You may never be on the television reality show “Income Property” with two minutes to make a decision involving tens of thousands of dollars. But if you’re thinking about putting money into your house, the tools you use at work are just as useful at home – and can give you answers quickly.
As I write this, I’m also watching “Income Property,” a reality show whose host, Scott McGillivray, renovates homes to create an income suite (a rental property) within the owners’ house. That’s Scott on the left, by the way (I think he’s a very savvy businessman; my wife tells me he’s also a cutie).
I’ve just got to the part of the show McGillivray presents the homeowners with two renovation options. In this episode, Option 1 is a suite that would generate $800 a month in rental income, a renovation would cost the homeowners $25,000. Option 2 is a suite that would generate a rental income of $1,000 ($200 more) but the renovation would cost the owners $29,000 ($4,000 more). The homeowners now have to answer the question “Is the extra $200 a month worth the extra $4,000 investment?” As near as I can tell, the home owners have about two minutes to decide which option to take.
If these home owners had taken Learning Tree’s Finance for Non-Financial Managers course, this decision would be snap for them. While Learning Tree courses focus on improving productivity and effectiveness at work, the same skills work at home, too.
I recognize that, in your personal life, decisions about money are always emotional ones – you spend money on your home to so you can live the way you want. Only secondarily, do you consider the financial impacts that businesses look at first — resale value. That makes sense because resale value will only matter to you sometime in the distant future, when you sell your house. But that’s why this “Income Property” problem works as a purely financial problem- it’s a mercenary investment that pays off in the near future, as soon as the homeowners get their first rent check.
When making these kinds of decisions businesses often try to reduce the investment to a single number. The easiest single number to generate is the pay-off period which means, in this case, “How long will it take the homeowners to get their money back?”
With McGillivray’s numbers, the pay-off period is easy to calculate: The homeowners divide the $4,000 expense by the $200 per month in extra rent it will generate. That division comes to 20 months. In other words, the homeowners can take $4,000 out of their bank account and, 20 months later, they’ll have that money back in their account (to put it another way: in 20 months, the homeowners could use that $4,000 for some other money-making purpose). After 20 months, the homeowners will have paid all their costs and that extra rental income is pure profit.
So, using payback time, the single number is 20 months.
But what if the homeowners don’t have the money and have to borrow it? Now, the homeowners have something to compare their investment to. Whatever the homeowners do with the money they borrow, at the very least, it should give the homeowners more money back than the loan will cost them.
As I write this, I would suspect that if the homeowners’ went to their local bank to borrow the money, they would be charged between 7% and 10% interest. The question, therefore, is “What is the interest rate the homeowners will earn by investing $4,000 in a rental suite?”. This is the Return on Investment (ROI) number.
Interest is normally calculated on an annual basis so your first step is to calculate the “annualized” return. At $200 per month, the annualized extra rent is $200 times 12 months, or $2,400 a year. Since the homeowners are investing $4,000 and getting back $2,400, the return on their investment is $2,400 divided by $4,000. That calculation comes to 60%.
Using ROI, the single number is 60%. That’s already passed the first test: it’s more than the 7% to 10% the bank will charge them.
But having those two numbers (20 months and 60%) just puts the homeowners in position to answer the real question, “Is this $4,000 investment the best use of their money?” This is the “opportunity cost” question, which asks what the homeowners are giving up by putting their money in the house instead of into something else. The goal here is also to reduce that “something else” to a single number. With all of the options for their money reduced to single numbers, the homeowners can compare the various investments. As far as opportunity cost goes, if the investment in the house is better than any other use the homeowners have for their money then there is no opportunity cost.
Using the payback period, the homeowners would have to see if there’s some other investment they could make that would give them back their money in 20 months (or less). Quite frankly, I’d be surprised if they do. Outside of reality television, very few investments pay off in less than two years.
Looking at ROI, if the homeowners left that $4,000 in their savings account (a safe investment where they can get their money out any time they want), they’d be lucky to get 3% per year. If the homeowners put that $4,000 in a longer term investment — where they might not be able to use the money for a couple of years — they might get a 10% return (currently).
The homeowners could put their money in “junk bonds,” which sometime have returns in the range of 400% to 500%. But the reason these bonds are classified as “junk” is because, often, investors don’t get any money back at all. By the time you factor in the odds of getting back no money at all, junk bonds return about 5% to 6% more (on average) than other investments. I’ll be generous and say that investing in a wide variety of junk bonds might give the homeowners a return of 20%. None of those returns are anywhere in the range of the 60% ROI that the homeowners would get from McGillivray’s second option.
So, comparing the numbers generated by both methods (pay-off and ROI) with other options, this investment is a better choice for the homeowners than any other use of their money. They should spend the extra money and build the more expensive suite. And I bet they could have used these tools to make that decision in the two minutes available to them.