In real estate, the investor can realize market appreciation or forced appreciation. Here we will compare and contrast the two. Having a proper understanding of the two types of appreciation is important in formulating the optimal investment strategy for a given market/situation.
Market appreciation is pretty easy to grasp as it is present in many other assets. It is simply dictated by the supply and demand of the market. When something is in high demand, the price increases, and vice versa. When a person buys a baseball card or a piece of art and it becomes more sought after, appreciation results. This can be true in real estate as well. Historically, real estate value has increased about 3-4% annually, with some outliers in the mix. Some areas in the San Francisco Bay area have experienced as high as 12% annual appreciation for a period of time. The stock market on the other hand, has enjoyed appreciation of about 9-10% over the years, which is fantastic. Before we conclude that stocks are much better, we need to consider the details. When a person buys $100,000 worth of stocks, he must pay the full amount. If the $100,000 worth of stocks appreciate to $110,000, he has $10,000 in appreciation. In real estate, we can leverage our money and buy a $500,000 asset with $100,000 down payment. If we assume 3% appreciation, it is applied to the $500,000, which ends up being $15,000. Since we only invested $100,000 out of pocket for this asset, we realized 15% appreciation on the deployed capital!
We can compare this to forced appreciation, which results from the investor forcing the appreciation of the asset by improving its financial performance. To understand forced appreciation better, let’s discuss valuation. For residential properties, how much a similar home sold for in the vicinity determines its own value. Commercial properties are valued on the income it generates rather than the market comparison. This enables the competent investor to acquire an underperforming asset, improve the financials, and sell it for a profit. Because the valuation is a standardized formula based on the NOI(net operating income, which is rents – expenses) the investor can have a more accurate estimate of what the property will be worth as a result of forced appreciation. The investor is only limited by her imagination for improving the financial performance of an asset. Some properties are renting for under market due to lazy property management, and the investor can simply increase them to the market rate. Other times the units are outdated and the investor can renovate the units to command higher rents. From laundry, assigned parking, pet fees, storage, and utility billback, the list goes on for ways to increase the NOI. There are also opportunities to optimize operational costs. Hiring a better property management, replacing older equipment with energy efficient products, and looking for better ways to retain tenants can all add to the bottom line.
Increasing the financial performance is a like having the cake and the icing on top. It’s easy to see that increasing the income means higher cashflow for the investor. But that’s only the tip of the iceberg. The real treat is the forced appreciation that results from the increased income. To see how this works in real life, let’s assign some numbers. Let’s say that for a given market, the going cap rate is 7%. Cap rate is capitalization rate and it’s the NOI divided by the price of the asset. For example, if the NOI of an apartment building is $70,000 annually, and it sells for $1,000,000, then it is $70,000/$1,000,000 = .07 = 7% cap rate. A market at any given time has an accepted cap rate for valuing properties. For the example below, we will assume that the market cap rate is 7%. The asset is a $1,000,000, 25 unit apartments with $70,000 NOI. The savvy investor increases the rent by $100/unit. The $100 increase/unit is $2500/month for 25 unit and $30,000 per year. The NOI goes from $70,000 to $100,000. Divide this by the market cap rate of 7% and we get the new valuation. $100,000/.07 = $1,428,571! It’s easy to see that a seemingly small increase in rents can have huge effect on the asset valuation. This is what makes forced appreciation exciting.
In practice, there are pros and cons to each approach, and a property doesn’t have to be either/or; it can enjoy both market AND forced appreciation! Market appreciation is generally easier from the execution perspective, but the results are at the mercy of the market cycle and the accuracy of the investor’s speculation. A longer investment horizon is often appropriate to fully capitalize on the market appreciation, and also to ride out the market cycles. Over the long term, most assets in good markets will appreciate, but if we entered the market at the wrong part of the cycle, it may take years or even decades to come back out on top. If one were to invest in highest appreciation markets like the San Francisco Bay area(10-12%), often the assets are over-priced where the property won’t cash flow after leveraging. What one can do is leverage less by putting a lot more down (50%+) or buy it in cash. This decreases the power of leverage discussed earlier, but if the assets are appreciating at an aggressive pace, one may consider it. A more dangerous approach is to sustain zero or negative cashflow under the assumption of future increased value. In this case, what we have is an alligator – it takes money from us. This maneuver is highly speculative and can be quite risky, especially when the market does not behave like we expect it to. To sum it up, a lot more capital is required, the power of leverage is reduced/eliminated, and a longer horizon is appropriate for this approach. Also, can be more volatile and dependent on the investor’s speculation and the market cycle.
On the other side of the spectrum is the value-add strategy in the Midwest where an investor buys an underperforming asset to improve the NOI. These assets will usually cashflow after getting a loan, so even though the market appreciation is lower, it can be amplified through leverage. And by improving the financial performance, the investor can increase the cashflow and subsequently increase the value of the asset through forced appreciation. Forced appreciation can be quite substantial as seen from the example above. It can also be executed in a shorter timeframe, sometimes 12-24 months. It can be argued that the future value of the asset is more in control of the investor and predictable than the market appreciation strategy. It takes much more work, but the value add takes out a lot of the speculation and the dependence on the market cycle. The success of the project lies in the proper execution of the investor, and large gains can be realized in a shorter investment horizon.
There is no one way that is inherently superior as each approach has pros and cons. Different markets dictate what is the optimal strategy, as does the investor’s financial situation and goals. It is not necessary to take only one strategy or another; one can take a hybrid approach depending on the project. It is important for the investor to take inventory of their style, goals, financial situation, and the market to determine the optimal strategy.
By: Ki Lee