Why is the "appreciation perpetuity" being ignored when valuing properties?

Buying & Selling Real Estate
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Why is the "appreciation perpetuity" being ignored when valuing properties?

Account Closed
Investor · Los Angeles, CA · Member since 2015 · 13 posts · 14 votes

An investor who invests in a property with an 8 cap return for a hypothetical amount of $1,000,000 will earn $80,000/year in cash flow. I

The 8% return provides the investor a strong return which is about equal to the 8.4% return for stocks between 1990 and 2008. However, the overlooked aspect of the investor's return is the appreciation of the property.  The property's value will likely increase at at least 5%/year over the long term. If the investor holds indefinitely, the property owner is basically receiving a perpetuity in the amount of $50,000/year. At a conservative 10% discount rate, this appreciation factor itself has a NPV of $500,000. That means the value of this investment is $1,500,000 whereas it's only being valued at $1,000,000 based on the cap rate (the cap rate seems to provide a sufficient return on its own that justifies the $1,000,000 investment value.)   Why would someone ever sell a property and give up the appreciation perpetuity that comes from "buying and holding" indefinitely?

The above analysis is an un-leveraged scenario which also doesn't even take into account tax benefits.

Am I missing something? This seems too good to be true and I can't understand why anyone would ever sell? Why isn't the appreciation factor taken into account when valuing real estate?

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Joe VilleneuvePro Member
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
11y

Answers in the form of questions:

1 - Have we experienced a time(s) recently when the assumed equity built up from appreciation wasn't there?

2 - What good is appreciation unless you can use it?

3 - How do you access the equity built by appreciation?

4a - How many pizzas deliveries have you paid for with the equity build up through appreciation?

4b - Have you ever been able to figure out (I haven't) which part of the house is equity (appreciated or paid off) so you can maybe use a brick or two to buy the pizza?

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  • Aaron Knoll
    Investor · Sandy, UT · Member since 2015 · 70 posts · 47 votes
    11y

    I'm still relatively new to this, but from what I understand the main reason you would sell a property is if you see a bigger and better one that will generate more cash flow, and you want to increase your leverage.

    Or, if you're pretty sure property values are about to take a dive (either in the short or long term), and know of a way to protect yourself. 

    But yes, otherwise I think it is hard to go wrong with buy and hold. 

    1Reply
  • Joe VilleneuvePro Member
    Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
    11y

    Answers in the form of questions:

    1 - Have we experienced a time(s) recently when the assumed equity built up from appreciation wasn't there?

    2 - What good is appreciation unless you can use it?

    3 - How do you access the equity built by appreciation?

    4a - How many pizzas deliveries have you paid for with the equity build up through appreciation?

    4b - Have you ever been able to figure out (I haven't) which part of the house is equity (appreciated or paid off) so you can maybe use a brick or two to buy the pizza?

    10Reply
  • Christopher Brainard
    Rental Property Investor · Rockwall, TX · Member since 2015 · 891 posts · 701 votes
    11y

    @Account Closed

    Hi Josh and welcome to BP.

    People sell for different reasons. Some retire, some don't enjoy the business. Some people realize that their investment is declining and want out. Some people just flip or wholesale and that's just what they do. Real Estate does take a lot of hard work to be successful and land lording can be particularly difficult due to crazy tenants. It isn't the guaranteed win that your post infers and some people aren't up for the challenge and want to take their cash and go. 

    Appreciation isn't taken into consideration for valuation because that is speculation on the future. Real Estate is highly localized and one block can do well while the adjacent one turns into the hood. It is also cyclical, so if you are overleveraged and the market takes a drastic turn for the worse, you can lose your shirt. It isn't the easy street guaranteed millionaire pitch that the gurus send your way.

    -Christopher

    1Reply
  • Account Closed
    Real Estate Agent · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes
    11y

    "The property's value will likely increase at at least 5%/year" @Account Closed point out we can't use for valuation

    2Reply
  • Derek Daun
    Investor · Sacramento, CA · Member since 2012 · 289 posts · 151 votes
    11y

    Besides all the personal reasons; I can think of two reasons to sell by the number.

    1) If your property appreciates every year, and if it's financed, your principle gets paid down, so that the amount 'invested' (the value of your asset) is higher each year. Depending on how fast your rents go up; your ROI might be going down every year. From that standpoint, you should sell; leverage your assets more, and get more appreciation, and more income.

    2) If you buy properties at a discount, then a lot of the money you make is made day one. From a year over year ROI based on value of the previous year's equity, your best year might be your first or second one, so why not try to have more years like that?

    I have extra rows on my spreadsheets to analyze this. (In addition to the typical ROIs calculated) For year over year ROI I look at the potential cash I could have if I sell one year (taking into account 7% for selling costs) as the investment. The net income, and appreciation of the next year make the return. I also calculate an 'average compound interest to return'. This represents the average year over year ROI that would equal the amount if I sold the property this year. This number trends down over time.

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  • Ryland Taniguchi
    San Francisco, CA · Member since 2015 · 786 posts · 717 votes
    11y

    There is a proper way to calculate appreciation in real estate for all deals regardless if land development, commercial, SFR rental, or flips. You need to calculate the Time Value Of Money to factor in Present Value and Future Value and the Weighted Average Cost of Capital. First, you calculate the cash-on-cash return using Pre-Tax Cash Flow (which includes the Annual Debt Service) and not the NOI. Second, figure out the appreciation returns based on the time value of money. Finally, combine the numbers using a T-table to calculate the Internal Rate of Return.

    All real estate calculations should factor in appreciation in the Internal Rate of Return (IRR).

    Send me message if you'd like the excel spreadsheet to calculate this. 

    2Reply
  • Account Closed
    OP
    Investor · Los Angeles, CA · Member since 2015 · 13 posts · 14 votes
    11y

    Thanks everyone for the responses, lots of great points. I'm from SoCal where there has historically been strong and consistent long-term appreciation, but I understand that this can't be taken for granted and relied on.

    0Reply
  • Anthony GaydenPro Member
    Rental Property Investor · Omaha, NE · Member since 2014 · 2k+ posts · 3k+ votes
    11y
    Originally posted by @Account Closed:

    An investor who invests in a property with an 8 cap return for a hypothetical amount of $1,000,000 will earn $80,000/year in cash flow. I

    The 8% return provides the investor a strong return which is about equal to the 8.4% return for stocks between 1990 and 2008. However, the overlooked aspect of the investor's return is the appreciation of the property.  The property's value will likely increase at at least 5%/year over the long term. If the investor holds indefinitely, the property owner is basically receiving a perpetuity in the amount of $50,000/year. At a conservative 10% discount rate, this appreciation factor itself has a NPV of $500,000. That means the value of this investment is $1,500,000 whereas it's only being valued at $1,000,000 based on the cap rate (the cap rate seems to provide a sufficient return on its own that justifies the $1,000,000 investment value.)   Why would someone ever sell a property and give up the appreciation perpetuity that comes from "buying and holding" indefinitely?

    The above analysis is an un-leveraged scenario which also doesn't even take into account tax benefits.

    Am I missing something? This seems too good to be true and I can't understand why anyone would ever sell? Why isn't the appreciation factor taken into account when valuing real estate?

    It is 100% dependent on the timeline, your place in the current investment cycle, and your exit strategy. When we are talking about long term, I assume we are talking at minimum 10 years, more likely 20 or more years. If your exit strategy has you selling your property in the middle of a downturn like the one from the last decade, you will not have experienced the gains that you expected.

    There are a thousand reasons to sell. One very good reason is that the rental income for a property does not provide enough to cover expenses. I see this a lot in single family homes.

    Next off, people die. When they die, the next generation may have no interest in maintaining property or becoming landlords. They may even be forced to sell the property to split amongst multiple heirs. 

    My personal reason to sell would be to invest in something more profitable. 

    Also there are people looking to cash out and retire. Some people reach a certain point and no longer need or want additional money/wealth.

    Podcast Guest on Show #21
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  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    11y

    Once you factor in inflation to your long-term returns, it is almost a wash. A nice round number to estimate inflation is 4%.  Some things (like technology) may have a negative inflation rate, where things like tuition and healthcare are closer to 8%/yr.  The time value of money as @Ryland Taniguchi refers to is exactly right.  The reduced purchasing power of future dollars keeps us from applying an infinite return to our investments and over-paying @Account Closed.  Lose that metric to survive in this business!

    2Reply
  • CK Hwang
    Capistrano Beach, CA · Member since 2013 · 283 posts · 169 votes
    11y

    I think one of the problem with the metric is that appreciation is assumed to be linear at say x% per year. From experience, I have not found this to be so, even in Socal. Not even in some of the hottest markets in the world, New York, Tokyo, London, Singapore, the prices have never appreciated in a linear fashion and even in these hot market there have been prolonged downturns affecting both appreciation and rents. 

    Instead, I find appreciation on individual properties i have invested in to take on a more S shaped curved with a flattish tail and top and dips etc. I think that is where the money is to be made, in the discrepancies of this price curve.

    Not to mention as your property ages, wear and tear increases in a non linear fashion, the cost to repair can really eat up the returns. I've sold some properties just because the cost of rehab would have killed the returns.

    As a side note though, I don't completely disregard appreciation if begin a rental. I've just learned not to use it as the primary motivation. 

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  • Bryan Hancock
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    11y

    Kudos to those that mentioned inflation.  While you may get 5% in nominal terms you'd be hard-pressed to get 5% in real terms unless you are in a great market.  The 5% you think you're getting is likely something you'll pay tax on inflation tax for:

    See Tax On Inflation Tax Here

    unless you exchange and defer the tax until your basis is stepped up at death.  

    You can refinance to access the equity without triggering a taxable event.  This, however, incurs transaction costs and increases risk with higher debt service.  

    One should factor in ALL areas of return when analyzing any long-term projects like apartments:

    1.  Cash flow

    2.  Appreciation

    3.  Tax shields (investor specific)

    4.  Amortization of the loan

    Item 2 can be modeled based on your intended time horizon as the reversion cash flow.  

    0Reply
  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    11y

    @Joe Villeneuve I have brought lots of pizza with the $350k heloc I took out from my appreciated property in SF. Easy peasy. That was 2 years ago. Now I'm refying it all for a low fixed rate, and just for kicks, will go after another heloc just to see what else is available. I'll use it as an opportunity fund, you know, in case real estate prices softens again. 

    To OP: search on BP forums "cash flow vs appreciation" for an earful on why appreciation matters. Hint: since you're in SoCal you're already sensitive to this. But in short, cash flow pays the bills, but appreciation makes your rich. 

    1Reply
  • Charles Worth
    Investor · New York City, NY · Member since 2015 · 808 posts · 417 votes
    11y

    @Amit M.

    You have obviously taken the conservative approach from your statement about prices softening but for an investor without your good timing, is that appreciation still as reliable and how long is that wait? 

    I don't have as much experience as others with RE but I can definitely tell you that statistically the track record of investors in being able to buy low and sit on their hands in boom times is abysmal in every asset market. Today's prince is tomorrows pauper. I know many who have lost millions playing that game and a "crisis" happens just when you can least afford it and not just in RE but in equities, commodities etc.

    @Account Closed

    In addition to what has been said already, sometimes there is not a great reason from your perspective but more of a personal one such as refocusing a business on another type of asset, putting money into an even higher returning investment(s) or just because you made so much money that you no longer want to worry about it. It would definitely seem attractive if I had $5MM+ in RE value to just sell and invest in NNN or lending.

    0Reply
  • David Krulac
    Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes
    11y

    @Account Closed

    There's 49 other states besides CA.  In some states the recession hit harder than in others, and in some states the recession is still going on.  It's a SEVEN year recession and counting.

    There was an article just this past week based on Census Data, that home ownership has reached a 50 year low.  No if appreciation is going great everywhere, you think home ownership might be higher than 1965?

    Believe it or no there are some areas where there is little to no appreciation.  typically these would be small town outside the commuter ring of a large city.  Or a town where the major industry is closed, think coal mines, factories and such.  In these town people still live but in some areas that I'm familiar with the population is the same as it was 50 years ago.  One older gentleman that I was talking to told me that he graduated from HS in 1965 and the number of seniors was the same as this year when his grandson graduated.  That means that's a town that has had no growth in 50 years and little appreciation too.

    One of the areas where I have bought, I sold a property in 2008, then sold the identical property next door in 2013 for 60% less.  no appreciation there unless you count negative appreciation or count backwards. 

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  • Joe VilleneuvePro Member
    Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
    11y
    Originally posted by @Amit M.:

    @Joe Villeneuve I have brought lots of pizza with the $350k heloc I took out from my appreciated property in SF. Easy peasy. That was 2 years ago. Now I'm refying it all for a low fixed rate, and just for kicks, will go after another heloc just to see what else is available. I'll use it as an opportunity fund, you know, in case real estate prices softens again. 

    To OP: search on BP forums "cash flow vs appreciation" for an earful on why appreciation matters. Hint: since you're in SoCal you're already sensitive to this. But in short, cash flow pays the bills, but appreciation makes your rich. 

    You missed the point. What I said regarding equity and pizza was based on not accessing the equity. Once you get a HELOC, or refi, etc...you no longer have equity...at least you lost the equity equal to the HELOC.

    Equity (profits) make you rich.  Cash flow makes you wealthy.  Wealth wins.  Rich has a shelf life.

    0Reply
  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
    11y
    Originally posted by @Derek Daun:

    Besides all the personal reasons; I can think of two reasons to sell by the number.

    1) If your property appreciates every year, and if it's financed, your principle gets paid down, so that the amount 'invested' (the value of your asset) is higher each year. Depending on how fast your rents go up; your ROI might be going down every year. From that standpoint, you should sell; leverage your assets more, and get more appreciation, and more income.

    NOOOOOOOOOOOOOOOOOOOO!

    Selling is killing the Golden Goose!  

    Dang, if this property appreciates another $100,000 this year I may be losing money!!! ;-)

    0Reply
  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
    11y

    Joe, this top picture was taken for you when I was dining with one of my BP buddies and we were discussing how we were spending our APPRECIATION.

    The second is how I spent some more appreciation although not on Pizza or breakfast since the Benedict was included in the flight.  

    Now like @Amit M. I am taking out over $300,000 in equity on the property I bought at almost the height of the market in 2008.  That's all APPRECIATION.  If I sold today I could keep the $300,000+ and all the money from my original purchase PLUS the 7 years of use.  Oh, and my tenants agreed to rent increases that will pay off the loan.  

    There was a beautiful oyster with roe pic but I can't find it.  PIZZA?  Abbondanza!

    0Reply
  • Gabe G.
    Greenwood, IN · Member since 2013 · 346 posts · 93 votes
    11y

    You can't count on appreciation. Dependent on your market.

    For example here in Indiana, I bought a SFH, that the guy owned for almost 20 years, he lost money on it when selling to me. But we are a cash flow market. That's why at least in our market you must be looking at cash flow and equity pay down, as the only things you can count on in the deal. If you get appreciation great. But here, don't count on it. Especially when buying 50-60k houses.

    California or New York are different stories. You have to model appreciation into the deal, because likely it doesn't cash flow, or is even negative cash flow.

    Market dependent. 

    2Reply
  • Aleksandar Popivoda
    Investor · NW Indiana · Member since 2015 · 98 posts · 99 votes
    11y

    @Account Closed

    Let's start from the beginning of your post. Can you please explain to me how did you come to conclusion that property with 8% CAP rate will yield 8% Cash-On-Cash annual return? That simply isn't true just by definition of these two terms.

    0Reply
  • Brent Seehusen
    Investor · Orange County, CA · Member since 2014 · 137 posts · 96 votes
    11y

    @Amit M. @Account Closed

    The problem with counting on appreciation and HELOC'ing your way to the moon is that sometimes the appreciation fairy decides to take her gains away for very long periods of time. Then what do you live on? (A new buyer isn't going to start with any cash flow.)

    See the multiple corrections that San Francisco has sustained since 1980?  The current boom market, while not quite as out-of-whack as the 2007 market, is still much more inflated than either the early 80's market or the early 90's market.  

    Amit purchased in '97 when RE was probably slightly undervalued, but advising people to buy today with expectations of the same appreciation you experienced is bad advice, IMO.

    I'm all in favor of buying for appreciation, but do it near the bottom of market cycles, not in the midst of a new bubble being rapidly inflated.  

    Even somebody buying early in the formation of the last bubble, in say 2003, had to wait 10 years to enjoy any lasting appreciation. The current market is already more overvalued than that, based on it's relation to the long term trend line. Buyers today could be waiting a long time to cash in that HELOC money.

    In the meantime, they will be waiting maybe 5 years before rent increases manifest into actual cash flow.  Then it will take another 5 years to break even on the initial negative cash flow they sustained.  How is that a good deal?

    0Reply
  • David Krulac
    Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes
    11y

    Here's your appreciation:

    Look at property recently built in 2005 TH sold for $173,590.

    Just resold July, 2015 for $82,000.

    Yes it wasn't quite as nice as it was brand new, but it was in good condition and needed cleaning and painting, they even left the stainless appliances.

    Almost a negative $100,000 in 10 years, where the appreciation there?

    0Reply
  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
    11y
    Originally posted by @Brent Seehusen:

    @Amit M. @Account Closed

    The problem with counting on appreciation and HELOC'ing your way to the moon is that sometimes the appreciation fairy decides to take her gains away for very long periods of time. Then what do you live on? (A new buyer isn't going to start with any cash flow.)

    See the multiple corrections that San Francisco has sustained since 1980?  The current boom market, while not quite as out-of-whack as the 2007 market, is still much more inflated than either the early 80's market or the early 90's market.  

    Amit purchased in '97 when RE was probably slightly undervalued, but advising people to buy today with expectations of the same appreciation you experienced is bad advice, IMO.

    I'm all in favor of buying for appreciation, but do it near the bottom of market cycles, not in the midst of a new bubble being rapidly inflated.  

    Even somebody buying early in the formation of the last bubble, in say 2003, had to wait 10 years to enjoy any lasting appreciation. The current market is already more overvalued than that, based on it's relation to the long term trend line. Buyers today could be waiting a long time to cash in that HELOC money.

    In the meantime, they will be waiting maybe 5 years before rent increases manifest into actual cash flow.  Then it will take another 5 years to break even on the initial negative cash flow they sustained.  How is that a good deal?

     Case Shiller sucks...  The S&P/Case-Shiller indices do not sample sale prices associated with new construction, condominiums, co-ops/apartments, multi-family dwellings, or other properties that cannot be identified as single-family.         

    Does any of that sound like SF?

    Don't get me started on on the SF MSA as per Case Shiller.  And remember their information is for the average gains of all people, not just investors.  I'm lazy and I beat their numbers and from @Amit M 's posts he is a harder and probably smarter investor so he is probably blowing my doors off! 

    There is no argument against buying at the bottom of the market.  There may be some argument as when that is though.  I still think there is about a 50% increase available in the current cycle.  + or - I'm not really in the market now.

    This is also a snowball type of investing.  You are not going to quit your day job right away but it has allowed me manage extended time off between jobs from almost the start.

    You are overstating time to cash flow and time to recoup.  Usually the lack of cash flow is negated by tax advantages and healthy rent increases will provide cash in just a few years.

    Appreciation usually happens in large spurts so that is when you grab your gold. Right now I am taking out over 3 years of planned appreciation harvesting ($100,000 annually). You're not going to be doing that in a low appreciation area. You'll be managing your CapEx expenses from swallowing your cash flow. I'm only taking out what my recent rent increases will cover. I actually have experienced more appreciation but my cash flow is already enough for my expenses. I'm just taking extra money out so my equity to value isn't so out of whack. Pretty good problem to have.

    1Reply
  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
    11y

    @Brent Seehusen

      I wonder what Case Shiller has to say about the supposedly HOT cash flow markets like Indianapolis, Memphis and Kansas City?  Plenty of single family homes in each of those towns and I'm told plenty of average investors.  Can you post that information for comparison?

    0Reply
  • Brent Seehusen
    Investor · Orange County, CA · Member since 2014 · 137 posts · 96 votes
    11y

    @Account Closed

    I have checked that.  Most markets outside of California haven't shown much cyclicality other than the recent subprime bubble, which likely was a one time event.  The best markets for playing the cycle are San Fran, LA, and San Diego, although we could probably throw in Riverside.  I don't know about Honolulu.  Maybe you could shed some light on that?

    I'm all in favor of buying for appreciation but I think the market dictates when your entry point should be.  If you buy near the bottom of the cycle, not only do you reap the most appreciation, but you also have a chance to be cash flow neutral or positive right off the bat.  If you buy after prices have gone up 50-75%, you take on more risk and reap less reward.

    I think it makes more sense to shift to cash flow markets at that point in the cycle and wait out the California market.  Or shift out of real estate altogether and focus on other asset classes if the opportunity is there.  You can always reallocate those funds to California when the timing is right.

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  • Account Closed
    Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
    11y
    Originally posted by @Brent Seehusen:

    I think it makes more sense to shift to cash flow markets at that point in the cycle and wait out the California market.  Or shift out of real estate altogether and focus on other asset classes if the opportunity is there.  You can always reallocate those funds to California when the timing is right.

    There are large transactional cost to moving in and out of real estate.  Also once you have the large appreciation then the large cash flow is set to follow so why would you give that up?  Just because cash flow is not immediate does not mean it is not large and profitable when it happens.  Plus you give up your Prop 13 tax base.  It would probably be very difficult and costly to sell low/no appreciation properties to get back into CA.  

    Just the sales commission on a $50,000 cash faux property will eat up years of that cash.  I don't see how any of that makes sense.

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