When it comes to real estate investing, there are generally two schools of thought. Some people look to invest for cash flow, or the excess profit available after all operating and other expenses have been paid. Others look at real estate with an eye for appreciation, or the gradual increase in property value.
Typically, investors will look for some combination of both: properties that cash flow well and have appreciation potential.
In this article, we example how to recognize real estate appreciation opportunities.
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What is Real Estate Appreciation?
In short, the term “real estate appreciation” refers to the increase in a property’s value over time. At a macro level, appreciation may result from inflation, strong labor markets, a supply/demand imbalance, or other factors driving local market growth.
There are micro-level factors that can also influence property value. For example, adding a new exit or on-ramp to a highway may instantaneously make the adjacent properties more valuable.
There are property-level considerations, as well. For instance, upgrading a property will almost certainly increase its value.
Forced vs. Market Appreciation
Appreciation can take two forms. It can be either “forced” or driven by the market. Let’s explore the differences between the two.
Most people assume that appreciation is out of their control. That couldn’t be farther from the truth. In fact, owners have tremendous control over the value of their property. They can make strategic investments that result in “forced appreciation”. Forced appreciation is where, through your own efforts, you force the property to increase.
Let’s say you own two apartment buildings on the same street, located right next to each other. Let’s assume that they are, for all intent and purposes, identical. They were built the same year, have the same number of units, and have the same interior layouts and amenities. They are essentially carbon copies of one another.
Yet one of these buildings (Property A) is worth $1 million and the other (Property B) is worth $1.5 million.
How can that be?
In commercial real estate, values are often calculated based upon how much income they produce. In this case, Property B is simply generating more revenue than Property A. This could be for a number of reasons, such as higher occupancy or more robust rent collections. In any event, in order to make Property A appreciate $500,000 in value, the owner will need to increase the property’s cash flow. Period.
Of course, there are many ways to increase cash flow. At a multifamily property, the owner may reconfigure units to increase the bedroom count (e.g., making a 1-bedroom unit a 2-bed). They might repurpose underutilized basement space as storage lockers that can be rented out, or de-couple the parking spaces from the units and then rent each parking space individually (for a premium).
Owners can also increase cash flow by lowering their expenses. Strategies could include reconditioning vendor contracts, improving rent collection processes, and/or making building upgrades that lower utility costs.
Forced appreciation is most often realized by investors using value-add investment strategies. In a value-add business plan, you might expect the following:
- If the market is flat, the value of the building still increases with property improvements.
- If the market goes up, the value of the building, post-stabilization, increases even more.
- If the market goes down, then the building may not appreciate as much as in the other two scenarios, but the value still would not go down.For these reasons, many real estate experts consider forced appreciation the “holy grail” of real estate investing because it puts property value largely in their control.
Market appreciation, sometimes referred to as “natural appreciation,” is when a property gradually increases in value without anything changing at the property-level (i.e., without doing property improvements).
On average, real estate is said to appreciate by around 2-3% annually, but this can certainly vary from year to year and market to market.
After all, the market is unpredictable. It can go up just as quickly as it can come down. We saw that during the Great Recession and during the early days of the pandemic.
Market appreciation is generally driven by sales comps. Both properties for sale and for rent can impact the prices of the properties around them. Inventory, or lack thereof, can also impact market appreciation. When there’s a significant supply/demand imbalance, this can cause market values to dramatically rise or fall. An influx of new construction, for example, might cause the values of existing properties to fall.
There are other factors that can impact market appreciation. Market-driven forces include job growth, demographic changes, and migration. For example, an area with a robust economy might draw more skilled workers, which could, in turn, drive property values upward.
Market appreciation, unlike forced appreciation, is largely out of the control of an owner’s hands.
How to Recognize Real Estate Appreciation Opportunities
- Research the neighborhood.
Too often, investors look at markets generally. For example, they might believe there are real estate appreciation opportunities in Greater Indianapolis, or Northern Indianapolis. But you need to dig deeper and look at property metrics at the neighborhood level—even the street level—as properties are often part of a microcosm that performs differently from the properties just a few streets over.
Specifically, look for comps within this neighborhood (or on this street, if available). What have recent buildings sold for? What are market rents? Look at the condition of the property, what it might be worth, and how much work it might need to bring it in line with market averages?
All of this is important as it pertains to financing: you may be able to “score” a deal on a property, but if it needs significant work, it may not appraise for what you need to secure a traditional bank loan.
- Assess the cost/benefit of value-add opportunities.
Related to the above, you’ll want to pay close attention to what value-add strategies could be used to increase the value of a property. Then, calculate whether the cost of those improvements will generate enough return to warrant the investment. For example, if three bedrooms is standard for a particular submarket and you renovate to add a fourth, will the improvement be cost-neutral or will there truly be added benefit? Be sure you understand why you’re making certain improvements. This is another area that requires significant research.
Moreover, if you over-improve a property, there may not be comps for prospective buyers to use. This could ultimately hinder your property’s value and limit your pool of prospective buyers. You should always make decisions with your exit strategy and timeline in mind.
- Recognize opportunities for “delayed” forced appreciation.
In some situations, there may be an opportunity to force appreciation—just not quite yet. For example, if you buy a property in an up-and-coming area, you may not be able to increase rents to the extent you need to warrant the improvements. Instead, you might make more modest (e.g., new paint and carpet) investments in the short term and then plan to mobilize for more substantial value-add improvements two, three, or even five years down the road as the area gentrifies.
In fact, in areas that are gentrifying, you may be able to realize both forced and market appreciation over time. These opportunities can be great for those willing to make long-term investments.
- Understand where we are in the market cycle.
Real estate follows a cyclical pattern, which means that the value of properties in an area tend to ebb and flow over time. A typical real estate cycle lasts for +/- 10 years. In order to recognize real estate appreciation opportunities, you should always be aware of where we are in the cycle and anticipate what’s still to come.
Generally, when prices and activity are low, it signals a great buying opportunity – allowing investors to get a good return on investment when the market turns around. By monitoring economic indicators and keeping up with trends in your local housing industry, you can make more informed predictions that will allow you to spot key investment opportunities.
- Investigate government zoning policies and infrastructure plans.
When assessing a potential real estate appreciation opportunity, it’s important to also research upcoming zoning and infrastructure plans related to the property. Government zoning policies may change in the future, affecting how you can use the property or what areas of it you can develop or renovate.
Investigating local infrastructure projects that are planned or underway in an area can also provide insight into an area’s potential for appreciation. If a government plans to expand light rail service to a neighborhood, for instance, it could make properties ripe for transit-oriented redevelopment.
- Leverage soft costs to help drive appreciation opportunities and returns.
Soft costs like promotional expenses, leasing commissions, and insurance are all essential factors to consider when leveraging real estate appreciation opportunities. Investing in marketing and promotional efforts can help you attract increasingly higher rental amounts while ensuring the property is in good condition over time. Moreover, running a well-maintained property can significantly reduce insurance costs in addition to providing peace of mind for tenants. Understanding how soft costs will affect the potential return on investment of your property is key to determining its overall profitability.
Consider the potential tax implications. Real estate is a highly tax advantaged industry. Investors can often take what’s known as “accelerated” or “bonus” depreciation, which can translate into tens of thousands of dollars in tax savings in the first year or two after a property is placed in service.
So, what does this have to do with real estate appreciation?
When considering various investment alternatives, there may be situations in which you purchase a property that does not cash flow well but where you suspect there’s opportunity for appreciation (either forced or market). Let’s say you buy a property for $300,000 that needs $80,000 worth of improvements. Given your tax bracket, bonus depreciation saves you $50,000 in taxes. The IRS is essentially funding more than half of your value-add business plan, which will ultimately result in forced appreciation.
Let’s say you don’t make any improvements to the property today. Instead, you plan to buy and hold the property for three years given your expectations about market appreciation. That $50,000 in tax savings might be more valuable to you than any negligible cash flow, making the property still a worthwhile investment given the market appreciation potential.
Recognizing real estate appreciation opportunities is not easy. It requires you to sharpen your pencils and analyze data carefully. When underwriting these deals, you’ll inherently be making some assumptions (e.g., future rents and sales price). However, the accuracy of these assumptions will ultimately influence just how much a property appreciates over time.