The investment property market is rapidly shifting

As we’ve been covering in recent EIC articles, we are at an unprecedented time in the economy. In particular, the real estate market is being affected by several influences that are causing change in everything from pricing and valuation to investor liquidity.

The real estate market is accelerating its own change which means (among other things) you may find more “fixer upper” investment properties come on the market as investors start to unload properties that require large capital investments to compete for tenants. Examples would include properties that need a new roof, new boiler or things that came into disrepair over the course of ownership.

To the other extreme, single family homeowners may be putting their property on the market due to the need for quick cash given the enduring inflation and cost of living increases we’ve all been suffering from. Investors are using the changing times to clean house in their portfolios, rolling off properties that have diminishing cash flow margins or those that require the capital improvements mentioned earlier, taking advantage of over-inflated valuations.

During this rapidly shifting time, investors need to caution how they use capital for property acquisition, but more importantly, property improvements whether they be cosmetic or substantial. So whether you have planned a capital improvement on an existing property or have found a potential “fixer upper” that is a great deal but requires a lot of work, there are several things you’ll need to consider differently in this changing market.

How to evaluate a property’s potential in a rapidly shifting market

Evaluating when and what improvements to complete require more thoughtful scrutiny now more than ever. Rental property improvements are a business decision that are normally based strictly on financials, however, there are other factors to consider in turbulent markets. Making improvements that either improve the overall value of the property or allow you to increase rents is the way to create the most optimal cash flow over time, especially for the buy-and-hold investors, but cash is more important than ever during economic slowdowns, especially recessions.

In addition to which improvements to make, consider your timeline. A general rule of thumb is to not make cosmetic improvements until a unit is vacant, however capital improvements can be done anytime. Capital improvements are usually not unit-specific, however, cosmetic improvements can be. Here are a few things to consider when evaluating a property’s potential for cosmetic or capital improvements:

1. How much will the improvement cost and how much more rent can you get as a result? This is particularly important when inflation is at an all-time high and tenants who can afford higher rent are harder and harder to secure.

2. How long will it take you to make your money back? Another good point for the buy-and-hold investors, as you can extend the time frame given how long it would take for you to complete the improvements.

3. Are you accounting for the “J Curve?” (Listen to Jennifer explain the J Curve in this podcast)

4. How is the supply chain and access to resources to do the work in your market? Are general contractors, labor and materials readily available?

5. Is the improvement consistent with the neighborhood and surrounding area?

6. Is the improvement necessary or is your decision based on what you would like if you lived there? (A hidden trap for many first-time investors)

7. Will your improvement(s) enhance your property’s attractiveness to a high-quality tenant?

Be careful not to over-improve your property for the neighborhood and local rental market or under-improve which will hinder your ability to maximize cash flow.

Setting a strategic priority for your property

Whether you’re buying or evaluating existing properties, you’ll want to determine if the building is or would be costing you money. Issues that you are spending money and time frequently fixing are the best to deal with first. If you have a leaking roof that you have to keep patching, consider replacing the roof. If you have had backups or clogged drains frequently in your building, have the lines scoped to see if there is a larger issue causing the problem. Ignoring the repeat problems can put you at risk for more costly repairs to your property. Water is typically the number one offender in property damage. Water infiltration occurs many times without warning and it can be very expensive to repair.

How comfortable are the tenants? A happy tenant is a long-term tenant and one that keeps money in your pocket. Capital improvements may not necessarily increase your rent rate, but they can be a factor in how long a tenant will lease or renew. A tenant likely won’t care if a roof is brand new, but they will care if a leaky roof impacts their daily comfortability or damages their personal belongings.

Cosmetic improvements should be considered last if you’re on a tight budget. Make sure the project is worth it—ask yourself, “Will I quickly recoup the cost of this project and how long will it take?” If you want to upgrade a kitchen at $5,000, but by doing so you only get about $50 more in rent a month. It would take 100 months to recover the cost of that improvement, hence, unwise. If you can capture ROI in six months or less, it is a cost-effective decision.

Whether to go big or go small when improving

Cosmetic improvements such as painting, replacing cabinets and countertops or adding new flooring allows landlords to charge a higher rent rate and also sets your rental units apart from your competition. Giving your tenants a clean, well-kept and cosmetically appealing apartment to live in will also go a long way to setting a standard on how you expect your tenant to maintain their unit. If you’re looking at a fixer upper that’s sound but just needs a makeover, it may be a worthwhile investment you could flip easily into a rent-producing asset. However, if a fixer upper requires capital improvements such as a new roof or repaired foundation, you may want to pass up the deal if the numbers don’t work.

Capital improvements such as replacing the roof, separating utilities, replacing windows or adding bedrooms and bathrooms increase the overall value of the building as well as impacts your cash flow. Separating utilities allows you to turn that expense onto your tenants and will decrease the overall expenses you pay on a building. Replacing windows could have a direct impact on a tenant’s utility cost. Tenants that have very high and expensive heating or air conditioning costs tend to move much quicker than those that have controllable expenses from well insulated buildings. Turnover is costly, so consider how or if your capital improvement relates to your tenants’ overall comfort before making any final decisions.

It all comes down to cash flow

If you can increase the cash flow or value of a property then the answer is yes. If you can’t, take a pass. When you make the most cost-effective improvements to your rental property, your cash flow increases and so does the value. Completing the right improvements on a fixer upper now can help you:

• Reduce your rental property maintenance and operating costs. Lowering your out-of-pocket landlord expenses each month equals a higher net income, meaning more cash in your pocket. For example, install sub-metered devices to a multi-unit building, alleviating landlord payment of utilities and allows the tenants to be billed separately.

• Secure and keep high-quality tenants. When your property is updated and isn’t overflowing with maintenance issues, you will inspire higher-quality tenants to complete or renew their leases. Quality tenants are likely to pay rent on time and take care of the property.

• Increase property value and rent. By adding upgraded, functional utility to your property you can increase its value while making it more appealing to prospective tenants who are willing to pay more. Increased cash flow equals increased value.

• Stay competitive in the rental market. Assess your market for median rent rates to stay abreast of how rental rates are fluctuating. With changing economic conditions, rental rates may start becoming more competitive. If other similar rentals are upgraded and provide more conveniences than yours, higher-quality tenants will likely choose those other properties.

The cost of the investment and the time to recoup the cost of that investment has to make sense in your portfolio. Conduct a more thoughtful due diligence and weigh the factors that influence both capital and cosmetic improvements before spending the money to make changes.