Renovation budget
Also called Renovation program, Value-add capital, Unit turn budget.
A renovation budget is the funded capital a value-add plan spends to lift rents: the scope and cost per unit, the pace at which units can be delivered, and the rent premium the finished unit is expected to earn. It belongs in the sources and uses at closing, not in operating expenses.
How it works
Three numbers do the work and they are usually presented as one. Cost per unit and premium per unit produce a return on renovation cost. Units delivered per month produces the timing, and timing is what turns a good return on cost into an ordinary IRR, because a premium earned in year three is worth considerably less than the same premium earned in year one.
The premium is the number that needs evidence, and the only strong evidence is a renovated unit at the subject property leasing at the higher rent. That is why buyers ask for the seller's own rent roll split between renovated and classic units before believing anything in the marketing material. A comparable renovated property of the same vintage in the same submarket is the second-best evidence. A regional average is not evidence at all.
Scope creep lives on the cost side. A $12,000 interior refresh and a $25,000 scope that opens walls, replaces plumbing stacks or rebuilds kitchens are different projects with different premiums, different downtime and different permit exposure, and a budget quoted as one per-unit figure conceals which is being funded. Exteriors, amenities and common areas are frequently separate line items and are frequently left out.
Formula
Return on renovation cost = (annual rent premium x units renovated) / total renovation cost- Total cost includes the interior scope, appliances, permits, contingency and any exterior or amenity work the premium depends on
- The premium is net of any concession required to lease the renovated unit
- Downtime is a cost: a unit off line for a month is a month of rent not collected, on top of the turn
Worked example
140 of the 220 units are unrenovated. Interior scope at $18,000 a unit, an expected premium of $185 a month, one extra vacant month per unit to execute.
| Units to renovate | 140 |
|---|---|
| Renovation budget | $2,520,000 |
| Annual premium once every unit is delivered185 x 140 x 12 | $310,800 |
| Extra vacancy to execute, one month a unitat the $2,090 market rent | ($292,600) |
| Value of the premium at a 5.40% cap rate | $5,755,556 |
| Return on renovation cost | 12.3% |
A 12.3 percent return on cost against a 5.40 percent market cap rate is why the deal exists: $2,520,000 spent creates $5,755,556 of value. At eight units a month, a normal pace for one crew, the program runs eighteen months, so most of that value lands in years two and three rather than in year one.
Conventions worth knowing
- Ask for renovated and classic rents on the seller's own rent roll. A premium proven at the property beats any comparable.
- Contingency belongs in the budget rather than in the narrative. Ten percent is a common allowance and it is the first money spent.
The common mistake
Funding the renovation out of cash flow
A $2,520,000 program cannot be paid for by a property distributing $712,728 a year, and a model that tries either runs the cash balance negative or quietly never spends the money while still collecting the premiums. Renovation capital is funded in the sources and uses at closing or drawn from a lender holdback, and until it appears in one of those places the model has manufactured income it never paid for. The related error is booking turn costs as repairs and maintenance, which pushes capital above the NOI line and depresses the valuation of a property that is being improved.
Related terms
- Sources and usesA sources and uses statement lists every dollar going into a transaction and every dollar it pays for, and the two columns have to be equal. Uses are the purchase price plus all the costs of closing and funding; sources are the debt and whatever equity is left to fill the gap.
- Capital expenditure versus operating expenseAn operating expense keeps a property running in its current condition and is deducted above the net operating income line. A capital expenditure replaces or improves a component with a life beyond the current year and is deducted below it. Which side of the line an item lands on changes the property's value.
- Stabilized NOIStabilized NOI is the net operating income a property produces once the business plan is finished: renovations delivered, lease-up complete, concessions burned off, rents at plan. It is the income a yield on cost is measured against and the income an exit value is usually built from.
- Loss to leaseLoss to lease is the difference between what a unit could rent for at today's market rate and what the sitting tenant is contractually paying. It appears as a deduction from gross potential rent when the pro forma is stated at market rent.
- Yield on costYield on cost is stabilized net operating income divided by total project cost, including land, hard costs, soft costs, financing costs and carry. It is the development and value-add equivalent of a cap rate, and the spread between it and the market cap rate is where the profit comes from.
- Concessions and free rentA concession is rent given away to sign or renew a lease, most often as free months at the start of the term. It is a deduction on the way from gross potential rent to effective gross income, and it is what separates the asking rent on a rent roll from the rent a tenant actually pays.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.