Real estate is one of my favorite asset classes to build wealth because it’s relatively easy to understand, has tax benefits, is tangible, and provides utility. Let me share another reason why real estate might be a great part of your retirement strategy in this post.
Back in 2001, I spoke to a friend in the construction business who told me, “It’s always better to build than to buy.” I couldn’t afford a single-family home in San Francisco then, but I kept his advice in the back of my mind.
At the end of 2004, I finally saved up a large enough down payment to buy the cheapest house I could find in the north end of San Francisco. It traded at a discount to comparables because it was on a busy street, in between busy streets. But, it was a single family home with three bedrooms, one full bathroom, and two half bathrooms. And gosh darn it, I was determined not to live a lower quality life than my parents!
With three bedrooms on the top floor and only one full bathroom, I decided to blow out a closet and create a Jack and Jill bathroom for the other two bedrooms. The price tag? $24,000 after materials, labor, and permits. Value created? Surely someone would find having another full bathroom rather than a closet to be worth at least another $24,000, no? Run comparables in the neighborhood to see how much more a house of similar size with two full bathrooms are worth compared to only one full bathroom. Renovations rarely recoup 100% of the cost, but adding a feature does.
Despite my remodeling efforts, I realized I could do something more, but I didn’t have enough money until a decade later. That something more was to expand.
PROPERTY VALUATION ARBITRAGE
The north end of San Francisco – Pacific Heights, Cow Hollow, Marina, Presidio Heights – sells for $800 – $2,000 a square foot, depending on location, view, and condition. Location is clearly the most important mantra to buying a property with long-term appreciation potential. Today I’ll argue that expanding a property might be an even better way to make money in real estate.
Although my house isn’t on the best block, it’s in a good area that could sell for up to $1,100 a square foot based on my neighbor who sold their place in mid-2014 for $1,185 a square foot, with a nice remodel.
When I bought my property in 2004, I noticed that my left neighbor went back 13 feet, while my right neighbor went back the full length of my house because he hugged a perpendicular street. In other words, I knew I could expand by at least 13 feet back since the city allows for one to expand up to your neighbor’s depth. If I leave five feet of space between my right neighbor and myself to comply with fire safety regulations, I can expand by 13 ft. X 20 ft. = 260 sqft per level. Given I have three levels, that’s 780 square feet of legitimate expansion potential.
780 sqft X $1,100 = $858,000. Let’s be more conservative and peg a $900/sqft selling price = $702,000. $702,000 – $858,000 is the theoretical value created by adding an additional 780 sqft to the back of my home. Now let’s take a look at the costs.
Cost To Build
According to my contractor — who is currently building a master bathroom in a fixer-upper property I purchased in 2014 (a project I may write about at a later time) — it costs ~$200/sqft to build a basic completed room with hardwood floors, moldings, and electrical. It will cost him closer to $250/sqft since plumbing is involved.
A build cost of $200 – $250/sqft is in the ballpark because I’m paying $310/sqft to build the bathroom in my fixer. My costs are higher than his estimate because I’ve decided to go all out: high-end tile, double vanity, double showerhead, hot tub, electrical toilet seat and other fixtures.
You only live once right? I’ll happily spend $55,000 on a master bathroom and drive a $20,000 Honda Fit than the other way around. My plan is to live in the home after the project is done for at least five years and either rent out the home or sell.
After my contractor is finished building the bathroom in my fixer upper, I’m going to ask him to draw up some plans to submit to the Department of Building Inspection to expand my north end house by 760 square feet at a cost of no more than $300/sqft. Given he would just be expanding the ground floor room, creating a family room off the kitchen on the second floor, and enlarging the top floor bedroom, $300/sqft is generous.
The total construction cost is roughly $228,000 (760 sqft X $300). What goes into this cost?
- Architectural and engineering drawings
- Electrical, building, plumbing, mechanical permits
- Material costs such as lumber, paint, doors, windows
- Labor and overage time
The estimated time for completion is seven months: three months to get approval, four months to build. As good practice, one should always increase the estimate time and cost by 50%. Therefore, the project could take 11 months to build and cost up to $342,000.
Value arbitrage: The estimated low-end return is $702,000 – $342,000 = $360,000 over 11 months for a 105% return. The estimated high-end return is up to $858,000 – $228,000 = $630,000 in seven months for a 276% return.
THE DOWNSIDES TO EXPANSION
When you expand your property you’re creating more value and the city will tax you based on that value you’ve created. In San Francisco, property tax runs about 1.17% of the value of your property indexed to the initial purchase price plus an inflation index. For those who bought 50 years ago, thanks to Proposition 13, they are paying a much lower property tax than those who are purchasing property today as prices have far surpassed inflation.
Despite having to pay more property taxes after an expansion, the upside is that the property tax is based on the cost of construction and not based on the market value of the property, which is subjective. The property might indeed sell for $800 – $1,100 a square foot, but nobody knows for sure until the property is sold. What is for sure is the construction cost of the project because the building department must sign off on the plan and issue a permit based on the cost of construction.
The other downside to expansion is that it takes money that could otherwise be used for other investment purposes. During the downturn, there were people who were overzealous about property expansion and ended up having to fire sale their property due to a liquidity crunch. Before starting an expansion project, carefully run realistic worst case cash flow numbers to see how long you can survive before your money runs out. Having two years of cash flow is a good guideline.
Finally, do not confuse remodeling/renovation with property expansion. Remodeling/renovation is making new an existing living space. Property expansion is creating additional living space that gets inputted into the value of a property when being sold. People often erroneously assume that just because they spend $50,000 remodeling a kitchen that they’ll get more than $50,000 in return when it’s time to sell.
Take a look at the cost / value figures.
As you can see from the above charts, remodeling seldom recoups 100% of the cost of remodeling.
KEY TAKEAWAYS FOR VALUE CREATION
In order for such property value creation to work, you’ve got to:
- Buy property that has expansion potential.
- Buy property where the selling price based on all the research you’ve done is at least 50% more than the construction costs.
- Find a highly recommended contractor and never let him go.
- Do not confuse remodeling with expanding. Focus on building new livable square footage if you want to maximize value.
A Hansgroghe 10” showerhead will cost ~$750 anywhere you live in the country. But the labor cost will be different. What’s also tricky is that contractors may tend to charge you more if you have a more expensive house within your city because they feel they can take advantage of you. Don’t let them.
Expanding is kind of like hell on Earth if you don’t have an honest contractor who sticks to a schedule and a budget. But if you can find one who is honest, meticulous, and within budget, it behooves you to expand by as much as your city or county will allow. It just might take a lot of cash and patience to do so!
Readers, have you gone through any remodeling, fixing, and flipping before? How did it go and how much was construction cost in your area?
Latest posts by Financial Samurai (see all)
- Should I Buy A Vacation Property? - March 24, 2015
- Real Estate: It’s Almost Always Better To Build Than To Buy - February 20, 2015
- The Average 401k Balance By Age - February 5, 2015