The Leaky Pipe that Cost $5000 to Plug
Water was gushing out of a rusty galvanized pipe in the garden. My tenants sounded like screeching school children as they ran through a heavy mist on their way through the front gate.
Instead of spending $150 to repair the leak, I spent $6000 installing new copper pipe throughout the three unit building. I felt really stupid when I saw the plumber pulling galvanized pipe out of the wall that looked like it had 25 years of life remaining. And because tenants don’t usually think of new copper piping as an upgraded amenity, I was unable to increase rents. A year later, I lost $5000 on this investment (-85% return)! I’ll explain why in a minute.
Investment choices don’t end when you close escrow on a new building. You’ll be confronted with new investment options as long as you own the property. How you handle these choices will determine your ultimate return on investment.
In my case, I was motivated by the fear of another water leak. I imagined opening $1000 water bills and flooded units and black mold if I didn’t correct the issue right away.
And sometimes, we are motivated to make the improvements we WANT to make. I once saw a show on HGTV that was devoted to kitchen remodels. I was so inspired that, when my next vacancy came up, I remodeled the kitchen with new granite countertops and a farmhouse sink. It cost $11,000 and increased the rent about $65/mo. Not my best decision. I could have spent $3000 on the same kitchen and realized the same rent increase.
No two properties are alike. The improvement with the best return is different for every apartment.
In one building, an inexpensive kitchen upgrade may pay for itself in 1 year. In another property, spending $1000 to install a wall with a door might create a brand new $150/mo revenue stream for additional storage space (180% return).
It’s up to you to analyze your property and determine the greatest opportunities.
So, how do you determine which improvement has the biggest return for YOUR property? I believe any proper analysis requires at least these two steps:
- Determine an estimated rate of return (cash flow/cost)
- Compare this return to other options
With real estate investing, or any investing for the matter, the return is based on a future stream of cash flows. If you can determine how the rent roll or operating expenses will be impacted by the investment, then you can pretty easily determine the return.
The key question to ask is “How will my rental income and operating expenses be effected if I spend $….. to do …. ?” Once you know this number, you can divide by the cost of the improvement to calculate a yield.
Next, it’s important to compare one capital improvement option to another. This involves doing the above yield analysis on another project and comparing the two returns.
It’s a simple enough analysis, but how do you determine which improvements are likely to have the highest return on investment?
To do this, I have a mental model that works really well for me, and I think it will work for you too. I pretend that I’m going to try to rent an apartment in my building to my Mom’s best friend. From the very first impression of the landscape, to the smell of the apartment when she walks through the front door, what would embarrass me, if anything, about this apartment?
I think you’ll notice things that you never noticed before, like the landscaping, exterior paint, security, noise level, poor lighting, and the cleanliness. What is the biggest turn-off?
When you have a list of things that embarrass you the most, that is the list you analyze first. See which items on the list have the highest return and do those first.
As I said earlier, the investment I made in new copper piping cost $6000 for something that could have been fixed for about $150. If, instead, I decided to put the money toward a new roof (something the building needed at the time), I would have SAVED $5,000 in interior repairs the following year.
That’s the price I paid for not keeping things in perspective.
Think before you spend on improvements. Always analyze the impact on operating income and compare options before you decide.