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Double delight – renovating for profit in a rising market

Wednesday, 8th May 2013

renovating

Purchasing a property, fixing it up and then selling it for a tidy profit can be a solid business plan. But there are times when renovating seems even more appealing, such as when the market is rising. So what are the pros and cons?

It can strike at any time and it affects people from all walks of life. It’s the renovation bug and it becomes particularly active when the real estate market is buoyant and prices are rising.  Seemingly ordinary people wake up one day and decide they want to buy, renovate and flip a property for massive profit.

In Australia, renovating is a popular pastime and has been around since the seventies. We spend tens of billions of dollars on it every year, normally to make improvements to our own home. However, renovating can also be a good pathway to making money if it is done right. Purchasing a property, fixing it up and then selling it for a tidy profit can be a solid business plan. The reason for this is fairly obvious.

Firstly, the potential gains are substantial if the property you are renovating for sale increases in value both from the renovation and the natural increase of the market. I have witnessed firsthand people walk away with over $100,000 profit after a single renovation.

A rising market is also very forgiving, particularly for novice renovators who are likely to make a few mistakes here and there. Even if costs blow out a little or the renovation takes longer than expected, there is a good chance of still making a profit. But renovating for profit in a rising market is certainly not a foolproof strategy for wealth creation.

Whenever someone plans to buy, renovate and sell a property, timing becomes a particularly important issue. Rising markets don’t rise forever so there is a risk that while a property is being renovated, the market turns and values start to fall. Anyone who was renovating for sale as the GFC hit would have definitely been nervous.

Renovations can take time and the schedule can easily blow out without careful planning. There can be delays in obtaining materials, finding the right trades or having to correct previous mistakes. For many novice renovators, the reality is that a renovation almost always takes longer than expected.

Ideally, you would want your property to be ready for sale at the time the market is at its strongest so you can maximise your profit. But nobody knows how long an upward cycle will last or when it will turnaround.

Perhaps the biggest risk when renovating for profit is that of overcapitalising. There is a danger that you will spend money on the renovation that won’t be recouped after sale. Ideally, a renovator would like to gain $2 in value for every $1 spent but there is a point in every renovation where an extra dollar spent doesn’t generate a return and this is often dependant on the location.

For every property in a given location, there is a ceiling price the market is willing to pay. Spending, say, $20,000 on a new kitchen may raise the value of a property by $40,000 but a $50,000 kitchen may only raise the value of the property by the same amount. Renovators must understand how much they can spend on a property given the area, type of property, the expected sale price, the purchase price and the desired profit margin.

Before deciding to purchase a property to flip, astute investors will start their calculations with a likely final sale price in mind. They will then minus the purchase price, all the costs associated with buying, selling and holding the property, and the likely renovation budget. If there is healthy profit left over then they may consider buying the property.

The difficulty of course is being able to estimate all these figures before committing to the strategy, which is why many people end up overcapitalising on a renovation. In a rising market, people tend to become more complacent with their planning and due diligence which leads them into trouble.

Another less risky option than renovating for sale may be to renovate and hold. This strategy helps investors to increase their rental returns, attract better quality tenants as well as boost the value of their property. Executing this strategy still requires sound decision making but the margins aren’t as fine and the pressure isn’t as great as when renovating to sell.