How Forced Appreciation Works

Question

Let's say you buy
were to buy a property for $1,000,000 at a 5% cap rate which happens to be the
market cap rate as well. Through $200k of renovations and improvements, you are
able to increase rent resulting in the NOI to increase to $78k. That makes your
stabilized yield (the total cost of $1,200,000 divided by the new NOI of $78k)
= 6.5%. You've now forced 150 basis points of appreciation, which you can now
regain on the sale. If you were to sell at the market cap rate of 5%, assuming
the market hasn't changed, the value would be $1,560,000 = a $360,000 profit.
Essentially the value-add "forces" appreciation, allowing you to beat
the market cap rate and sell for a profit.

Michael Vazza · Answer

Hi @joe! yes - the
numbers input were arbitrary and this was posted to be simply conceptual in
nature. You can adjust the numbers to a market cap
of 7% or really anything you'd like and the example of forced appreciation remains the same.

But with your post,
the %'s definitely matter. At the end of the day, the market cap is the market
cap because that is where current transactions are taking place within the
market. If buyers were not willing to pay that price or cap rate for an asset, then the
prices would drop and the market cap would expand. In this example, I used
a stable market between the purchase and sale for simplicity.

In a market like Boston, you really should not be expecting to cash-flow immediately, at
least not substantially within the first few years until market rents increase over time, for immediate large cash flow to be the primary goal and purpose of buying an investment in this
market.

Scott Mac · Answer

Watch your time schedule from initial numbers through fix up and rent raises (which do not happen overnight) through listing for sale time and time to close and liquidate.

You are probably talking a few years, and in some areas right now prices seem to be heading down, meaning possible additional hold and operate time.

Good Luck!

Joe Villeneuve · Answer

Since you used the metric CAP rate, I'm assuming this is a commercial property.  With that in mind, and throwing out misleading, useless percentages, and sticking with numbers that matter (the ones with $$$ in front), here's what I see...(a great deal, as a flip):

Gross Cost = $1.2MSold = $1.56MPotential Profit:  $360k

However, if this is to be a rental unit, regardless of it being Commercial or residential, after someone buys the property at $1.56M, with the increased mortgage pmt, does the property still (if it ever did) cash flow?  Remember, NOI doesn't include the mortgage pmt, so with such a low CAP Rate, I'm skeptical if it ever cash flowed to begin with.  If it doesn't cash flow, you are dramatically reducing the number of buyers that would be interested.  When you figure a 75% PP LTV for a mortgage, I calculate the CF being less than $2k per year, that's PER YEAR.

Pushing the CAP Rated value up is a great thing, but this is an example of percentages being misleading.  The CAP Rate jumped, but the property is only making the seller money...not the buyer.  If the end number with $$$$ in front says the property isn't buyable, it doesn't matter what the number with a %%%% behind it says.