Sooner or later every owner of an apartment complex is faced with a remodeling dilemma. Should I upgrade the flooring to wood laminate?  Should I replace a broken appliance with stainless steel? Should I add a ceiling fan in every bedroom?  With each decision, an owner must weigh the cost of the remodeling against the amount of time it takes to recoup the expenses. While most owners realize apartments are classified as income-producing assets, many fail to realize the connection between remodeling and the value of the property. Understanding how apartments are valued is the key to making a wise decision.  While a rental house is based on the historical sales of similar homes, the value of an apartment complex is entirely dependent on its income it produces. For example, an apartment complex that produces $25,000 a year in net income is worth far less than a complex producing $250,000. The amount of money an investor pays to get that income depends on what other investments exist and the money those competing investments could generate. For example, every bank offers certificates of deposit, of CD’s.  Today, CD’s pay a paltry amount of about 2% on a multiyear CD, but in boom years, it’s not uncommon to find CD’s paying 5% or 6% or more.  So a $500,000 pile of cash invested in a CD paying 5% a year would generate $25,000 of income a year.  An investor with $500,000 cash who is trying to decide between investing in an apartment complex that makes $25,000 a year or a CD with a 5% interest rate would be a fool to pay $500,000 for the apartment complex, if the bank down the street offers a CD, fully insured by the FDIC, that provides exactly the same amount of income with virtually no risk. On the other hand, if the investor can negotiate the price down and only pay $250,000 for the complex, the investor would now make a 10% return on the investment.  That is, a $250,000 investment that generates $25,000 a year in income is equivalent to a $250,000 CD paying 10% a year. Good luck finding a bank offering a CD with that kind of interest rate. The rate of return that an apartment investment would pay if bought with all cash is known in the industry as the Capitalization Rate, or Cap Rate.

“Okay, so what does this have to do with determining whether to do a remodeling project?” you ask.  Well, let’s suppose an investor determines that adding wood laminate flooring to an apartment would enable the property manager to charge an extra $100 a month in rent, but it will cost $5,000 per apartment, and you got ten apartments.  Many investors would simply take the cost of the remodeling divided by the extra rental income to see how long it would take to “get back” their money. In this example, an investor would have to wait 50 months, or 4.17 years.  At that point, many investors would stop thinking about the problem and decide against installing the wood laminate.  However, investors should also look at the increase in value of the property. If this 10 unit property is generating $25,000 a year, and an investor spends $50,000 to install flooring that allows the rent to increase by $100 per unit per month, or $12,000 per year, then the investment now makes $37,000 a year.  If buyers in this area of town are trying to make a 10% cash return on their investment, then ask yourself what is the highest sales price you could put on this building that would still enable an investor to make a 10% cash return?  Or put another way, if you somehow had a CD with a 10% interest rate that was generating $37,000 a year in income, what is the value of the CD? The answer to both questions is $370,000. So in this example, an investor can take their original $250,000 apartment investment, spend $50,000 remodeling the floors, and wind up with an investment worth $370,000.  This is a profit of $70,000.  At this point, deciding to invest in the flooring is the obvious choice. Of course, an investor will only see this $70,000 gain when the property is sold, or, more shrewdly, refinanced. The gain that is possible depends on the rate of return that apartment investors are trying to earn. In this example, we used a cap rate of 10%. The cap rate has a multiplicative effect on the value of the apartment property. So any remodeling that allows higher rents increases the value of the property in a multiplied fashion. Conversely, remodeling efforts that result in little or no change in rents, has no effect on the value of the property. And what happens if an investor refuses to do basic maintenance?  When the neglected maintenance results in lower rents, the value of the property drops precipitously.  For example, supposes an investor tries to increase their cash flow by choosing never to replace the carpet or clean up the apartment between tenants? Aka, a slum lord in the making. Over time, the rents the property manager can charge will go down, as the manager must effectively put the apartments “on sale” to find someone willing to move in.  Investors only focusing on cash flow might figure a $50 drop in the monthly rent might be better than paying $2,500 to replace the carpet, but at a 10% cap rate and 10 apartments, that $50 drop in rent results in a $60,000 drop in the value of the property. Neglecting maintenance can be extremely expensive, but many apartment investors never realize this, because when the property is eventually sold, they only see its current sales price, rather than the price it could have sold for had the slum lord investor performed basic maintenance all along.

So when you contemplate a remodeling project, ask what the effect will be on the rents and consider its effect on the property’s value.  Renovations that allow you to increase or maintain rents are often worth a surprising amount of money, while renovations that have little or no effect on rents are probably a poor choice. At Red Door Management, we can help you determine if a remodeling project is worth the expense and the effect a renovation project could have on your rents and property value.

Mark C. Brown
Managing Broker, RDM Realty

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