Rehab - Required vs. Enhancement

7 min read
A frequent question we are asked about rehab is, "Which items must be done and which items are optional enhancements?" Unfortunately, the answer is not short.

The goal of rehab is to maximize profit while minimizing cost. Note that profit is a function of: rent, time to rent, tenant quality, maintenance and length of tenant stay. The right combination of items to rehab also varies by seasonal demand, climate, market condition and other factors. Before we explore what you should consider when deciding what items to renovate/rehab/enhance, we need to first cover a few important concepts: target tenant pool, market ready condition and why tenants choose a property.

Target Tenant Pool

Each property defines a tenant pool. You do not get to choose who the tenant pool will be, the property does.

For example, suppose you want to target hospital personal who earn on average $7,000/Mo. People generally choose to live in the best place they can reasonably afford, which is usually about 1/3 of their gross monthly income. So, if your target hospital personal make about $7,000/Mo., they are likely to live in a property that rents for about $2,000/Mo. ($7,000/3). So, if you buy a property that the market dictates will rent for $800/Mo. it is highly unlikely that the hospital personal will choose to live there. Note, to simplify the text for the rest of the article, we will use the term "target tenant pool" instead of saying "the tenant pool that the property targets".

The point is that when considering rehab, you should only spend money on items that will make the property more desirable to the (property's) target tenant pool.

Market Ready Condition

Market ready condition is largely defined by the property's competition. Note that your property's competition is what prospective tenants perceive as competition, not what you think is competition. So the competition may not just be the property down the street, it could be a property across town. How can you decide what is the competition and what constitutes "market ready" for the target tenant pool? Rely upon your property manager. An example of tenant pool driven rehab will probably help.

Suppose all the competition has vinyl floors and the target tenant pool values tile floors. You will likely get market rent with vinyl flooring and your time to rent will likely be at the average for all competitive properties (all things being equal). However, if you installed tile floors your time to rent would probably decrease and the rent could be increased. However, the rent will only increase by an amount tenants perceive as the value of having tile floors compared to vinyl floors. In any case, it will not significantly increase the rent, but it will likely decrease your time to rent. Rents are not elastic, they are locked to the competition but can be increased to some degree with the right enhancements.

Why Renters Choose a Property

Each renter is an individual with their own personal set of values and criteria. In order for a renter to choose your property, in that renter's mind your property has to offer them the best combination of:

  • Location
  • Price
  • Configuration (single family, condo, 2 bedrooms, 3 bedrooms, etc.)
  • Condition
  • Features

If your property is not perceived by at least one renter to be the best, your property will never rent. In order to get the property rented, you will need to lower the price or enhance the property until it is perceived by at least one renter to be the best.

With all the above understood, on to required vs enhancements.

Required Renovation Elements

While there are a lot of tenant pool specific items, these are certain items that apply equally well across all demographics:

  • All systems (water heater, HVAC, appliances, faucets, drains, toilets, lights, etc,) must operate correctly.
  • Clean - The property has to look and smell clean. I am amazed how often I go into properties for rent and discover that the property is dirty and/or smells bad. A stinky or dirty property is not the way to get a property rented at market value or quickly.

Can you rent a property that is not clean or attractive by reducing the rent? Absolutely yes. The problem will be the tenant quality. Under most conditions, the only people who will rent a property that is not in market ready condition is someone who does not care about the condition of the property and are unlikely to take care of the property. When they move out, the property will likely need significant rehab.

So the basic rehab requirement is that all systems work and the property is clean and inviting.

Enhancements

Enhancements can either be a waste of money or almost a necessity.

Waste of Money

Not infrequently, we see properties that owners decorated to their own taste as opposed to the target tenant pool. Some owners mistakenly believe that by over improving a property, they can drastically improve the rent. Rent is not very elastic and over improving will increase rent only by a relatively small amount.

For example, one property I saw had travertine marble floors (between $8/SF and $15/SF). The tile we use typically costs between $1/SF and $1.25/SF (just the tile, not installed). This property had about 1,000SF of tiled area so the cost difference for just the material was likely: ($8 x 1,000) - ($1 x 1,000) or $7,000. The travertine floor might (repeat "might") increase the rent by $25/Mo. but I doubt much more than that. At an increase of $25/Mo., it would take $7000/$25 = 280 months or over 23 years to recover the material cost difference.

Another property I saw had a high end Bosh refrigerator, which costs between $3,000 and $5,000. A typical side by side stainless steel refrigerator costs about $1,250 and would have done just as well and likely will require less repairs over a 10 year period.

The point is to focus on the target tenant pool, not on your taste. Over improving a property is a waste of money.

Necessity

Sometimes enhancements are almost essential. For example, suppose your property and the competition have laminate counter tops and granite countertops are valued by the target tenant pool. If the property goes on the market at a slow time of the year, granite counters might reduce the time to rent by months. If the property rents for $1,500/Mo. and granite counters cost $3,000, it does not take long for the vacancy cost to exceed the cost of granite counters. Also, you will hold the property for a long time. If the granite saved you one month of vacancy or increased the rent at each tenant turn, granite counters will save you money over time.

Tenant Quality

Enhancements can also have a huge impact on tenant quality. A good tenant will reduce your operating costs in multiple ways. Before I continue, I define a good tenant as someone who:

  • Has stable employment in a market segment that is very likely to be stable or improve over time.
  • Pays all the rent on schedule
  • Takes care of the property
  • Does not cause problems with neighbors
  • Does not engage in illegal activities while on the property
  • Stays for many years

Know that good tenants are the exception, not the norm. You get good tenants by having a skilled property manager select from multiple qualified applicants. If the property is in basic market ready condition, the number of applicants may be limited and the property manager will have no option but to choose the best from a small pool of poor applicants. The "best" tenant in such a situation may not be good enough.

Not having a good tenant can be very expensive. For example, if the selected tenant has a history of moving every year, you are likely to lose a lot of money over a tenant that stays for 3 years on average. Below is an example cost of a tenant turn (assuming the rent is $1500/Mo):

  • 1 or more months of vacancy $1,500
  • Rehab cost - assume $1,000
  • Property manager rent-up fee, assume 1/2 of a months rent: $750
  • Utilities during the time the property is vacant, assume $200.
  • Total tenant turn cost in this example will be $3,450 in lost rent and or expenses.

However, suppose you invested $3,000 to install granite counter tops and the property manager was able to select a tenant with a history of staying +3 years. Your cost savings over a 3 year period will be:

  • One turn every year for three years: $3,450 x 3 = $10,350
  • One turn after 3 years: $3,450
  • Cost savings: $6,900

Demographic Impact

The demographic of the target tenant pool has a significant impact on what is essential. For example, suppose a property targets larger families with small children. If the property is mostly carpet, odds are that you will have to replace the carpet every 2 or 3 tenant turns. If the average stay is 1 year, carpet would be far more expensive than tile.

Suppose the property targets empty nesters and the average stay is 5 years and you need to replace the carpet every 3 or 4 turns. In this case carpet would be the much cheaper option.

So what you should change/enhance is dependent upon how long you plan to hold the property and the target tenant pool.

Summary

Required

At a minimum, the property must be market ready. Market ready is defined by properties that the tenant pool perceives as the competition. Failure to have the property in market ready condition will result in: lower rent, longer time to rent, poor tenant quality or even all three and will result in significantly reduced profit, or even a loss.

Enhancement

You never want to spend one penny more than you have to in order to maximize profitability over your expected hold period. Only consider enhancements that: increase the rent, increase tenant stay, increase tenant quality, reduce time to rent, reduce maintenance costs or any combination. However, investing money into items that the target tenant pool does not perceive as high value is a complete waste of money.

How do you know what is a requirement and what is a recommended enhancement? The primary source of this knowledge is the property manager.