Renovations don’t always pay dividends

Should you invest money in your home if housing prices in your area are flat or declining? When home prices are escalating, adding more money to an asset that's increasing rapidly in value is a no-brainer. But given current market conditions, it's more important to consider the financial ramification of a renovation before giving your contractor the green light.

First, find out how much the anticipated project will cost. Then add 10 to 20 percent for cost overruns. Next, figure out how much your home would be worth after you complete the improvements.

The market value of renovations varies from one area to the next. According to Remodeling magazine's Cost Versus Value Index for 2006, a mid-range basement renovation -- in terms of cost and finishes -- returned on average about 80 percent of the cost when the home was sold.

For comparison, the basement renovation used in the Remodeling report consisted of a 20-by-30-foot entertainment room with a wet bar and bath. To determine the return on investment, Remodeling, in conjunction with the National Association of Realtors, relied on data compiled from a survey of Realtors.

Even though the national average return on the basement renovations was only 80 percent, a comparable job in San Francisco returned 112.7 percent. Consult with a Realtor to determine how much the improvement you are considering will increase market value of your home.

Investment potential is just one variable to consider when weighing whether to improve your home and how much to spend. Generally, the longer you plan to stay in your home, the more it makes sense to make improvements. However, keep in mind a basic rule of real estate investing is to avoid overimproving for the neighborhood.

HOMEOWNER TIP: To get the most out of a renovation, make sure work is done with building permits. Sellers and contractors often proceed with renovations without taking out permits, either to save time or money. This might not matter to you if the work is done in accordance with building-code requirements, but it could come back to bite you when you sell.

Appraisal standards have tightened recently along with credit standards. Today, an appraiser might not count a basement conversion as livable square feet unless the homeowner could show that the work was done with a permit. This could result in an appraisal for lower than the buyer agreed to pay if you represented that the den added value as livable square feet.

When the market is racing upwards, a low appraisal won't necessarily cause a deal to fall apart. But, in today's environment, an appraisal for less than the purchase price could cause a buyer to renegotiate the price.

It's quite common to find basements that were finished without permits. Sellers should take care how they market such improvements to prospective buyers. In California, state law requires sellers to disclose if work was done without permit. Misrepresenting livable square feet can have legal consequences. Rather than take that risk, make sure buyers know exactly what they are buying.

THE CLOSING: It's prudent to be forthright when describing the livable square feet of your home. Sellers have ended up in court over disputes about square footage.

Dian Hymer is author of "House Hunting, The Take-Along Workbook for Home Buyers," published by Chronicle Books.