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?

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?

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!

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

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.

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.

You mean like this? http://news.theregistrysf.com/shorenstein-recapita... Let's see, $110,000,000 2011 purchase. $200,000,000 lipstick rehab. Now at $900 a sf that makes this a BILLION dolar property. In San Francisco! Yep, can't make any money in CAlifornia.

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.

@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.

@Josh Beroukhim 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

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

Account Closed

Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes

11y

Originally posted by @Account Closed:

The property's value will likely increase at at least 5%/year over the long term

What's long term? I can show you thousands of properties that have not returned to 2005 values. So that's negative appreciation after 10 years. In California. Where did you get this 5% annually over the long term idea?

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Brent Seehusen

Investor · Orange County, CA · Member since 2014 · 137 posts · 96 votes

11y

Originally posted by @Account Closed:

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.

Speaking of Prop 13, you will lock in a lower tax basis by purchasing at cyclical lows, which boosts your long term profitability as well as your immediate chances at cash flow.

The sales commission for the $50,000 property would be $3,000 and as long as the property is greater than a 6 cap it will cover that in less a year. Jus sayin'. :)

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

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