Dec. 13, 2016
Cost vs Value Report and Why You Can Beat It
As you may have been aware, I conducted an expert roundup a couple of weeks ago where I asked 45 experts what they felt were the best home improvements to increase the value of your home.
Even though the roundup was a great success and produced a number of very useful insights, a number of readers raised some concern. The results seemed to differ from what is typically published in the Cost vs Value Report in that some home improvements in the expert roundup showed a positive return of investment, while in the Cost vs Value Report none yield a positive return.
Wouldn’t it be a sad state of affairs if every home improvement that we made didn’t even recoup what we paid for it?
Well, I’m going to show you today that it is possible to consistently add value to your home that out ways your investment.
I have always been wholeheartedly convinced that the right home improvements do add value over and beyond the cost required to make them and I still do!
I’m going to be explaining to you exactly why this is the case, and why the results of the Cost vs Value report may be skewed metric if you’re using it to assess the return of investment on your home improvement.
Just before we start off, let me just note that I’m not trying to argue that my expert roundup is any better. The Cost vs Value Report is clearly based on much more thorough research and data.
I do, however, think that the outcome of my research is more in line with reality if your intention indeed to increase the value of your home.
So which one is right? Is it possible to make a profit on your home improvement or is the best that you can do to only recoup part of your investment?
What Is the Cost vs Value Report Anyway?
Before we get onto the juicy bits, let’s have a quick look at what the Cost vs Value Report is.
For those of you that don’t know, it is a report published annually and is largely regarded as the industry benchmark for measuring the ROI on home improvements. It only covers the US market at this point in time.
The costs of the home improvement projects are estimates of generic projects that are generated by RemodelMax, which is a publisher of estimating tools for remodelers.
The resale value data is aggregated through the collection of survey results of around 4,500 members of the National Association of Realtors (NAR).
The members of the NAR are provided with three-dimensional illustrations, construction costs, and median home prices when asked what premium they thought each improvement was worth.
Based on the average home improvement costs, and the resale data collected through the surveys, an average return was calculated which forms the basis of the Cost vs Value Report.
Is the Cost vs Value Report Misleading?
If you are making a home improvement with the objective of increasing the value of your home, the answer is yes. Let me explain.
If you happened to click on the link earlier and had a look at the Cost vs Value Report you would have realized that none of the projects actually generate an average positive return on investment.
In other words, the statistics are stacked against you if you’re making home improvements. You will be losing money (on average) on every home improvement that you make!
However, from personal experience I know that with the right decisions you can consistently deliver home improvements that add value you to your home – if that is indeed your goal.
So why can’t we take the numbers in the Cost versus Value Report as a given as someone that is hoping to increase their home value?
Home Improvement Motivations
The Cost vs Value Report is an average which leaves one big question unanswered.
What is the motivation of the people that chose to make a home improvement? Was it done to increase the value of the property? Was it done to increase the quality of life? Or was it done for some other reason?
The answer is that we simply don’t know exactly what assumption is used in the Cost vs Value Report.
To get a feel for what it may have been, a good starting point would be a recent survey that was conducted by Houzz which noted that only 54% of those who conducted a recent remodeling project, considered increasing home value as an important factor.
This means that 46% did not factor increasing their home value into their decision making. That’s nearly half of the people!
On the other hand, 83% considered improving the look, feel, flow and layout as an important factor. It appears that this by far the primary driving factor when people decide to make an improvement to their home.
The end goal of the latter group isn’t to improve the value of their homes, but it’s primarily to improve their quality of life, regardless of what that may do to the value of their home.
Mr. Smith and Mrs. Johnson
To give an example, imagine that Mr. Smith and Mrs. Johnson both own a three bedroom home in a fairly affluent suburb of Chicago. Mr. Smith knows it will only be a matter of time before he and his family move back to the West Coast which is where he is originally from, while Mrs. Johnson has found her dream home and will happily live there for the rest of her life.
Not being completely happy with the kitchen, Mr. Smith decides he wants to upgrade his kitchen. He always felt it lacked in quality compared to the rest of the house. Being cognizant of the fact that he will likely relocate and sell his home within the next 2-3 years, he decides to do some research on the style of kitchen and the type of improvements that are currently in demand. He decides install new cabinets with light and neutral colors to improve storage, install a tile backsplash, and upgrade to stainless steel appliances.
Mrs. Johnson also isn’t happy with her kitchen, and would also like to upgrade. She is a big fan of pink, and decides to install pink cabinets and pink tiling. They remind her of her childhood. She is also a big wine enthusiast and has always had a dream of having her own built-in wine fridge but this will be an expensive improvement. She wants it so much that she decides to go ahead with it anyway and instead of upgrading her existing appliances to stainless steel, she decides to add install her very own wine fridge. To her the joy that she will get out of this is far greater than installing stainless steel appliances.
Which of the two scenarios do you believe would add more value to a home?
It’s obvious that because Mr. Smith took the time to research what is in demand and he considered his home’s resale value, his improvements are likely to appeal to a wider audience, and therefore have a greater positive impact on the value of his home.
This doesn’t mean that what Mrs. Johnson did is incorrect but it means that both had completely different objectives when making their home improvements.
Ultimately both parties above achieved their objectives, but it becomes troublesome when we start using this data to measure the return on investment on various improvements – especially when the motivation is to increase the value of your home.
The Cost vs Value Report is likely based on a similar assumption as mentioned in the Houzz report, and it significantly skews the data and lowers the average return calculated for those using it as a reference to increasing the value of their home.
If almost half of the people did not even take home value into consideration, how can we expect the outcome of home improvements to show a positive ROI?
The answer is that we can’t because this wasn’t a desired outcome for many of those that made an improvement to begin with.
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Home Flippers Generate Consistent Positive Returns
So let’s have a look at a group of people whose primary motivation is their return on investment. Maybe that will paint a more rosy picture.
What better group than home flippers whose sole purpose is to purchase homes, improve them, and sell them at a profit?
In RealtyTrac’s Home Flipping Report for Q2 2014 notes that the average return on investment of 21% was experienced on flipping homes in the US, with an average gross profit of $46,000 per flipped home.
This isn’t a coincidence either. These guys (and girls) are able to consistently make profits by doing this and have been doing so for years and years.
So why are they able to generate a consistent and positive return on investment? Because the ultimate goal of a home flipper is to generate as much return on investment and each and every activity is focused around that goal.
So what does the home flipper do that generates this return?
Well, for one it’s being able to spot a house that is currently undervalued. Often times, this means it is a home that is in bad shape from an aesthetical standpoint so there is little demand for it and as such is sold below-market.
Why do flippers want to buy these properties? Because they feel that they can add value and bring these properties up to a standard that is acceptable to the market and make a profit by doing so.
How do they make a profit? You guessed it — they know that by conducting the right improvements, they are able to find home buyers that are consistently willing to pay a price that is greater than the flipper’s initial investment and the cost of the home improvements that were made.
The flipper doesn’t add a built in wine fridge, he doesn’t paint the walls pink, and doesn’t build improvements that increase the quality of life in the property without it adding any value. He focuses just on the improvements that he know will make his property more marketable and those will help him sell his property at a higher price point.
Focus and motivation is key to making sure you generate a positive return when making a home improvement.
The Completed Puzzle Effect of Home Improvement
How often do you hear that it makes no sense to install a high-end kitchen, with marble countertops, with stainless steel appliances while your bathroom is still sporting vinyl flooring, and plastic showerheads?
Well, the reverse is true when you suddenly decide to upgrade that last room in your house that was still lagging in quality compared to the rest of your home. It makes great sense because suddenly it all starts to click. Your house is suddenly in complete harmony and each and every space complements each other.
I like to call this the Completed Puzzle Effect of Home Improvement.
The Completed Puzzle Effect of Home Improvement – when upgrading that straggler room suddenly transforms your home into complete harmony!
Although I have to admit that I’m speaking from my gut here, I feel that the value increase resulting from this undeniable state of bliss can be much greater than the cost of the home improvement.
Let me know whether you agree or disagree by posting a comment below.
Unfortunately there is no scientific way to measure this because we are starting to get into fuzzy territory, but in my opinion this is where rationality starts to go out the door and potential buyers start to create an emotional bond with the property.
The feeling of we just have to have this property starts to take precedence over would it really be wise to spend this much money? and the chances of receiving a higher offer for your property increases dramatically.
It is an emotional pull that draws potential buyers to your house, and the premium that you end up receiving for the house because of your home improvement, is greater than the sum of the parts that were used to create it.
In the analysis in the Cost vs Value Report there is no emotion involved. People were simply asked to look at a picture and rate the added value as a result of it in a rational way.
The real estate market just doesn’t work that way.
Other Impacts That the Cost vs Value Report Does Not Consider
In an effort to keep this post somewhat concise, let me list out four other factors that you should consider as part of your return that aren’t measured in the Cost vs Value Report.
DIY Versus Professional Home Improvements
The average costs of home improvements in the Cost vs Value Report are based on having those improvements outsourced to a third party. Third party labor estimates are factored into the average costs.
In reality, however, the US Census Bureau has measured that around 37% of all home improvement projects are carried out by do-it-yourselfers.
Again, that’s a pretty significant piece of the pie.
DIY projects can be significantly cheaper than hiring a professional. Just to give an example, this study by Harvard notes that homeowners saved an average of $7,624 on a bathroom remodel by doing it themselves as opposed to hiring a professional.
That’s a significant chunk of change in anybody’s books!
If we look at the average cost of a bathroom remodel from the Cost vs Value Report and subtract this number just for the fun of it, we end up with an average DIY cost of $8,504 for a bathroom remodel.
That means with an average resale value increase of $11,688 as per the Cost vs Value report we now suddenly end up with a profit of $3,184 on the project. This translates to an ROI of 27.2%.
Not too shabby if you ask me!
Cost of Holding
How often do you hear the phrase that time is money? That’s because it’s true.
The same goes for when you’re trying to sell your home. The longer it takes the more money it will cost you.
A home improvement can improve the speed at which your home sells. This should be measured as part of the return on investment if you are planning to sell your home. The Cost vs Value Report doesn’t take that into account.
Every month that you shave off that time, is another mortgage payment and another set of utility bills saved. This is money in the pocket!
This is particularly relevant for those projects where the intention is the flip the house. The quicker you can offload it, the quicker you free up money that you can invest in the next property.
Although this generally isn’t relevant for those that have lived in the property since a $250,000 to $500,000 capital gains tax break is given anyway for those that lived in the property in the last 3 out of 5 years prior to the sale.
However, it is for those that buy properties for just investment purposes with the intention of selling them at a later date.
Given that 36% percent of households rented according to the United States Census Bureau, a sizeable portion of those making home improvements are likely to be investors that have never lived in those properties themselves.
Although most home improvements aren’t tax deductible, they do generally allow you to increase your tax base which will likely lower the amount of capital gains tax you pay upon sale of the property.
For example, if you purchased a property for $300,000 and made $20,000 of home improvements to it, your tax base would be $320,000 ($300,000 + $20,000).
If you were to then sell that property for $380,000, you would only have to pay capital gains tax over the $60,000 which is the profit calculated based on your new tax base of $320,000.
This is definitely something you should take into account when making a home improvement and could have a significantly positive impact on the return of your home improvement!
Improvements that Reduce Your Expenses
Lastly are the improvements that add value to your home in other ways by reducing your monthly costs.
Improvements such as this include things like adding insulation, energy efficient exterior windows and energy-efficient heating and air conditioning systems.
In addition to the money that you will save by decreasing your utility bill, you’ll also be able to apply 30% of the costs of these improvements as an income tax credit.
Even though we may not be talking big dollars here, these types of investments do add up and can make a significant difference over the long-term that may just turn your negative ROI project into a positive one.
The Cost vs Value Report Can’t Be Applied to Individual Properties
All these factors contribute to the fact that the Cost vs Value report can’t be applied to specific projects in a specific property.
It’s not a decision making tool.
In fairness to the folks at Remodeling that produce the Cost versus Value Report, they are the first to admit that.
In their own words, “The Cost versus Value Report provides an accurate snapshot of the national housing market, but it cannot be applied accurately to an individual modeling project for a particular home at a particular street address”.
So guys and girls remember… if you conduct a home improvement with the right motivations, do your research up front, use a style that is in demand, and make sure you watch the costs – you can more than recoup your investment through home value appreciation
I’m curious to know what you think. Leave a comment below and let me know whether you agree or not.