A famous idiom goes “If it isn’t broke, don’t fix it”. To apply this to real estate, if you have a tenant who is paying rent, then the property is just fine and does not require you to have someone refurbish it. However, if the real estate is vacant, or the only way you have been able to find a tenant is by lowering the rent below market rate, then it might be time to consider refurbishment to increase the marketability of the property.
There are two types of refurbishment: “reform” (リフォーム, rifo-mu) and “renovation.” “Reform,” when referring to real estate, is a Wasei English word (i.e. made in Japan, not readily understood in the Anglosphere). It means doing superficial things: replacing the wallpaper, changing the flooring, and making small changes to the bathroom, kitchen, etc. “Renovation” is the second type of refurbishment; it goes deeper and might involve installing new walls, changing the layout, etc.
It often makes financial sense to “reform” the property to make it presentable, to aid in finding a new tenant. “Renovation” should be approached with more caution. There are situations you should consider renovation, but only if it increases the return on investment. It is also not advisable to buy a “fixer upper,” renovate, and flip it by selling it to a new buyer; you should instead focus on refurbishing to improve rental income.
When A Tenant Moves Out – Do I Refurbish?
Most tenants generate some kind of smell as they live in their apartments, houses, etc. Whether the tenant repeatedly cooks a certain type of food, has a unique odor for whatever reason, smokes, has pets etc. various smells will probably seep into the wallpaper over time. Perhaps the tenant’s cat has scratched the wallpaper with its claws. The wallpaper or carpet may end up stained/worn, as well. To assist in finding a new tenant, it is prudent to have these replaced.
If you are aiming to be the world’s nicest landlord, you could pay for new wallpaper, flooring, minor repairs, etc. yourself. However, remember, when your tenant first signed the contract, he or she paid a deposit in the form of hoshōkin, shikikin, or both. It is generally understood between tenant and landlord that some of this will go towards cleaning/minor refurbishment fees, especially if the condition of the wallpaper or flooring degraded during the tenancy, or something was broken. This is expected and the tenant will probably not contest it. You can use part of the hoshōkin and/or shikikin, then return the balance. Your real estate agent will likely coordinate the repair purchase and deal with the refunding of the left-over deposit money to the old tenant.
Dealing With Prolonged Property Vacancy
“If no fish are biting, there is probably a problem with the bait.” Well, assuming you are not trying to fish in an area with no fish in it. Tokyo, especially the 23 Special Wards, is the real estate equivalent to a well-stocked lake; there should be regular bites in the form of interested prospective tenants, even those who are willing to pay key money just for the privilege of paying you rent. The same goes for many other megalopolises in Japan. If there are few bites, consider renovating it to make it more appealing because the lack of interest is indicative that the property compares poorly to other available options on the market.
Large Scale Property
Renovation In Japan
Dai-kibo-shūzen (大規模修繕) means “large-scale repairs.” These are recommended every 12 years. You do not necessarily have to make them every 12 years, but you should plan and budget as if you would. Do not make them unless they will increase the ROI of your property, and certainly do not make them if it will make an otherwise profitable investment an unprofitable one. Remember, the point of real estate investing is to make money, not to spend it (though the local remodeling company would really appreciate it).
Dai-kibo-shūzen covers things such as repairs to the building’s exterior, waterproofing, plumbing, etc. As with other major forms of refurbishment, permission from the condo management company might be required if you are not the owner of the building itself. If you just own one apartment in an apartment building it is likely that these large scale repairs will be suggested, coordinated and completed by the building’s management association with no required input from yourself. The cost of the work will be met by the building’s repair fund.
The majority of dai-kibo-shūzen cost ¥750,000-¥10,000,000. Typically, ~12 years after the unit was built, there will be a first round; that costs, on average ¥1,000,000. The second round, ~12 years later, costs ¥979,000 on average, and then, ~12 years after that, the next round costs ~¥809,000. I.e. it is a significant cost, but the good news is that this cost is infrequent and generally goes down each iteration.
The Real Benefits Of Renovation
Obviously if you can tenant an untenanted unit by refurbishing it, or if you are able to increase the rent on an old property by making it look nicer, then that is good and you should do it. What is less well-known is that refurbishments are tax-deductible. Remember that investment real estate is classified as “income” (給与, kyūyo) on the “Blue Tax Form” (青色申告, Ao Iro Shinkoku) at the tax office; not only do rental income and deductions such as refurbishments fall under that category on the tax form, the income from your day job does, as well. Imagine the following scenario:
“Robert” is making ¥10,000,000 per year at his job in Tokyo and ¥5,000,000 from his real estate.
With an “income” of ¥15,000,000, this places him firmly in the 33% tax bracket.
One day, Robert decides to refurbish a unit. Perhaps the tenant just moved out, and Robert thinks refurbishing it would make it easier to find replacement renters faster, or even increase the amount of rent he could charge. Therefore, he spends ¥2,000,000 to refurbish it.
Of course, in the future (perhaps over a period of many years), all of that ¥2,000,000 will return, but in the short term, Robert is out ¥2,000,000, right? Wrong. Because he is in the 33% tax bracket, he can deduct these reforms, renovations, etc. and lower his taxes:
-¥2,000,000 (costs to refurbish) × 33% income tax = -¥660,000 (income tax paid that year)
Therefore, the real cost to Robert is only ¥1,340,000. He then finds a new tenant immediately (versus waiting a long time), and can charge considerably higher rent. The result is that in a few years, the refurbishment has paid for itself, and a few years later, Robert has made a million or so yen more than he otherwise would have had he not reformed/renovated; this is a major improvement in his ROI.
The Bottom Line
A necessary part of property investment is to refurbish, and Japan is no different. Prudent management involves maintenance, and this management is sometimes expensive in the short term, but will pay for itself and then some with a great ROI in the long-term. All expenses are tax-deductible under the “income” category of the Blue Tax Form. In the highest tax bracket, that means tax savings of 45%. In short, although it is not free to refurbish, is one of the most important tools to increase ROI and achieve your financial goals with real estate investment.
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