In the context of comprehensive financial planning, our clients often want to know if it makes sense for them to improve their rental property. This is a really good question, and we think there at least 7 things to consider before making such decisions:
Obtain comparisons. Before making improvements, it makes sense to obtain comparisons from other rental units that have similar upgrades so that you can find out how much more you might be able to obtain in rent for making improvements. These comparisons can be obtained on Craigslist and other rental websites.
Get local advice. Have a local real estate professional who is familiar with the area come take a look at your property and provide you with her/his perspective on what improvements/repairs might result in higher rents. A local professional is often very familiar with surrounding properties and can be an invaluable resource. If the agent thinks there’s a possibility of gaining you as a client at some point, then you can often obtain their feedback at no cost.
Be careful not to make upgrades that your local market won’t support. Some people make the mistake, for example, of making high-end improvements in a rental market where those improvements won’t increase their ability to obtain higher rents or increase the value of the property. Personal knowledge and judgment is paramount here; some landlords maintain a strategy whereby they aim to keep repairs and improvements to a minimum, and they’re still able to attract enough in rents to make a profit. Others landlords, however, need to make improvements in order to get their rents to a place of profitability. Of course safety is always critical, and you’ll want to ensure that your property is regularly maintained in such a way that it will adhere to appropriate safety standards.
Focus on profitability. We recommend that you analyze your rental in terms of a calculation called a capitalization rate (cap rate). The cap rate is the ratio of Net Operating Income (NOI) to property asset value. For example, if a property was listed for $1,000,000 and generated NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%. This is an easy way to get a sense as to how hard your investment is working for you. If your cap rate is negative or is very low and, if you could earn a higher rate of return on your money elsewhere, then it makes sense to improve your cap rate or invest your money in a more profitable investment. Don’t forget that, at the end of the day, a rental is an investment like any other investment, and the goal is for it to be profitable.
Know that certain repairs will always be necessary. Paint and carpet are generally two expenses that will need to be incurred on an ongoing basis. Some landlords plan to do both every two years. Using personal judgement on how much money to invest in paint and what grade of carpet to use will depend on the types of renters you attract and how long they tend to lease from you. Generally semi-gloss paint is more durable, yet still looks professional, and a mid-grade carpet can be installed at a more reasonable cost than a more high-end carpet.
Consider your broader finances. When it comes to making upgrades and repairs, you’ll want to think about how you’ll pay for the upgrades and repairs. If you’ll have to finance the costs, you’ll also be incurring interest charges, and this could decrease your overall profitability. If you’ll have to pull money from another profitable investment, then this, too, could diminish your net profitability. If, however, you’ll be using money from a low-interest savings account, then perhaps your improvements/repairs will result in increased rents and a better rate of return on your capital.
If you are going to improve your property, focus on improvements that will pay off. Kermit Baker, director at the Joint Center for Housing Studies at Harvard University, maintains that kitchens and baths are what tend to pay off the most, and sometimes these improvements can pay off by as much as 80%.