There are risks when you over-improve rental properties, such as the payback period is longer and your return on investment in the short-term is lower. Another risk is that you can’t refinance your investment. Over-improving also leads to higher maintenance costs for the property. For example, if you put a high-end stove in a low-end rental (or any large margin between the cost of repair and repair warranty), your long-term overhead will be more than the upfront cost.
So, we know why we shouldn’t over-improve, but how can investors avoid this trap?
Envision the end market
Before you start your next renovation project, you need to think through what you are working on and what purpose it is serving.
There are, for instance, levels of rehabs with renovation projects.
Tenant rehab is about making the property safe, presentable, and of a certain quality, but the finishes need to be on the value side of the available options.
This means using the same color, the same tile, the same flooring, the same toilet, the same sink, and the same faucet every time (assuming the items are still available). It involves replacing all of the electrical plugs and switches and repairing windows or the roof. Also, make sure that certain items, like cleaning out the main plumbing line and checking/servicing the HVAC, are done before the tenant moves in.
The next is quality rehab. This involves finding deals on quality pieces. Make sure everything is done correctly to code. Make everything inside and out show well.
It’s amazing how much the small things like caulking windows before painting and getting plugs and switches updated make everything look better. Don’t scrimp on little things that could make a big impact on how the property presents itself.
That being said, some properties need more attention. This could be replacing the HVAC or completely updating electrical and plumbing.
Make every detail look clean and updated, inside and out.
Numbers over niceties
Plan the exit portion of your process first. That means making sure to speak to a lender before purchasing or bidding on anything to make 100% certain that your refinance (refi) strategy is concrete. The No. 1 hurdle people encounter after buying a house with the assumption they can refi is after the rehab is done and the tenant is placed, they find out something isn’t lining up.
The lender can tell you which hurdles you may need to overcome and where your strategy is lacking.
You must know what a rental will be worth with a good degree of accuracy after the repairs. Getting the After Repair Value (ARV) wrong means you may very well over-improve the asset. This will throw off your refinancing.
Think rental comps
Before you purchase, you should know what the rentals in the area go for. Just like with finding the ARV, you’ll check comps—and you ought to get pictures of them. Aim to make your purchase look like the other houses or buildings.
Does the house next door have Formica countertops? Does it have tile or hardwood or laminate floors? Does it come with newer appliances? Ask your contractor for the budget of items.
Find market rents that are the same as the ARV, first through your Realtor, and then use the internet for your own research. Hopefully, you’ll have investor friends to give you some insight as well. Finally, ask the person who will be collecting the market rents (that is, the property manager) what they think the property will rent for after the rehab.
Consider strategy more than style
Gauge response rate
Why spend money on your rental unit? There’s only one answer: to earn a better return for the long-term.
Every improvement you consider, from new flooring to central air conditioning to a new deck, must be justified by higher rents. Period.
Before making any improvement, you need a good answer to the question: “How much more can I charge in rent if I invest in this upgrade?” Then determine how long it will take to recover the cost.
Here’s a hint: The best upgrade investments pay for themselves within a single tenancy, let’s say a two-year period. Many property upgrades have diminishing returns, either because the tenant will cause wear and tear or because technology and tastes evolve. After all, olive green appliances were once all the rage, but how long did that trend last?
You need to target a price point and then advertise at it. You can gauge your accuracy and success by the response rate to your rental listing. How many people contact you with interest? Be careful to adjust for demand in the area; with some neighborhoods, you may not get many replies, no matter the price.
Use standout amenities
Some amenities are uncommon enough that they grab prospects’ attention and intrigue them. They can compensate for, and even outweigh, other shortcomings.
This could be anything from smart home tech to a wine cellar to a hot tub.
Anyone who makes dinner knows that undercooking is better than overcooking—you can always throw it back in the oven. You can’t uncook it, though.
The same goes for rental properties. You can’t unspend that $3,000 on new hardwood floors. You can, however, always make additional improvements over time.
Let your response rate be your guide. If you get plenty of responses from qualified applicants, congratulations. If the phone is quiet or you get only unqualified applicants, spend five minutes and $0 updating your rental listing by advertising that new upgrade or amenity you’ve been considering. If qualified applicants then start calling, you can send a contractor over to make the upgrade.
Keep good tenants
Keep good tenants because turnovers are profit-killers.
So how do you keep good tenants? Aside from being responsive and courteous, be proactive in making occasional upgrades and then raising the rent.
Train your tenants that rents go up every single year. The rent will never spike an astronomical 20%, but they should come to expect a 2%-6% increase each year.
Touch base with them periodically to ask what upgrades and amenities they’d add if they could wave a magic wand. Your tenants will undoubtedly give you some good ideas, and those upgrades can increase the marketability and expected rent for the next tenancy. Look for sturdy, permanent improvements that will survive this tenant’s occupancy and help you rent the property for a higher amount next time around.
Be realistic about renters
One reason people over-improve rentals is because they are emotionally attached to the property or the tenants. It usually happens on the first property because every well-intentioned landlord wants to provide a nice building for their tenants.
It’s exciting to improve initially, but the profitability of a property comes from the mundane. Investors must care deeply about the condition of their properties while being reasonable and diligent in their investments.
Improve your property to the same level as the next closest neighbor—and no more than that.
You might be emotionally attached, but the truth is the tenant won’t care about the house or building itself and won’t care what type of flooring it has or the make of the fridge, as long as everything works.