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Successful real estate investors understand how to balance A) rehab cost, and B) return on value. In other words, they know how to get the most “bang for their buck” when it comes to renovating a home. New investors don’t always have this insight. As such, people often ask me: Ryan, what rehab projects bring the most value to a home?
As a rule of thumb, a dollar of rehab costs should return $2 to $3 in increased home value. But, this depends on market comps. To find what rehab projects increase home value the most, investors should look at all of the sales comps in their market. These comps will show how rehabs relate to value.
I’ll use the rest of this article to dive into home renovations – and how they affect value. Specifically, I’ll cover these topics:
- The Rehab-to-Home-Value Rule of Thumb
- Where to Focus Your Rehab Projects to Increase Value
- Confirming How Rehabs Affect Home Values in Your Market
- How Comps Build Your Rehab Scope of Work
- Developing a Rehab Plan
- My Recommended Rehab “Bonus”
- Avoiding a Major Rehab-to-Value Mistake
- Final Thoughts
The Rehab-to-Home-Value Rule of Thumb
As with everything in real estate, how much value a certain rehab project brings to a home depends largely on the local market. For instance, in some neighborhoods, granite countertops are simply expected. Accordingly, finishing a home with this touch wouldn’t necessarily increase value above market – it would simply bring the property on par with its comps.
Despite this market-specific reality, I use a rule of thumb for what you should require in value returns for every dollar of rehab costs. For every dollar of rehab you put into a home, you should want $2 to $3 back in increased value. For example, $10,000 in rehab costs should increase a property’s value by $20,000 to $30,000. If you don’t receive these levels of added value, it’s hard to justify the cost, time, and effort of a given renovation.
What Rehab Projects Bring the Most Value to a Home?
After considering the above rule of thumb, the question remains, where should I focus my rehab projects to increase value. For fix & flip investors, answering this question proves particularly important. When investors analyze a flip, they need to closely balance A) rehab costs, against B) after-rehab values, or ARV.
The Danger in Chasing ARV
The larger the appraised ARV, the larger the hard money loan investors can secure for a purchase and rehab (NOTE: Do Hard Money issues hard money loans up to 70% loan-to-value based on a property’s ARV). And, as ARV depends largely on a detailed contractor bid for what rehab work will occur, this creates a dangerous assumption: if I just spend more on the rehab, the ARV will increase, and I will qualify for a larger loan!
This assumption rests on faulty logic: that value will continue to increase as rehab costs increase. In reality, local market conditions – as discussed above – will dictate a value “ceiling.” Once you hit that point, values simply won’t increase substantially, regardless of your added rehab costs. Consequently, fix & flip investors need to narrowly focus their rehab costs on projects that will increase value. This allows investors to A) maximize home value, while B) not spending money on rehab work that will not drive a return on investment.
Focus on Kitchens and Bathrooms
Regardless of the local market, renovating two areas will consistently provide you the most value “bang for your buck” – kitchens and bathrooms. This largely comes down to human nature. Simply put, people generally spend the most time awake in these parts of their homes. And, when guests visit, they tend to congregate in kitchens and – inevitably – need to use bathrooms.
As a result, when potential buyers tour a home, they normally focus their attention on kitchens and bathrooms. Sure, a nice living room helps. But, in most cases, a high-quality, beautiful kitchen and stylish bathrooms will set a home apart from others. That is, all else being equal, nicer kitchens and bathrooms will lead to people buying one home over a comparable one.
For investors, this reality should guide your rehab budget. If you’re torn between allocating $10,000 towards finishing a basement or improving a kitchen, the kitchen rehab will generally generate more value.
A Note for BRRR Investors
BRRR investors 1) buy, 2) rehab, 3) rent, and 4) refinance properties. As such, they look to purchase similar properties to fix & flip investors, that is, distressed homes at a discount. But, when it comes to adding value with rehab projects, BRRR investors have some unique considerations due to the fact that they rent renovated properties. They don’t sell them for a profit like fix & flip investors.
Accordingly, when it comes to rehabbing a rental property, I take a different approach than with a fix & flip house. How I address a particular property largely depends on the market. If renters in a certain area expect a given style and amenity level, you’d hurt your rental prospects not meeting those levels.
Having said that, here’s my general philosophy when it comes to rehabbing a rental: quality of materials matters more than quality of work. With quality of work, I don’t need to pay a master carpenter to create intricate woodwork throughout the rental property. The benefits just don’t outweigh the costs. But, I do want to make sure all of the materials my contractors use will stand up to the wear and tear inherent to a rental property – hence, quality of materials.
In a rental, you also don’t want appliances and other materials that’ll fall apart quickly. For example, when I redo rental property walls, I make sure to use a very heavy texture. That way, if a tenant scuffs it up, it’ll still look good when I repaint it. You want to find the perfect balance between longevity and cost. In other words, you need to stay within your budget while making sure you won’t need to replace items every year. As a landlord, you want to do as few repairs as possible. And, by purchasing higher quality materials up front, you’ll save on back end repairs.
With respect to style, your property doesn’t need to be something out of an interior design magazine photoshoot. But, as stated, the style needs to A) generally fit the standards of the market, and B) appeal to potential tenants. You may get a great deal on high-quality materials, but if your rental looks like something out of the 1970s, you’ll struggle to lease it.
Bottom line, BRRR investors cannot solely chase added value. While rehabbing a home, these investors also need to account for tenant preferences and material durability.
Confirming How Rehabs Affect Home Values in Your Market
I like to consider the above overview more of the art to how rehab projects relate to values. With that said, here’s the science to how rehabs affect home values in your market.
To estimate a property’s values, you need to look at the local comps, that is, the similar homes that have recently sold in your market. If a property has actually sold, the sales price reflects market reality. Conversely, listing comps (i.e. similar properties listed for sale) reflect market aspiration – what people hope to get in sales price.
Recognizing this, I’ll pull comps data for local homes that have had similar levels of rehab to the plans for my property. But, that’s only the first step. After doing the background research on these properties’ values, I need to see how the rehab work drove those values. In other words, I need to tour – either in-person or virtually – these properties to see exactly what sort of renovations have been completed.
When I inspect a property, I gain insight into how home conditions drive associated values. Put simply, a tour shows what a home needs to look like to command its recent sales price. If my sales comps average $300,000 and all have granite countertops, I know with certainty that, for a $300,000 valuation, my property will also need granite countertops. Ultimately, touring comparable properties takes the guesswork out of the relationship between rehab projects and home values.
Finding Sales Comps with Investor’s Edge
Finding the above sales comps can be challenging without Multiple Listing Service (MLS) access. Fortunately, third-party data aggregators now have access to this MLS information. At Do Hard Money, we absolutely recommend our own software, Investor’s Edge.
We poured our entire team’s collective real estate experience into creating the best software for investors. This program provides you access to over 90% of the MLS data in the US market as well as postal data, tax records, and more. Simply put, Investor’s Edge provides you the data you need to make informed rehab decisions.
How Comps Build Your Rehab Scope of Work
These home tours translate directly into your scope of work, that is, the renovations you’ll complete on a property. With rehabs, you inherently begin with a distressed property – not necessarily a blank slate, but pretty close to it. As such, home tours dictate what your property will need to look like after the rehab. More precisely, these tours tell you the condition, materials, and style requirements a renovated property should meet to achieve a certain home value. For example, if all of the $300,000 comps have granite countertops, tiled bathrooms, and central air, your rehab better include those items, as well.
At the end of the day, you don’t want to over- or under-improve a property. If you over-improve, you won’t recoup your rehab costs, as the local market won’t support the increased value. Alternatively, if you under-improve a property, it won’t sell, as it doesn’t meet the local market expectations. Instead, your rehabs should match the condition, materials, and price points of sales comps “like for like.”
Developing a Rehab Plan
How should I actually develop a rehab plan? To find the ideal balance between rehab costs and added value, we recommend following the below steps to develop a detailed plan.
First, you need to create a detailed scope of work. You should do this by walking the property with your general contractor. As you walk the property together, you’ll talk about everything that needs to be completed during the rehab process, which should closely parallel what you saw on your property tours of comparable properties. And, you need to document each one of these items. As the investor, you are ultimately responsible for the deal’s budget and execution – not your contractor. Personally, I like to record these conversations on my phone, as I can use this as a reference when I’m building the below scope of work.
After completing the walkthrough, you’ll document every single item in what’s known as a scope of work form. This form includes a line-by-line description of every task to be completed, the quality of the associated materials, and the cost per item.
NOTE: At Do Hard Money, we have detailed scope of work form templates. We also have project managers who support our investors through the entire process, as we understand developing and executing a rehab plan can be challenging.
After you’ve added the tasks and materials to the scope of work form, I recommend meeting with two contractors to have a pricing meeting (with our borrowers, this is actually a requirement). During these meetings, you’ll assign costs to each of the line items in the scope of work. The total cost for all of these items becomes your rehab budget. And, meeting with two contractors for pricing bids lets you solidify a primary and back-up contractor. This will give you flexibility during the rehab process in case one of the contractors A) doesn’t perform, or B) needs to back out due to unforeseen circumstances.
Additionally, meeting with two contractors confirms fair market pricing on the project. You don’t want one contractor to significantly underbid and then request another $10,000 or $20,000 once the rehab begins. By getting two bids, you’ll have a clear picture of market pricing for the renovation.
With pricing confirmed, both you and the primary contractor will sign the scope of work form. That way, if you have any discrepancies in the future, this form will serve as the final arbiter. At this point of time, you have successfully A) developed a detailed rehab budget; and B) matched rehab costs to market conditions and value.
My Recommended Rehab “Bonus”
I like to add one exception to the above “like for like” guidance. With the majority of rehab projects, I want to mirror the renovations in comparable properties. But, I also like to add one “bonus item” to give my property some sizzle, that is, something to set it apart from similar homes.
Usually, I’ll carve out $1,000 to $2,000 in my rehab budget to put a property over the edge. This could be adding a tiled backsplash in the kitchen, creating a dual vanity in the master bathroom, upgrading the front yard’s landscaping, or any number of possible flourishes to separate my home from the other ones in the neighborhood. That way, when potential buyers tour my home, they’ll quickly realize that it has everything they expect from homes in the neighborhood. But, it also has that one little bonus that puts this one over the edge, convincing buyers to go with my home instead of another.
Avoiding a Major Rehab-to-Value Mistake
I touched on this rehab mistake above, but I want to reiterate it here. Many real estate investors make the major mistake of pouring more money into a rehab than the local market will support. For instance, say that none of the neighborhood comps have granite countertops. If you spend $10,000 installing them, you won’t receive an associated $20,000 to $30,000 bump in value. The local market just won’t support this return-on-cost.
Will installing granite countertops in this situation provide some value? Sure. But, whatever limited bump in value you see likely won’t outweigh the time, effort, and cost to completing the project in the first place. If you take nothing else away from this article, just remember: when it comes to rehabs, follow the “like for like” approach and imitate the comps.
From a mathematical perspective, every $1 of rehab you complete should bring an additional $2 to $3 in value. But, how do you confirm these numbers? Comps! To truly understand what rehab projects bring the most value to a home, you have to become intimately familiar with the comparable homes in your neighborhood. If you want your property to achieve a similar valuation, you need to tailor your own rehab plan to mirror the style/condition/material of these comps.
If you fail to follow this “like for like” rehab guidance, you risk one of two bad outcomes. One, you under-rehab a home, and it doesn’t sell. Or two, you over-rehab a home, and you cannot recoup your renovation costs. Phrased differently, work smarter, not harder. The local market has already demonstrated what rehab projects will drive valuations. Don’t overthink your own rehabs – just follow the market.