As the tides have been shifting in the real estate industry, one particular question has sparked debate among investors regarding the success of deals that went full cycle in the last few years. It relates to whether or not these deals were so successful as a result of the operator’s skills and performance, or if the strength of the market and external forces are responsible. This conversation hits on one of the key factors that every investor accounts for in their underwriting decisions - appreciation.
Appreciation is the increase of a real estate property over time. There are two distinct types of appreciation, and we’ll be comparing them throughout this article. There is forced appreciation, and natural appreciation.
So how are these types of appreciation similar, and how are they different? What are the benefits and risks of each one?
Keep reading to find out.
We Appreciate Appreciation
Appreciation is the increase in value of a property overtime. Market appreciation is one way this occurs, and forced appreciation is another way. Appreciation is a good thing for investors, because it allows them to make a higher return on their investment. Almost every real estate investor aims to make a return, and appreciation is usually the main way they plan to do this. The only question is, how is the property going to go up in value?
Riding The Market Wave
Natural appreciation, aka market appreciation, “occurs when the overall market goes up.” This means that property values in a particular market are increasing due to external reasons outside of anything the investor does (aside from choosing a good market). Natural appreciation in multifamily real estate is seen when rental rates and occupancy rates increase across a market. As these increase, so does the value of the property. Remember: multifamily real estate is valued based on its net operating income. If a property is generating more income due to higher rent collections, then its NOI increases, which pushes its value higher.
Market appreciation can occur from a variety of factors outside of the investor’s control. For example, an increasing population can lead to higher demand for multifamily units, which will allow the investor to increase rents. If a large business moves to a market, and it experiences an influx of jobs, this can also drive up multifamily demand, resulting in higher rents and thus, higher NOI. A third factor can be a lack of houses, and the rising cost of buying a home. This makes renting a more attractive option.
Warning: The Tide Eventually Goes Out
The problem with banking on natural appreciation is that as an investor, “you have almost no control over it.”
I’m reminded of Warren Buffet’s saying, “A rising tide floats all boats….. only when the tide goes out do you discover who's been swimming naked."
This quote is extremely relevant today. Many investors who were relying on naturally increasing rental rates and high occupancy rates in order to meet their projected returns are experiencing struggles now that rental rates are stabilizing in some markets, and occupancy rates are faltering as well.
No market is invulnerable to volatility and economic conditions. In the event of an economic downturn, a market can experience a decline in property values, and/or falling rental rates. An investor that is relying on natural appreciation can experience slower returns on their investment, and be unable to pivot or mitigate the impacts of these economic forces. Other factors like government regulations or a change in neighborhood demographic can also severely hinder the performance of a property. Without any “levers” to pull in order to preserve and have control over the value of a property, an investor is at the mercy of the market winds. And this is a position of vulnerability that might seem great while the tide comes in and the waters are high, but is painful if and when the tide goes out and investors are left exposed.
Control Is King
Forced appreciation allows an investor to make deliberate decisions to improve a property and increase its value. This process starts at the beginning, when the investor acquires the property. These investors employ what is often called a “value-add” strategy, where they find a property that has the potential for improvement through renovations, improved operational efficiency, rental rate increases, and more. Improving the condition of the property allows the investor to essentially create equity, because they can charge more in rent, which increases the NOI, and increases the market value as a result.
As mentioned earlier, forced appreciation is powerful because it puts control in the hands of the investor, and not in the hands of the unpredictable market. By utilizing knowledge and experience, investors can strategically purchase undervalued assets and increase their value through strategic improvements. This strategy offers a more reliable and potentially faster path to property appreciation than market appreciation.
Forced appreciation comes in many shapes and sizes. For example, adding amenities to a multifamily complex can increase NOI of the property and thus, the value of the property. Updating the interiors of the units is another popular method. Renters are willing to pay more in rent for a nicer unit. Many investors will also create additional revenue streams, such as implementing a pet fee. It’s evident that forced appreciation is a creative approach to increasing the value of a property!
Appreciation is a critical element every investor must consider before doing a deal. As explained above, natural appreciation relies on market forces and slow growth over time, while forced appreciation allows an investor to actively increase the value of a property through improved operations and physical enhancements. Both are useful for an investor, but understanding their differences is key to maximizing the profit potential of a deal and mitigating risk.