Return on Works or 'ROW' is another useful return on investment metric to have in our property investor toolkit
(Note to self...remember to add it into our Property Investor Toolkit!)
There are lots of ways to invest in property. There are also several ways to measure our return on investment. One way is to buy what I like to call a 'doer-upper', which is a property in need of updating, refurbishment & improvement, or possibly conversion / extension, then add the value and refinance or sell to generate that return on investment. The spend on works gives rise to this uplift in value - this I call 'return on works'.
New kitchen, bathroom, heating, electrics, redecoration, carpets are all opportunities to make a turn on our 'works investment' spend. But where do we stop? What about choice of fittings, replacement windows & doors, painting the picket fence or filling in a pond (yep, done that!)?
We all know instinctively that if we undertake some level of improvement to a property that we should see an increase in it's capital value or rental returns...or perhaps both...our return on investment.
Some expenditure could be essential to make the property safe or compliant, such as smoke alarms, earthing water pipes or installing circuit breakers...and these would add little in terms of value to a property.
Some expenditure could increase the desirability of a property, potentially reducing void periods, or retaining tenants for longer, such as a better energy rating.
However, some expenditure will have a direct impact onto the capital value of the property and may include some of the desirable expenditure as mentioned. For further background on the return on investment generated by specific property improvements, check out this insight from my scoop.it page.
An example before and after view of one recent project; new kitchens add more value and 'appeal':
The big question is - how do we decide where to draw the line, especially when it comes to discretionary expenditure - will we get a decent 'bang for our buck'?
This is where the Return On Works equation comes in to supplement our return on investment evaluation.
Return on Works defined:
ROW = post-works valuation less purchase price / cost of works
Purchase price £95,000
Post-works value £135,000
Cost of works £8,000
ROW: £135,000 - £95,000 / £8,000 or 500%
Return on Works essentially measures the increased equity resulting from undertaking works to a property. I tend to ignore additional costs and expenses in my rough calculation but in reality these should also be considered. I have a rule or target of at least a 200% Return on Works expenditure, which also provides for some cover towards additional fees and expenses (e.g. legal costs, financing fees and interest, etc.)
As per my definition of Return on Works, my last 5 projects were: 150% / 192% / 1325% / 500% / 833%
The 150% was an HMO and so the higher cashflow is why I flexed the rule here. The 192% fell below the bar as I added more works to the job mid-way for a better layout but it was close enough to my target. The other three were low value refurbishments, in combination with a below market value purchase....which I really like 🙂
In truth, where the property is bought at a discount from market value, then the return on works figure is slightly distorted, as both factors (discount and improvements) play a part in the net return on investment result. However, often they are interdependent or causal...I mean: who wants to buy a property that smells of urine, or has mould, or a pink Jacuzzi bath with gold-effect taps (yep, done that too!)?
Some examples of the usual winners to get a high return on works can include: an extension or loft / basement conversion, new kitchen / bathroom, double glazing, updated central heating and so on. See this insight for more on this.
Other works expenses can be a bit more hit and miss but equally somewhat surprising, like flooring, decoration and even a decent clean-up can pack a ROW punch.
To make the metric meaningful, we need to know two key pieces of information - actually three but one we can deduce from the first two:
- Post-works value
- Cost of works
The third is the purchase price obviously, however we could use the first two in our equation to calculate the maximum purchase price we should be paying for the property.
How to establish the post-works value
The simple method is the desktop method. This is where we look for similar properties in the immediate vicinity of the target property on the property portals and establish what I call 'recent market comparables'. In other words, properties that are ideally in good/excellent condition, within 1/4 of a mile, of the same style, size & configuration and sold within the past six months. That's the starting place, although we may have to flex some of the criteria if we cannot find too many. However, be careful if we do that as the further we drift from these basic criteria, the greater the risk of getting it wrong.
Another method to establish this value is to engage a surveyor and ask them their opinion of the before and after works value
In either case, we would also need to know the extent of any works to be undertaken.
Scoping out the required works
Similarly, we have two simple ways to undertake this exercise.
The first is an educated guess, or one based on experience, for example on a modest project:
- New kitchen £2k-£3k
- New bathroom £1k to £1.5k
- Carpets/flooring £1k to £2k
- Decorating, £1k to £2k
- Replacement boiler / heating upgrade £1k to £2.5k
and so on...
We then add up all of the likely expenditure, not forgetting labour & VAT and allow for a contingency - always! This will get us a spend range for the cost of works.
Alternatively, we can get quotes from a builder and other trades and don't forget about project management unless you can manage it yourself. I would get two or three quotes for most jobs and take either the mid-point or highest quote to run my calculations...again always allowing for a contingency.
When doing an initial pre-screen I can quickly assess the likely return on works to test the upside potential. As I highlighted, it is great if we believe we are also getting a discount on the purchase price. However, be careful when considering discounts, as for some projects the 'discount' is the cost of works!
If I wish to proceed with a project, I would probably get a survey done and a professional onion on the likely extent of the works required to achieve my end-valuation target.
Next, does everything 'need' to be done? Does it 'need' to be to a certain specification? Invariably not...
Magnolia walls, simple kitchen units & sanitary-ware, low-to-mid range flooring, fixtures & fittings and so on are usually 'good enough' for most rental properties. The key thing to consider is: who our target tenant of buyer will be, depending on our exit strategy (rent or sell). Always remember that we are never specifying a property according to our personal taste and preference...that will most likely result in a poor return on investment on improvement works expenditure.
Some more before and after photos, notice what changed and what remained:
Once we have all of the information at hand, we can run the Return on Works calculation and decide whether the project is worth it or not. Does it meet or beat our rule? We can also have different project variations, so that we can compare different alternatives against each other. Is it really beneficial to do that two-strorey extension, which will mean an empty property for 6-9 months when a light refurbishment, tenanted within four to eight weeks will do?
This is where a metric can only guide...it cannot decide for us. That is our job, to add judgement into the equation. What are our goals and strategy, what are our available funds and cashflow requirements, what is our skill set and risk appetite, how far away is the project, how strong are the comparables, what does the market trend say, etc.? These are just some of the wider issues that we need to take into consideration when evaluating our return on investment through undertaking improvement works.
That all said, I do love the Return on Works metric for potential 'doer-upper' or 'added-value' property opportunities as a component of how I look at the overall return on investment. It makes me think about value, comparables, upside, risk, options and purpose and so for me it is standard part of my property investor armoury.
What about you...how do you evaluate spending money on works in a property improvement project?