Return on investment (ROI) is a commonly used metric when purchasing an investment property. In this post, we show you how that same ROI metric can be utilized later down the line when making decisions about property improvements and help you avoid making renovations and additions that aren’t going to improve the bottom line.
Kenji likes to say that the “real work” starts after we’ve made an investment purchase.
Instead of buying a rental property and sitting back, passively letting the cash roll in month after month, we take a different approach. After we make a purchase, we try to maximize earnings by increasing rental revenue and reducing expenses.
As we’ve mentioned in previous posts, this is also when we start harvesting the hidden value of a particular property. This is how we make good investments into great investments.
But it’s sometimes tricky to decide what “hidden value” to harvest and what types of improvements to make on a property. You might spend a lot of time and money making improvements but ultimately not get the higher rents or lower expenses you were seeking.
So how do you decide if an improvement/addition is worth doing?
This is when we suggest going back to the basics and (re)using the return on investment (ROI) calculation to guide your decision.
Background: What is ROI?
ROI (Return on Investment) is a commonly used measurement to determine the profitability of an investment property purchase and compare it to other investment choices.
The ROI calculation is as follows:
ROI = Net Profit divided by Initial Investment x 100
As we’ve discussed in previous posts, we use an ROI calculation called cash-on-cash (COC) return when choosing what to buy. We aim for a 10% COC return. Refer to this article for more details.
It’s an extremely useful metric because it helps the investor make an apples-to-apples comparison of the rate of return from the property investment to other potential investments.
We find that ROI is useful not only at the time of purchase but also to evaluate day-to-day spending decisions for properties we already own.
**Download our free COC Return Calculator and use it to track your ROI!**
Examples of how we use ROI
Example 1: Eliminating utility expenses
One major expense item is utilities. For a duplex in Spokane, water/sewer can run $250 a month, more than 10% of the monthly income. Not surprisingly, we’re always trying to figure out a way to pass off some of these water/sewer costs to the renters to maximize our return.
Recently, we were quoted $10,000 to separately meter the water for one of our duplexes. We, of course, had sticker shock. It’s just a water meter – it’s not like we are replacing the water lines!
But rather than getting emotional about it, just do the numbers to help you decide if it’s worth it or not.
When you plug it into the ROI calculator at $200 a month in savings ($2,400 a year), you end up with a 24% ROI. We don’t earn that type of total return on some of our properties!
By calculating the ROI, we can see that separately metering the water/sewer for this property is clearly a worthwhile investment. Add that to Kenji’s to-do list!
Example 2: Installing storage sheds
During an extensive (and expensive) renovation of one of our Seattle duplexes (recently sold using a 1031 exchange), we realized that we might be able to fit a couple of storage sheds in the backyard to bring in extra income.
Kenji found some amazing deals on some well-constructed wood sheds at Costco. But before moving forward with the purchase, we calculated the ROI.
We estimated that two sheds would probably rent for close to $75/month and the cost to purchase and install these sheds was $2,000, giving us an ROI of 45%!
That’s not a return you see every day.
In the end, the sheds did rent for that price and, as an added benefit, the $75 of extra income represented nearly $20,000 in property appreciation ($75 x 12 months divided by the 5% cap rate).
Remember, every time you increase the monthly income of a rental property or reduce expenses, the property appreciates in value. This is called forced appreciation, and it’s the main reason we were able to grow our portfolio so quickly.
Example 3: Rehabbing a detached garage
When we first started out, we bought a duplex in Auburn, WA that had a detached one-car garage. Instead of letting the renters use the garage for free (which is what most people end up doing), we decided to try and rent it out to a third-party (in other words, rent it out to someone who doesn’t live at the property).
In order to set the garage up as a separate rental, we ran electricity to it and set it up on its own meter, sealed off the doors and windows, and put in a heavy-duty secure roll up door. This cost us about $10,000.
It didn’t take long to get it rented and we were able to get $250/month or $3,000 per year.
The ROI on this garage fix-up is 30%. This allowed us to pay off the initial cost of the garage upgrade in a little over 3 years. We ultimately sold the property for a significant gain and the garage income contributed significantly to that gain. When you do the numbers, assuming a 5% cap rate, the garage itself increased the value of the property by $60,000.
Example 4: Using our properties for supported living
As we’ve mentioned in previous posts, when we moved one of our Spokane duplexes into a Supportive Living program, our COC increased from 10% to 40%. However, there was a cost to moving it into the program: vacancy.
For whatever reason, it took a long time for our property to be accepted into the program. The administrators at the Supported Living company agreed to use our property for their program, but it sat vacant for a total of 9 months before final approval (one unit was vacant for 3 months and the other 6 months). This was a huge cost.
So was it worth it?
We know in the second year it is definitely worth it, but how did we do in the first year?
Calculating ROI, in this case, is a little different than the previous examples.
The net profit is a combination of the increase in rent that we get with Supported Living plus the decrease in expenses. The rent went up by $600/month and expenses went down by $543/month, therefore, our net profit is $1,143/month.
The initial investment in this case is the cost of vacancy. In other words, how much did we lose by having the property sit vacant? The property was renting for $950/month, so the total cost was $950 x 9 months or $8,550.
ROI = $1,143 divided by $8,550 = 13%
This means that we’ll recover our investment (cost of vacancy) in a little less than 8 months.
So if you are worried about vacancy, know that even if your property stays vacant for as long as ours did, it’s clearly worth it based on the ROI.
Example 5: Cost segregation to maximize tax savings
In a prior article, we wrote about the importance of sheltering your W2 or 1099 income and front-loading your tax savings in order to maximize the return from your real estate portfolio through compounding (assuming you are a real estate professional or taking advantage of the short-term rental tax loophole). And cost segregation is one of the most effective ways to achieve greater tax savings.
In brief, cost segregation is a way to front-load your depreciation deductions rather than spreading them out over 27.5 years for a residential property (these are your single-family rentals, duplexes, fourplexes, and larger multifamily properties) and 39 years for a commercial property (short-term rentals are considered commercial properties).
However, cost segregation studies are expensive. For example, we were recently quoted $7,000 for doing cost segregation for our new mixed-use property.
Most people would look at the cost and run the other way. However, if you think about it from an ROI standpoint, this one is a no-brainer.
For our mixed-use property, we were able to save about $60,000 in taxes. So the ROI is 850%.
Now it’s important to point out that there is something called depreciation recapture, where you may have to pay back the depreciation at a later point in time. We say “may” because one strategy to avoid depreciation recapture is to use a 1031 exchange. Using 1031 exchanges, you can maintain that high ROI from doing the study.
Conclusion
Learning to apply the ROI calculation to day-to-day decision-making in your real estate investing business can drastically alter your choices. Instead of making decisions based on upfront costs, you will shift to looking at the whole picture.
Let us know, what did you do differently when you applied this formula.
Did you find it changed your course significantly?
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