Originally published in the July issue of Think Realty Magazine, DLP Lending evaluated the key steps real estate investors can take in order to make smart renovation decisions and maximize profits on their fix and flip projects.
The process sounds simple. Purchase an undervalued property. Renovate the home. Then, sell or rent for a solid profit.
However, there’s a lot of work involved to successfully cross that finish line. For value-add real estate investment projects, you must define the proper levels of renovation, identify the ROI sweet spot, and then skillfully execute the plan.
While the design and aesthetics of your renovation are often considered the sexy part of the process, the return-on-investment boils down to your project and budget numbers. After all, having a renovation budget and plan that’s misallocated may leave your investment in the negative.
Designing an effective renovation strategy will ensure your value-add projects are a successful investment.
The Value of Design in Real Estate Investing
How do you determine the necessary renovations to truly wow people?
I recommend making decisions based on your exit strategy. Doing so will give you direction when creating your renovation plans and scope of work.
If you plan to sell, be aware of your price point. Your repairs should align with the market in which you are operating. For example, a home on the higher end of its market will require high-quality finishes.
If you plan to rent, think of quality but also be economical. Since tenants will cause wear and tear, you want durable materials. For instance, hardwood flooring may cost more than carpeting upfront, but it will be more cost-effective long term due to the lower cost of maintenance.
Additionally, when deciding what design enhancements to make, ask yourself these three questions:
- Will this renovation improve the project’s ROI?
Most often, inexpensive yet highly visible repairs and updates effectively boost resale value. And certain expensive repairs can cost more than what you will recoup at the sale or over time in rents.
For example, constructing a grand entrance by enlarging the space and upgrading the front door may enhance a home’s curb appeal. However, this comes at an average cost of $9,254 and only increases the resale value by $4,930. If the sole purpose of upgrading the entry is better aesthetics, this renovation is not an optimal choice. Other expensive upgrades, such as a mid-range master suite addition and major bath remodel, don’t provide great returns either.
- How much “fix” do I need to get the best “flip”?
To identify your project’s proper renovation strategy, you need to focus on your “return on costs.”
First, calculate the property’s after-repair-value (ARV) by examining comparable sales in the area. Then, identify what type of renovations you will need and how much they will cost. Once you have calculated the total cost of renovations, determine if you are getting a good return on the investment. Do this by comparing your budget to the difference between your cost basis (purchase price + renovation amount) and your ARV.
Keep in mind you cannot massage the budget to make the numbers work. But, you can make sure your budget aligns with your overall investment strategy. This way, you ensure the property is appealing to your end buyer or renter and that you can optimize yield.
- Is there value in highlighting existing character?
Sometimes new isn’t always better. The property you are renovating may have qualities that are worth maintaining and making a focal point. Not only can this save costs, but it can also retain integrity and show your attention to detail. For example, original exposed brick has become quite popular. As an article in The Independent notes, it shows the owner “has their finger on the design pulse.” As an investor, leaving exposed brick as is not only attracts would-be buyers and renters, but also saves you money on your renovations.
Keys to Effectively Executing a Fix and Flip Project
As Michael Yardney, a leading property investment advisor, writes, “a lack of strategy and poor handling of finances are primary reasons real estate investors fail.” That should motivate you to prioritize project planning and finances. Renovation costs can add up quickly, so create a solid plan in advance and stick to that plan as closely as possible.
Your success depends heavily on your discipline, the selection and capabilities of your partners, and how you manage your team. Poor management can lead to making the wrong renovations and hiring the wrong contractors.
Since project managers and contractors can be your biggest asset or liability, you must vet them thoroughly by looking at their experience and reliability. Also, select them according to the level of work you want done. If you invest in affordable multifamily housing, hire contractors who have a history of success in the multifamily space. If you are flipping a mansion, hire contractors who have experience with luxury properties.
When working with contractors, you should also:
- Write concise, carefully worded contracts that outline responsibilities.
- Build some flexibility into renovation timelines to account for unexpected issues.
- Itemize different aspects of your renovations and put in specs (the type of flooring, lighting, molding, etc.)
Additionally, hiring a professional designer may help you navigate the process and reduce your workload. To make renovations go more seamlessly, consider a contractor-designer package (aka a “design-build” contract). This will unify the project and ensure a single point of responsibility, making it easier for you to stick to your budget and schedule.
Having that design eye will help during renovations as well. From coloration to floor plans to room remodels, a lot goes into interior design. When designers detail exact plans and finishes to contractors upfront, your contractors will be able to move more quickly through their renovations. They can order materials right away, as they don’t have to wait for your decisions.
Plan Accordingly When Financing Fix and Flip Projects
First, make sure you are requesting the right loan.
If you apply for a purchase-money loan when there is a renovation component, you will end up getting lower loan proceeds. This will require you to invest more cash into the project. One reason this happens is because the loan will be based on the existing value of the home that needs improvement or is in disrepair. Keep in mind, purchase-money only financing will require you to pay for all the renovations out of pocket, and you won’t get reimbursed until the property sells.
You have another option, though.
If your project has a significant amount of renovation associated with it, we recommend taking advantage of financing the rehab portion as well since lenders will provide more proceeds. With this type of loan, you’re typically allowed to use the after-repair-value (ARV). Because you will explicitly outline the renovation plan, this enables you to get higher leverage and have money set aside throughout the deal. Lenders are also willing to provide higher leverage on the initial purchase, mainly because they know you are planning to increase the property’s value. When you seek funding from the lender, make sure you convey how the renovations will be executed and how they will add value.
Second, to ensure you have enough capital for the project, add a cost contingency of 5-10 percent in your scope of work for the unexpected. Additionally, always account for overages. If a contractor gives a quote between $4,000 and $6,000 to fix a kitchen, use $6,000 so that you are not left paying out of pocket.
Adding cost contingencies should be fine, as long as the deal stays within the lender-approved loan-to-value or loan-to-after-repair-value ratio (LTV or LTARV). Crunch the numbers and make sure your LTV ratio works, and you will be able to finance most of your additional contingency budget.
As you renovate the property, utilize your renovation holdback to your advantage. It can help maintain cashflow. Renovation projects can become unpredictable, as everything from labor to weather issues can impact your budget and timeline. Other variables like construction material costs, which increased by nearly 5 percent in 2019, can affect the budget. So, preparing for the worst and planning conservatively is advisable.
Winning the Deal with Great Design, Execution, and Financing
With value-add real estate investment projects, you must take a 360-degree perspective and consider all aspects of the process (upgrades, operations, and budgeting). Accounting for each of these allows you to build a renovation strategy that delivers the best possible ROI.
After all, renovating a home involves much more than aesthetics (though important). Execute every step with precision. That means identifying the proper budget and renovations, partnering with reliable contractors and designers, and having the right loan and lender.
If you diligently manage all aspects of the project, and stay disciplined, you will transform the home into a highly desirable, highly profitable investment opportunity and achieve your goals for the deal. And along the way, you will have gained valuable experience, which will enable you to make the next project an even greater success.