite returns or sell. However, in general, it's best to hold onto your rental property for as long as possible.
Remodeling Your Rental Property To Create More Value
Now that we see how remodeling can increase rental returns, let's now look at how remodeling can increase your rental property's value.
I ended up spending about $130,000 to create 630 square feet of living space. The 630 square feet consists of a living room, bedroom, walk-in closet, full bathroom, and laundry room. Therefore, I spent $203 per square foot.
Given selling costs for a remodeled home with views in my area are about $1,200 a square foot, I could say that I created $756,000 in value. The gross profit would therefore be $756,000 minus $130,000 for $626,000. However, this calculation is incorrect.
I didn't create 630 square feet more of livable space. I only created 330 square feet of livable space because I had to blow out 300 square feet of existing space. But the 300 square feet of existing space feels way better. But its increased value won't go into this calculation.
To calculate the new building cost for new livable space, I now take my $130,000 cost and divide it by 330 square feet to get $394. The value created from my remodel can now be calculated as $1,200 per square foot (average selling price) times 330 square feet equals $396,000. Therefore, my real value creation is only $266,000 ($396,000 – $130,000).
$266,000 is better than a kick in my face. But it's certainly not the original $626,000 gross profit calculated. That said, if I were to estimate, I would say I improved the original 300 square feet of living space by at least $80,000. Hence, the total return may be closer to $350,000.
How Much Do You Really Want To Optimize For Maximum Rental Income?
The reason why mom-and-pop landlords like myself don't make maximum rental returns is that as we grow older, we tend to opt for simplicity instead of money. We want more harmony and less turnover. Simplicity is why I've invested a good amount of capital into private real estate funds. I just can't deal with more tenants and maintenance issues any longer.
I'm just looking for good long-term tenants who will take care of the property. Yes, it would be great to earn maximum rent. But I will happily charge less for better tenants and fewer tenants per rental unit.
If you want to try and earn maximum returns, then investing in a real estate fund, a public REIT, or a real estate syndication deal with a sponsor may be the better move. Their number one goal is to earn the greatest returns possible for their shareholders and limited partners.
I simply don't have the same hunger for making money as I did in my 20s and 30s. All I really want is to have as much free time as possible to do what I want.
It's funny, but before writing this post, I was feeling a little bad that my rental remodel had taken so long and cost $30,000 more than expected. But after doing the math, it turns out the returns are just fine. Always do the math folks!
Invest In Real Estate More Strategically
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are low and stocks are much more volatile.
The combination of rising rents and rising real estate prices builds tremendous wealth over the long term. Meanwhile, there are more ways to invest in areas of the country where valuations are lower and net rental yields are higher thanks to crowdfunding.
Take a look at my favorite private real estate investing platform, Fundrise. It is a way for all investors to diversify into real estate through private funds for as little as $10. Fundrise has been around since 2012 and has consistently generated steady returns through difficult times. The platform has over 400,000 investors and manages over $3.5 billion.
I've personally invested $810,000 in private real estate funds across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$350,000.