BiggerPockets

IMHO, this is impossible to evaluate with any accuracy. You have to make some guesses about future appreciation and inflation and its effects on both rents and expenses.

The most accurate guess, again this is just my opinion, is that inflation, appreciation, rents and expenses all track in lock step. The long term, inflation adjusted Case-Shiller home price data shows that, after adjusting for inflation, home prices have been flat since the late 1800's. That's 1800's, not 1900's.

That neglects a few big changes - WWI, the changes in lending practices post WWII, and the recent bubble. Those are "black swan" events and are unpredictable.

http://www.ritholtz.com/blog/wp-content/uploads/2011/04/2011-Case-SHiller-updated.png

Other than those events, there were small ups and downs, but the overall trend is clear: inflation drives price appreciation.

Now, that neglects local effects, which can be huge. A major loss or gain of jobs and population can certainly affect prices.

The lesson I take from this is if you want cash flow in the future you better have it right now.

OTOH, if you get appreciation, you can turn that into cash flow. You can sell, which generates a wad of cash or you can refinance, which also generates a wad of cash.

My advice is to use just one or two input parameters for these future predictions. I'd use a single inflation rate parameter to drive rents, expenses (read about the 50% rule to estimate expenses from rents) and values. Then, if you want to account for excess appreciation (above inflation) and a second parameter for that.

Mostly what I'm saying is that its hard to predict the future. When you make guesses about the future, you can fool yourself about a deal by making minor changes in your guesses. Its much easier to understand the situation as it is right now.

In theory, rents should rise over time, expenses should rise and values should rise. Meanwhile, your payment (assuming fixed rate long term financing) stays the same. So, your cash flow improves. In reality who knows what will happen.

I wouldn't discount appreciation completely. I do not think we will ever again in our lifetimes see the kind of appreciation we saw during the bubble. But a few percent per year is certainly possible. I'm just not convinced we're at the bottom, yet. Macroeconomic events will affect us, and we have no control over those. Another 10% decline will take several years of 3% appreciation to make up. If I were to guess about the value of a property five years from now, I'd guess the same value as today. For 30 years out, though, I wouldn't even hazard a guess.

Whether or not equity is significant to you depends on your strategy. If your play is to buy and hold forever (leaving the properties to your heirs) and you want cash flow, then equity doesn't really matter. You're not going to get that cash. If your strategy is to hold for a while then sell, then equity does matter. Or, if you're planning to refi at some point and take some cash, then equity does matter.

In commercial deals, a "total return" calculation is often done that accounts for principal paydown. Problem is you can't eat equity. Whether you sell or refinance its expensive to turn equity into usable cash.

Ryan,

Expect no appreciation and you'll always be in good shape.

This means you make your profit when you buy. Poor cash flow in a good location, but underperforming, will serve your long term goals because you will increase the income and value with carefully selected renovations and aggressive management.

Good luck!

I recommend you use the spreadsheet we have developed on BP:

Pro Forma Template

or use a simple one you develop. Garbage in equals garbage out though so you need to be CONSERVATIVE.

Rent and expense escalators of 1-2% are fine. I think using zero discounts the value of the inflation hedge that is implicit to buying and holding long-term. That PI portion of your payment is FIXED until you pay them off.

I would also assume conservative things to arrive at your NOI. A 50% rule of thumb may or may not be suitable for older buildings that have better "cash flow" or current yield. You also need to factor in more capex set asides for older buildings.

You can get carried away with all of this though. Trust your instincts as the tie breaker and use conservative modeling assumptions for the raw numbers. It is better to be approximately right than precisely wrong.