When is a million dollar home not a million dollar home? When it’s in a $200,000 dollar neighborhood!
You can put rainforest granite in both of your laundry rooms (don’t laugh, I’ve seen this!), build a three story addition behind your humble ranch starter home, and hire landscapers to recreate the gardens at Versailles in your front yard…and at the end of the day, you’ll still have to contend with the concept of overbuilding.
An overbuild means that it would cost more to rebuild your absurdly upgraded house than it would really be worth to a buyer. For those of you who are visual learners, this fantastic video from The Sacramento Appraisal Blog explains overbuild in a succinct 30 seconds:
Here’s how it often goes:
John and Susan decide to buy and flip a fixer upper house for $100,000 in a neighborhood where homes sell for between $175-225,000.
They put $300,000 worth of labor and materials into the renovation, and when they are done, they try to re-sell this renovated home for $500,000. John and Susan are not likely to get their $400,000 of capital back, and they’re even less likely to see $500,000!
Even if they can find a buyer, no appraiser worth their salt is going to be able to justify that selling price. When picking comparable properties, the appraiser will be looking at recent sales and listings in the immediate area: if all the houses surrounding the renovated house are selling for $200-225,000, the value of this exceptionally renovated home will be at the upper end of that range, but it will still be limited by the neighborhood.
Financing will not work, because a bank will not lend money if it looks as though the asset is not worth what is being paid for it because it’s their money on the line if the homeowner defaults on the mortgage!
Everyone’s heard the tired old adage:
“Location, location, LOCATION!”
and while it’s hardly a fresh concept, it still holds true. At the end of the day, the value of your home is still largely determined and limited by your neighborhood.
The takeaway? Think carefully about how you renovate and upgrade your home. Sometimes it’s a much better return on investment to simply sell your house and move to a different one with the upgrades that you want. When you renovate your home, you rarely make back what you will spend on the renovation.