What to Consider Before Renovating
The return on investment (ROI) of any given renovation project is a function of local market characteristics, the condition of the residential real estate market when the property is sold, and the quality of the work performed. Historically and on average, certain projects, such as the addition of a wood deck, kitchen and bathroom upgrades, and window replacement, have shown the greatest ROI regardless of the property's location or the state of the residential property market.
Bigger renovations are not always better, as spending more does not always ensure greater value creation.
However, unless the remodeling project is designed to fix a structural issue or design flaw, it is unlikely that a homeowner will earn back more than the cost of construction. If cost recovery is as important a consideration as increased enjoyment from enhancing the property, then homeowners should consider the tastes of prospective purchasers when deciding which projects to pursue.
For investors remodeling rental property, the cost of enhancing it can be recovered not only at sale time, but also through the increased rental rates commanded by updated residences.
Still, homeowners need to be careful of which projects they choose to complete, since the potential value gains can only be realized to the extent that there are buyers willing to pay for the renovations.
Consider Your Location
When considering any type of project, it is essential to ensure that the improvements made are appropriate for the particular type of dwelling and local property area. One mistake homeowners often make is improving their homes well above the average for neighboring houses. Buyers are attracted to particular neighborhoods because of the services located nearby, and because houses in that area are selling within that buyer's price range. Although a house improved well above others nearby may still receive the same level of interest compared to others being marketed, it is unlikely that it will command a premium well above average simply because of the extra improvements.
Real estate agents will know when percentage value increases are higher for the average- or below-average-priced homes in a given neighborhood, and lower for houses priced at the top of their respective markets. It is during these periods of increased economic activity and increased real estate demand that improvements will have the greatest impact on a home's market value.
Time will also have an impact on an improvement's ability to increase property values. Making structural or design improvements, such as building additions or finishing raw space, will add value for a longer time frame than, say, updates to kitchens and bathrooms or technological improvements, such as new air conditioning systems, because the latter tend to become obsolete over time.
Geographic location will also have a great impact on the quickest or greatest payback from projects. For instance, the maintenance time and cost of in-ground swimming pools make it difficult to recover the cost of installation, and in some cases will reduce the overall value of a home. However, this may not be the case in the southern regions of the U.S., where extended periods of extremely hot weather make swimming pools a valuable addition for some homeowners.
How the Government Can Help
Because of mortgage interest is deductible from income taxes, Uncle Sam may help to subsidize home improvement, making the cost of construction even less burdensome for property owners.
For the less risk-averse, property owners that have accumulated adequate equity in their homes can use financial instruments, such as a cash-out refinance or home-equity loan, to finance their construction projects. Using these methods, the only cash necessary to complete the planned projects would be the interest payments to maintain the loans, which in most cases are tax-deductible. The principal can be repaid when the property is finally sold.
Project Returns on Investment
The ultimate reason to take on any home remodeling project as an owner-occupant is the enjoyment received from living in an updated home. For those hoping to also profit from a remodeling, there are several sources offering insight into expected payback on specific projects. For example, REALTOR® magazine publishes an annual "Cost vs. Value" report that compares the cost of common remodeling projects and shows the payback that homeowners can expect. These payback estimates are based on the residential real estate market fundamentals at the time, as well as the average cost of construction.
Table 1 contains national average estimates, but homeowners can find more specific information at Remodeling Online, offering the same estimates for different geographic areas of the U.S. These average payback ranges for the most common remodeling projects give prospective sellers a broad indication of which projects have the greatest probability of returning a bulk of the project cost at sale. Differentials in average recoveries are explained by the scope and quality of work performed, with smaller, less-useful projects being on the lower end of the range.
Wood Deck Addition 80-85%
Siding Replacement 75-83%
Minor Kitchen Remodel 75-83%
Window Replacement 75-80%
Bathroom Remodel 70-78%
Major Kitchen Remodel 70-78%
Attic Bedroom Remodel 65-76%
Basement Remodel 65-75%
Two-Story Addition 65-74%
Garage Addition 60-70%
Source: Remodeling Online
Improvements, such as office and bedroom remodeling had the largest recovery ranges, from 50-70%. The large spread is due to differences in the size of the renovations and the importance the room has on the overall design of the home, such as guest bedroom versus master suite.
The Bottom Line
When contemplating any remodeling project, homeowners should consider the value they will receive from the project over any cost recovery that may be available from a sale. However, when contemplating two equally useful changes, homeowners should research local real estate guides to determine which projects are most likely to pay for themselves. Remember that bigger is not always better, and spending more does not always ensure a greater degree of value creation. Home prices will always reflect the tastes of local property buyers and the amounts those buyers are willing to pay in a particular neighborhood or subdivision.