On a regular basis, I complete appraisals for private investors. Over the years, I cannot remember a time when an investor became upset when the estimated value of a property they wanted to purchase, was lower than what they had anticipated the property to be worth. They want to be informed. Investors don’t want to loose money by over-paying for a home. They understand that one of the fastest ways to loose money on a property is to over-pay for it.
Needless to say, my investor clients appreciate the value an appraisal provides them. An appraisal fee is cheap in comparison to the money they might loose by paying too much for a property.
While that is the case with investors, it is not always the case with home owners and prospective home buyers who are not investors. Why?
OWNERS ARE EMOTIONAL ABOUT THEIR HOMES
For home owners, there is more involved than just money. Home ownership comes with emotion. Buyers have specific desires and expectations about where they want to live and the kind of home they want to live in. Often, improvements they make to their property are influenced, at least partially, by emotion.
As home owners, we remember ever project. We remember how much time and money we spent on every improvement. We enjoy the emotional satisfaction that comes from making improvements to our home. That is completely natural! Our home may be perfect in our eyes.
However, our emotions regarding our home does not always equate to value, or at least the value we anticipate our home to be worth.
I recently appraised a beautiful luxury home. In recent years, hundreds of thousands of dollars in upgrades were spent on the property. Additionally, the owner purchased a large portion of land behind their property to increase the acreage in order to provide more privacy. Sadly, the home didn’t appraise for any more than it had sold for before the improvements were made. How is that possible? There are two factors that contributed to this situation.
First, it appears that the buyer may have over-paid for the home when they purchased it.
Second, they added improvements to the home that the market did not recognize as adding major value.
In this example, I had appraised numerous luxury homes in the area. Because of this, I had a first hand knowledge of their upgrades. Most were similar to, or superior, to the subject. Is a buyer willing to spend hundreds of thousands of dollars more for one property than another, when both homes offer comparable quality and upgrades, simply because the owner spent that much money on the improvements? The answer is clear. This demonstrates a principle in real estate. The principle of substitution. Basically, this principle states that an informed buyer is not going to pay more for a property than they would pay for another comparable property.
There is also another principle at play here. It is called the Law or Principle of Diminishing Returns. Appraisers see this principle in action all of the time. Many have probably never even heard about it. So what is it?
THE LAW OF DIMINISHING RETURNS
This law states that there is a point in which the added value of an additional improvement or addition, is less than the cost of that item. A home can be improved to such a degree that the additional improvements will add little, if any, additional value to the property. A home owner may want to make an improvement to their property. But, they will usually not see a dollar for dollar return in value for the money that they have spent on the improvement.
What if the roof or windows are in need of being replaced? The market expects the home to have a roof and windows. Therefore, while installing a new roof and windows may increase the value, it is not likely to be dollar for dollar. For example, if a home owner spends $10,000 on a new roof, it is unlikely that this improvement will increase the value of their home by $10,000.
Here’s another example. What if a home owner has to spent $30,000 rebuilding a portion of the home’s foundation? As is the case with a roof, prospective home buyers expect a home to have foundation that is in tact. Foundations repairs are expensive. However, when they are made, it usually not observable. Foundation repairs usually don’t enhance the appearance of a home. Whereas, a new roof or windows will add not only to increased functionality, but often curb appeal. So, there is a good chance that foundation repairs will have even less of a return on value than other things like roofs and windows.
Clearly, whatever the improvement is, there is a cap on what it will bring in terms of added value. Making improvements to a property does normally improve the condition of a home, which in turn, lowers the effective age of a home. That does normally have a positive impact on value to some degree. Just not dollar for dollar.
If this is the case, how do investors make money?
THE LAW OF INCREASING RETURNS
Investors try to buy homes at a discount. Since there is a limit to the amount of return on investment (ROI) they can receive on a property through improvements, they understand that much of their money is made at the time they purchase the property. Therefore, investors often look for distressed properties that are being sold either below market or are being sold at a very low price, due to the property being in need of many repairs. Of course, distressed sales are usually in need of repairs.
Investors rely heavily on another law. The Law of Increasing Returns. This law is the opposite of the Law of Diminishing Returns. The Law of Increasing Returns states that the value an additional feature adds to a property, will bring a larger return in value than the money spent on making the improvement.
For example, a home may be in need of many repairs. Because of this, it may have very low market appeal. Many market participants are not interested in buying a home that is in need of many repairs. However, by simply making the needed repairs and improvements, the home’s value may increase fairly rapidly, especially if it is in poor condition to begin with. In this scenario, since there is the potential of making a profit by making the improvements, this serves as an incentive for entrepreneurs to purchase the property, and make the needed improvements. But there is a limit how much value the improvements will bring.
There is a fine line between the two laws. Who decides where that line is? The appraiser? Actually, no. It is the market. That line is determined by examining what comparable sales are selling for.
HOW CAN AN APPRAISER HELP YOU?
A licensed or certified appraiser can help you to determine where that line is. You can hire an appraiser to estimate the market value of your potential investment property, as though the improvements were already completed. By doing so, you will be armed with some very important information about what you can reasonably expect to see in terms of return on investment. An appraiser can help you weight your options, which will help you to make an informed decision regarding purchasing a property!
Are you a home owner that is thinking about shelling out big bucks on an improvement to your home? Hire an appraiser to value your property as though the improvements were already made. You may find that the improvement is not going to give you a dollar for dollar return. You may actually find that a certain improvement will bring no additional value to your property at all.
Does that mean that you shouldn’t go forward with the improvement? That is something that you will have to decide. Many times, home owners go ahead with making a certain improvement, even if it is not going to add market value to their home, because there is value to them in terms of the enjoyment, or usefulness, that improvement will bring them. If you have an appraisal completed, at least you will be armed with more knowledge. What you decide to do after that is your business.
I hope you enjoyed this article. Thanks so much for reading it!
Here’s My April Monthly Market Update
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Hi-Brid, Lo-Brid, No-Brid? Hybrid Appraisals, Part VI – George Dell’s Valuemetrics Blog
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The Power of Praise – Rachel Massey, SRA, AI-RRS, IFA – Working RE
Praising Appraisers; Hobbit Houses; New York AMC Law – APPRAISAL TODAY
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6 thoughts on “How To Minimize Diminishing Profits in Real Estate”
Nice job Jamie. It has to sting badly when an appraisal does not reflect the cost – especially when such a significant amount of money was spent on a property. But that’s the thing. Not every improvement adds value. And we certainly don’t see “dollar for dollar” in the vast majority of cases. This is precisely why investors need to acquire properties at a discount and really be in tune with the right improvements for the specific property and neighborhood.
Thanks so much Ryan! I never spoke to the home owner about where the appraisal came in at since it was for a loan and my client was a bank. They did indicate to me during the inspection that they fully expected not to are a full return on their investment. So, hopefully they were not terribly surprised.
Good job Jamie. Enjoyed this.
The classic advice is to buy a house that has a pool. Don’t pay to put one in because you’ll never get your money back.
Thanks Joe! For sure! It’s funny that you mentioned pools. The owner if the home, in the example I gave in this article, was also playing around with the thought of adding a pool. To your point!
How important are pools out by you? We value them in the Sacramento Valley because of the heat but up in Portland OR, pools have less contribution.
It depends. They are very common for luxury homes out here. Anything under $500k we don’t see a lot. It gets hot here in the summer but our warm season is relatively short compared to other areas. Pools do add some value on the upper end of the price range. But usually not a huge return.