What Renovations Generate The Best Returns For Toronto Real Estate Investment Properties?
If you’re new to real estate investing and you want to get into value-add opportunities with a limited budget, the more confusing part might be figuring out who to make the best use of your renovation dollars because returns might not be all the same. It’s true, some renovations cost more, are higher risk, take longer, and yet don’t give you much value-add appreciation. So in this video, let’s talk about what type of renovations you should be focusing on and how the types of renovations you choose might change depending on your budget.
But like I mentioned before, not all renovations are worth the same. In my opinion, I’d say there are three broad types of renovations. The first type is my favourite and easiest: cosmetic repairs. Picture your grandma’s house, which she’s lived in for the past 60 years. It’s old, but it’s still extremely well maintained. But because she’s lived in it for 60 years, everything inside looks like it’s 60 years old, and so if you buy this home, you’d have to modernise it to make it appeal to today’s audience.
This is the most straight-forward renovation you can get. Not much can go wrong when you’re replacing kitchen cabinets, bathrooms, floors, and painting the walls. Because of this, projects like this don’t take that long to do and generally don’t require permits, which further reduces your renovation time. On the other hand, the end results are huge. There’s a big wow factor with cosmetic renovations, and so they generate the best ROI. I took a look at the numbers from HomeStars and the Appraisal Institute of Canada and here’s what I found. The ROI of a kitchen makeover is between 75 and 100%, a bathroom makeover is between 70 and 100%, and new paint can generate between 50 and 100% in ROI.
We have cosmetic repairs, and then we have structural repairs. With older homes, you’ll often find that some things are not up to code. For example, you might find knob and tube electrical wiring throughout the home, and so you’ll need to replace the whole thing to bring it up to code. If there’s an oil tank in the house, you’ll need to get rid of it. You might need to replace an old furnace or a worn-out roof. The thing with structural repairs is that there’s not much of a wow factor.
These things are generally expected to be there and working, so these repairs are definitely needed to maintain the home’s value, but you generally won’t find very high value-add returns from taking these projects on. The other thing is that some structural repairs, like plumbing or foundation issues, might be much more risky compared to cosmetic repairs, because you don’t know what exactly you’re in for until you rip apart the walls. So, higher risk, less value-add, and possibly more time and money do not make structural repairs very attractive if you have a low renovation budget and are looking for the best returns for your effort.
The third type of renovation is what I call “creation projects.” What this does is it creates more valuable rentable space within the existing home, and so you can substantially improve rent yields. For example, splitting a home into two units can raise your monthly rent from $3,200 as one unit to a combined total rent of $4,000, with $2600 on the upper and $1,400 on the lower. It’s even possible to take that a step further if you’re able to add extra bedrooms, which can raise rents even more. For example, if you can turn a 1-bedroom basement apartment into 2 bedrooms, then you might get an extra $400 bump in rent down there.
Absolute returns are great for creation projects, but they do require more money, work, time, and risk compared to cosmetic renovations. So, the ROI is good, but not as good compared to cosmetic renovations. HomeStars tell us a new basement suit might generate a 70% ROI, and AI Canada expects around 50 to 75% in ROI.
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I know what’s going through your mind now. If structural repairs don’t have much of an ROI, why should you even take them on? OK, so here’s the other part of the value-add equation. Besides getting a bump in returns when you trade in time for money, you can also get an extra bump in returns if others get priced out of more major projects.
When we talk to real estate investors, most of them will have no financial issues with taking on a cosmetic renovation of under $50,000. But when a house needs more work involving all of the three types of renovations I talked about: cosmetic repairs, structural repairs, and creation projects, then we’re looking at a much bigger budget. This means, even if an investor was willing to take on these projects, they might not actually be able to afford them from a budget standpoint. So when this happens, more buyers end up dropping out of the buyer pool, which means those buyers who can afford these more major projects are able to get an extra discount.
Take a look at this. If you just take on $40,000 in cosmetic repair, you might get an ROI of 75%, or a return of $30,000. That is awesome. If you take on a $40,000 creation project, you’ll probably get a 50% ROI, or a return of $20,000. That is a good second alternative. If you do a $20,000 structural repair, there is not much ROI on its own. But when you choose a project that needs all three of these things, you’ll first need a bigger renovation budget of $100,000. If you do this and are willing to take these bigger projects on, you might get a further 5% discount. On a $1 million home, that’s a $50,000 bonus. So now your total returns look much better at $100,000. In other words, you bump up your renovation ROI to 100%, which is better than any of the three renovations on their own.
Let’s test things out and see how the numbers might change if you take on an even bigger project at $150,000. Remember, it’s not just $150,000 that you’re forking out, but you also have to pay around $250,000 for the downpayment, closing costs, and holding costs on a $1 million house. So, you’ll need around $400,000 of capital for a project of this size. If you’re able to get 8% off the purchase price because of the size and scale of the renovation project, then you’ll make an extra $75,000 compared to taking on smaller projects. So in this case, your absolute returns are better at $150,000 and your renovation ROI starts levelling off at 100%.
But take a look at this. That extra discount for taking on bigger projects is actually taken off your purchase price. So if you do a $150,000 renovation on a more expensive property, then you can get an even bigger discount if you get 8% off. 8% off a $1.5 million property means you get an even bigger bonus. So in this case, your absolute returns get bumped up to $187,500, or the best ROI of 125% in this case.
As you can see, your renovation ROI not only depends on the type of renovation you choose, but also on the total project size. If you have a more limited budget and you have to pick and choose your renovations, then choose the ones with the best ROI, which tends to be cosmetic repairs. But if you’re looking to generate the maximum ROI and you have a bigger budget, there’s a sweet spot where you can get an even better ROI on more major renovation projects up to a certain point because of the extra discount for bigger projects.
But as the projects get too big, the dollar amount of returns grows, but the percentage discounts start tapering off. And then once you hit more massive renovation projects beyond, say, $200,000, you’re likely going to move into more of a development space, which is a different class of work compared to our typical value-add renovations. You’re looking at a more expensive permitting process, a much longer project duration, and you’ll likely have to deal with construction loans.
The second thing I wanted to talk about is making sure that the property you buy, even if it’s distressed, is still livable. If it’s not livable, you’re not going to qualify for a bank mortgage, which will make the whole deal fall apart. If you end up going with a private lender, the substantially higher interest rates will negate the budget discounts from bigger projects, so it probably won’t make sense either.
The third thing I want to touch on is that even though value-add returns are a one-time bump, that doesn’t mean you’ll get better returns if you sell your upgraded project after a short period of time, because transaction fees over a short period of time will eat into your gains. For example, if you end up making $100,000 from a $100,000 renovation, but you end up selling the property after 5 years, the extra transaction fees that you incur will be around $87,000, assuming property prices go up 5% per year and you pay 5% in transaction fees plus HST. In other words, you only make $13,000 more versus doing nothing on a turnkey investment, which, in my opinion, isn’t really worth it.
I actually think that the biggest main benefit of doing value-added work is that you accumulate capital much more quickly at the beginning, so this will let you scale and invest more money sooner, and so you will be able to get much better total returns in the long run. Remember, renovations actually lower your leverage if you’re paying for them out of pocket. So if you are looking to maximise your returns, you’ll need to refinance your property after renovations so that you can get the same leverage as compared to a turnkey investment property. Once you pull that money out, you’d want to reinvest it into something with similar returns to maximise your ROI.
Next, renovation success and returns will depend on experience. If you’re very experienced in renovations, then you will likely make fewer mistakes and finish a project in less time than a newbie. In other words, an experienced investor might have a very different ROI compared to someone who’s still learning the ropes. So, even though it can be tempting to choose bigger projects once you see the more attractive returns right away, we always recommend starting with easier and smaller projects.
There’s a lot to learn already with real estate investing, and taking on a very complicated project might actually stall your growth if you go overtime or over budget. Assuming you’re going to the continent to refinance and grow your real estate portfolio, your first project will likely not be your last. Keep things simple, start small, gain that experience and confidence so that you can achieve long-term success! Of course, getting help from experts who know what they are doing can also help you speed up this learning process. We’re not just a regular real estate brokerage, but we’re real estate investors too, and we purposely tackle the most complicated projects so that we can help you out better and you can learn from our mistakes.
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When we help our clients with real estate investing, we take an end-to-end approach. We start off by learning more about your needs and requirements, teaching you what makes a good real estate deal, and then helping you buy your investment property. As an exclusive service for you, if you are our client, we guide you with renovations, like what renovations are needed, how much things might cost, show you what returns might look like, and then connect you with our reliable network of contractors.
Once your property is ready to go, we also have optional leasing and property management services if you need them. If you want to learn more about how we can help, just connect with us!
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