Optimize Your Home Renovation ROI and Hike Your Home Equity Potential by Using This Simple Formula
Image courtesy of Bigger Pockets (2017)
If you are considering buying or selling a home that needs to be upgraded there is a simple metric known as the: After Repair Value (ARV) ratio you can use to help you better evaluate the potential of any residential real estate property in any market. Widely employed by real estate investors, the ARV ratio represents the expected value of a property post-renovation. Mastery of ARV is key to grasping the potential equity a property can attain through strategic renovations.
1). The ARV ratio
1-1). How to calculate the ARV?
The ARV formula is straightforward: it is the ratio of the purchase price with repairs over the estimated value after repair. Expressed as a percentage (don't forget to multiply by 100), this calculation is extremely useful in assessing a real estate property's potential by determining its after-repair value.
1-2). How to assess the scope of repairs?
To do so, simply hire a home inspector to identify the necessary repairs. The inspection report will offer recommendations and guidance regarding the type of repairs required or recommended based on the current market standards. The inspection report will also help determine if the renovation will be mostly cosmetic or will require more extensive work such as plumbing, electrical, or structural repairs.
The next step is then to get at least 2 quotes from distinct contractors who are familiar with the type of repairs that need to be made. That said, always, keep in mind that even with the most experienced rehabbers, repair costs often go over budget, therefore always plan to set aside extra money AKA contingency fund for unforeseen expenses. A common recommendation is to allocate around 10% to 20% of the total renovation budget for unexpected repairs.
1-3) How to choose the right ARV ratio?
Start by analyzing comparable sales of similar properties in terms of square footage, bedrooms, bathrooms, and location over the past 6 months.
The ideal ARV ratio for home buyers typically falls within the range of 60% to 70%. Many consider a 60% ARV ratio as a sweet spot. However, a more realistic approach involves accounting for closing costs, holding costs (such as property tax and maintenance), and financing costs. Therefore, a range of 65% to 70% is often considered, taking into consideration the various expenses associated with the purchase and renovation of the property.
2). AVR and real estate property equity
As a reminder, property equity represents the ownership interest or financial stake that an owner has in a property. It is the difference between the property's market value and the amount of outstanding mortgage or debt on the property.
Equity is actively built over time through mortgage payments, property value appreciation, and any improvements made to the property. In other words, equity reflects the portion of the property that the owner truly owns outright. Well-planned renovations that enhance the property's aesthetics, functionality, and overall appeal can be a powerful tool to increase real estate property equity. You will find below for your convenience a list of the the most notorious ways by which strategic renovations can contribute to boosting property equity:
2-1). Do not try to reinvent the wheel: Prioritize renovations that are known to offer a high return on investment (ROI). For example, kitchen and bathroom remodels, adding extra living space, or improving curb appeal are considered high-ROI projects that can significantly increase property value.
2-2) Invest in energy-efficient upgrades, such as installing new windows, doors, or energy-efficient appliances, which not only add to the property's appeal but can also lead to long-term cost savings. Buyers and appraisers often value energy-efficient features, contributing to increased property value and equity.
2-3). Invest in necessary repairs and address structural issues when needed to prevent the property from deteriorating further. Fixing problems with the foundation, roof, plumbing, or electrical systems not only enhances the property's safety and functionality but also maintains or improves its value.
2-4). Optimize the layout and use of space to make a property more attractive. This might include removing walls to create an open floor plan, adding storage solutions, or converting unused spaces into functional areas. Such improvements can have a positive impact on property value.
2-5). Upgrade finishes, materials, and fixtures to higher-quality and more modern options to give the property a fresh and contemporary look. This can be appealing to potential buyers and positively influence the property's perceived value.
3). Gather useful information about the property
As a seasoned listing agent, apart from helping the sellers identify and prioritize the necessary repairs or improvements based on their budget, I usually perform the following research to get a better understanding of the property value in the long term before putting it for sale:
3-1). A thorough market analysis to identify comparable sales in the area. By analyzing recent sales of similar properties, it is easier to provide insights to the sellers and the buyers into the potential ARV of the property in question.
3-2). Gather information about the historical appreciation of home values in the neighborhood. If property values have consistently increased, it can instill confidence in buyers about the potential for the property to appreciate over time.
3-3). Compile comprehensive property information: I usually add to my disclosure package for the buyers as much information as possible about the property including but not limited to a list of the maintenance items, renovations, and upgrades performed by the sellers during their ownership of the home. This transparency can positively impact the buyer's perception of the property's worth.
3-4) I try to find out if there are upcoming developments or positive changes in the neighborhood. This information can influence buyers to perceive the property as having long-term value, contributing to an increased ARV.
3-5). List the neighborhood amenities: Highlighting nearby amenities, such as parks, top-rated schools, shopping centers, public transportation proximity to highways, etc. It is well known that proximity to desirable facilities can increase the property's attractiveness and contribute to a higher ARV.
To conclude, although the ARV ratio is only one of the metrics that can be used to determine the future potential profitability of real estate property, it is most certainly one that needs to be utilized to avoid the biggest mistake of all for any homeowners i.e. overspending. Overspending in a home renovation can lead to financial strain, potentially exceeding the anticipated return on investment and diminishing the overall value gained from the improvements. To put it simply, you should never be the owner of the nicest house on the block.