How to Determine ARV with a Garage Conversion
Over the years I have bought, rented, sold and funded many houses with garage conversions. Yesterday, a client of ours asked the following question, “How does a garage conversion affect the value of a property?” Great question and one that confuses new investors and some seasoned ones as well.
The Challenge
Garage conversions can be complicated to evaluate. Some garage conversions may appear to be seamless parts of the original home, while others will give the appearance of an obvious garage conversion, which will look and function differently from the rest of the house (meaning you can tell it was a garage that has been converted to a living space). In any conversion, functional parking and storage space are lost. So any potential “gain” has to be weighed against the value lost to the garage space. To properly evaluate, the buyer must first ask a series of basic questions:1) Is the newly created space necessary, or is it simply creating an over improvement?2) Is the functional use of the home better, or worse off, with this conversion?3) What is the quality and functionality of the finished product?
4) Was the conversion permitted by the city?
When answering the first two questions, the buyer must look at the broader market. Many investors feel like anytime additional living area can be added, it will guaranty a return, but this is not always the case. In a community of 3/1 or 3/2 homes, is it really necessary to have a 5 bedroom, 1 bath home? In that same community, would a second, or even third living area be well received? Probably not, especially if this means surrendering and thus losing the value of enclosed parking, or valuable storage in a neighborhood in which a primary occupant may be blue collar workers with trade tools to store. Often, the easiest way to determine market demand for this sort of “improvement” may be to simply stand in front of the home and note if any other homes in the area have similar conversions. If none are noted, then it is likely a good indication of a lack of market demand. Remember, every micro market is different.
Once you have determined market demand for a conversion, then you can evaluate its financial return in the market. Keeping in mind that you have lost parking and storage, you will be starting at a deficit. So any monetary return must exceed the financial loss from the parking before it makes sense. Whew! That can be a bit much to grasp, but this is exactly what an appraiser is going to do when evaluating a house like this. With that in mind, there are two basic types of conversions you will encounter: The Do It Yourselfer and the Professional Conversion.
Types of Conversions
The Do It Yourselfer is typically the most common one you will encounter. If the house you are evaluating has this type of conversion, it will more than likely not add any value and could very well reduce the value after considering the loss of parking. These conversions are notable from their step down and/or sloped floors, dis-functional access and oddly shaped or oversized rooms (a 20’ by 20’ room with few or no windows). These conversions typically have little or no wall and attic insulation and may have undersized cooling and heating systems, or even separate window units. The best approach when encountering this sort of conversion, in absence of consulting with an appraiser, is to attribute it zero value return, as any gain will likely be offset by the loss of parking.
On the other hand, I have seen some garage conversions that were so professionally done, you could not tell the house ever had a garage. If the conversion is professionally and correctly done, it will typically look seamless to the rest of the house with same level flooring (no slope and no step to get to the next room), a vent drop for a common HVAC with the appropriate amount of tonnage (i.e., no window unit supporting the space) and appropriate siding in place of the overhead garage door. It will also need to be free from any functional obsolescence, and of comparable finish out to the rest of the home. Most importantly, the new space will enhance the functionality and use of the home, relative to the neighborhood, and still remain within a reasonable size range. For example, a 2/1 home in a neighborhood that contains many, if not mostly, 3 bedroom 2 bath homes, would likely do well to have a garage conversion to transform the home into a functional, seamless, 3/2 design. Particularly if the existing garage is a smallish sized, single car garage, which would not likely be utilized for parking modern sized cars. Another thing to note here is whether the conversion was properly permitted by the city. In some cases, certain conventional lenders will not allow the appraiser to count the additional square footage if it was not properly permitted.
Determining Value
When evaluating a house with a garage conversion, we typically see the following investor approach. The investor will add the square footage of the conversion to the overall livable square footage of the house, and then look at price per square foot of sold properties (many times using comps without garage conversions) to determine the value of the subject property. This approach is what gets investors into trouble….
Let’s consider the following as an example. You have a house in a given area that has 3 bedrooms, 2 baths, with 1400 square feet, and a 400 square foot garage. The garage gets converted to a living room. You add that square footage to the overall number making it 1800 square feet. However, the homes in the area naturally range from 1100 square feet to 1500 square feet with similar bed/bath count and 2 car garages. The homes in the area sell for $100 per square foot putting the top value at $150,000 of any sold comp. You take the $100 per square foot and multiply that times 1800, giving the subject property a value of $180,000 or 20% higher than the highest comp. Do you think you calculated the correct market value?
What you must do is ask yourself the following question: if you were an owner occupant buyer, would you pay 20% more for a house in a given area to get 400 square feet more living space and not have a functional garage? The answer to that is probably not. In fact, the property will more than likely not appraise for a value this high for the same reason. What many investors forget to do is put themselves in the position of an occupant buyer when evaluating a property’s value.
Here is the correct approach to evaluating a property with a converted garage. If there are supporting comps with converted garages, use as many of those as you can to evaluate the subject property. However, if you cannot find any supporting comps, then you have to back out the garage (by subtracting the additional square footage), and evaluate the property with the comps available to determine the value.
Why do we have to do this? First, the square footage of a garage is not included in the overall square footage of the house, as it’s not considered livable space. Second, a conversion, even if professionally and correctly done, could add square footage to a house making it larger than any of the area comps without conversions potentially forcing larger adjustments to be made to determine the value. When evaluating a property with a garage conversion, 3 results can occur: the value of the subject will increase, remain the same, or decrease in value. It’s based on what the market is telling you in that area. This can also change as market conditions change.
In some cases, not having a garage (even with a nice conversion) can actually lower the value of the property. We have seen this many times and it bothers investors because they cannot understand why that additional square footage does not help. You have to put yourself in the shoes of an occupant buyer. An occupant buyer (especially true in properties with higher values) most likely wants a garage to park their cars and store things. If that’s not available, they will find another house that offers this. Of course, this is not always the case, as there are no absolutes in real estate. However, you don’t have to guess at whether this is the case or not, as the appropriate comps are the evidence that will support the correct value. Use those comps and you should be able to determine the market value of a house with a converted garage.
Mike Hanna is a real estate investor, mentor, author, and public speaker. He has been an active real estate investor since 2002 in both single family and multi-family properties, and has been in the hard money business since 2005.