HMW #144: When Should I Renovate a Long Term Rental?

Read Time: 7.5 minutes

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I (Alan) am here to save you from the newbie curse of over-renovating a rental property. This desire usually comes from a variety of things: wanting to make a rental something you would want to live in, fear of being a slumlord if you don't have the nicest home on the block, or thinking brand new everything automatically makes the most money.

These ideas are from the truth. My mantra is: you want your house ugly in the street and sexy in the spreadsheet. It's an investment after all and the only thing that matters is what returns your rental investment is giving you. You with me?

Great! Let's dig in.

Scenario 1: You can't rent it as-is

Always try to rent the property it it's current shape and condition before considering a renovation. You should know within 15 days on the market if it's acceptable to tenants. If you have no applicants after 10 showings it's either overpriced or needs a facelift at the current price. The market will make it clear.

Understand that tenants only care about 3 things: bedroom count, proximity to work, and the monthly rent amount. 

Tenants filter for properties online by budget, bedroom count, and area. If you fall in that window, they will make an appointment. Rarely does the renovated property farther away or with higher rent win out because it doesn't show up in search results. No renter is looking to rent the nicest place on the street. They want to save their money for when they buy a place for themselves one day!

Imagine giving a rating on a rental house of 1-10.  For example, a 1-star house is beautiful to a person moving out on their own for the first time. A 2-star house is amazing to someone previously living in a 1-star house. You don't know your tenant's journey, but know that there are tenants looking for every star rating out there at all times. Be the landlord that serves their needs. The 10-star homes are usually the toughest to cash flow and make the worst investments (especially from a cash flow perspective), so stay away from the newly renovated gems that are impressive in pictures and not in your bank account.

Sorry! Going nuts on design is great for flips and primary homes, but not so much for long-term rental returns.

Scenario 2: The renovation pays for itself in 3.5 years

I like my investments to pay for themselves in 3.5 years. For you, maybe it's 2 years or 5 years. I chose 3.5 years as a good balance on short-term and long-term returns. But the number one thing having a rule of thumb like this does is eliminate decision fatigue. Every renovation I do this simple calculation:

• Get quote of renovation (example: $12,000 to redo kitchen)
• Divide by 42 months (3.5 years) to see monthly breakdown
• Compare with the rental bump you get in return for doing it

So, a $12,000 kitchen makeover divided by 42 months is $285.71. If I can get a rental bump of at least $286 then I'm approving the renovation. The tenants are going to pay for it over the next 3.5 years and then I'll get ongoing returns for the rest of the rental life of the home. And I'll get a bump in value, too!

It makes all renovation decisions easy peasy. No emotion, just math.

Great! You are well on your way to making for a great long-term investor.

Scenario 3: You are going to sell it when reno is done

You might not get top dollar from a tenant, but you will get it from a home buyer looking for a house hack, new primary home, or a newbie investor like you used to be who will pay top dollar for a renovated house. It makes sense to sell when it's in tip-top condition, but renting in tip-top condition is like driving a new car off the lot: it immediately starts to lose value. This is not good investing.

This "ready to sell" stage is when you can get your inner HGTV dreams out and flip the property. I'd recommend doing a 1031 like-kind exchange to defer taxes and get a bigger rental but it's okay to cash out on your savvy investment over and treat yourself too. You've earned it. Now bask in your success and tell your parents you are ready for your own flipping show!

So in short, don't renovate like you are going to live there because you aren't. Renovate if rental bumps pay for it. And renovate if you are going to sell it as soon as you are done. Otherwise, resist the newbie urge to plow money in every rental that becomes vacant.

You won't do that, right?

Oh man. At least I tried. Looking forward to your new show "Flop & Flop."

Summary

• Your needs in a home are not your tenant's needs
• If a rent bump supports a reno, then do it
• Go nuts on rehab before a sale
• 1031 and repeat