How to figure out AFV when improving a property

Question

I have a duplex that I am currently renting out fully. I made several cosmetic fixes and I have started looking into turning the second half of the very large basement into a studio apartment.

I know how to get a price estimate from comparables generally. But I don't really know how much I can count on the cosmetic fixes. And as far as I know, there are not any duplexes turned triplexes in the area. (I know that I need to look into zoning to ensure I even can add a unit). But how can I confidently figure out what the property will be worth when I try to refinance? Obviously I know it can range and even depends on the appraiser, but I just want to be as close to possible to make sure it is worth it.

Pat Parrillo · Answer

Nice work thinking this through before diving in.

You’re right: zoning is step one. No point in moving forward until you’re 100% sure adding a third unit is allowed. Even if it’s not allowed now, sometimes you can apply for a variance or special use permit, so it’s worth checking with your city’s planning department.

As for property value post-refi, here are a few key points:

•	Appraisal will likely be based on income approach if you’re adding a unit. That means more rent = more value, even if there aren’t comps for a triplex.

•	Since there are no similar 3-unit properties nearby, appraisers may blend the income approach with comps of other small multifamilies, which adds a layer of subjectivity.

•	Cosmetic upgrades do help, but mostly in rent potential and marketability. They won’t drastically move the needle unless they bump your rent significantly.

•	Talk to a local lender who’s done a lot of investment property refinances. They may have insight on how appraisers are currently valuing units in your area and what they’ve seen on similar conversions.

Is it worth it?

If zoning allows it, and you can rent the unit for a decent amount, yes, especially if you’re improving cash flow and forcing some equity. But if it’s expensive, the layout is awkward, or zoning is a stretch, it might not pencil out.

Peter Mckernan · Answer

The majority of people in the primary purchase market are the ones that are really into the vanity of the home. Cosmetic fixtures are great for that, and 2-4 units speak to that crowd a little bit, I would say it levels off a bit at the 2-4 units. The next thing these investors are going to be looking at are the roof, electrical, plumbing, foundation, and HVAC.. They know they will have to pay CapEx for that stuff and the value goes down for you.

I would focus on the 2-4 units selling in that area with the same rents as your property. These investors will not look at this 100% like big multifamily investors, but this will be a bigger leading indicator of the price for sale. The lenders will be looking at this especially if you are getting a buyer with a DSCR loan. Biggest advantage for you on the out price (ARV), get the rents the highest you can get them.

John McDonald · Answer

In my experience, cosmetic improvements are one the best ways to improve tenant retention,  increase cash flow and significantly increase the value of a property. This, of course, depends on the state of the property and many other variables but lets take this example.

$300K property purchased at 10% cap rate. Assume 10% of purchase price for cosmetic improvements($30k). Total investment is $330k. Once you've stabilized the tenants, you sell after one year(long term capital gains) with a newly increased rent and compressed cap rate of 7%; the new value of the property is $492,857, for a profit of $162,857.

My colleague uses this formula to make $1.2M/year(net) on multi-family properties nationwide. It works.

Riley Schaefer · Answer

Really hard to comp small multi family properties (1-4 untis).  Banks still comp them like SFRs (using comparables), which causes a lot of issues if there are not many actual comps in the area to use.  I've seen a lot of appraisal issues on small MF properties.  I don't think cosmetic improvements make that much of a value add (not as much as SFRs).  Most duplexes and small MF are tailored towards tenants only vs retail buyers, so I would not put too much time into cosmetic improvements to increase value.

Randy Halverson · Answer

Try getting a BPO.  Broker price option.

Seth McGathey · Answer

@Peter Mckernan this is good feedback. One caveat though, I am not looking to sell currently. I am looking to cash out refinance. So what I currently care about it was it will appraise for rather than what it will sell for. I want to make these improvements and then be confident that I can get all or most of my improvement cost back.

John McDonald · Answer

Hi @Seth McGathey

Given that this is a multi-family property, you'll be better off using cap rate as a determination of value rather than comps. Especially considering that you dont have many similar comps to choose from. Cap rate will give you a much more accurate value for a mulit-unit rental property, unless you decide to see each unit individually, then you're back to stand home comps.

Let me know if you have any other questions.

How to figure out AFV when improving a property

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