You cannot force a rain, but you can force a property to appreciate
One of the ways real estate allows to create wealth is through appreciation. Appreciation can either be forced or natural.
Let us first look at the definition of the word appreciation. According to the Miriam-Webster dictionary appreciation is defined as “increase in value”. In other words, when a value of an item has gone up either organically or by force, we normally refer to such an increase as appreciation.
A property’s value may appreciate naturally due to favorable market conditions, but we can also force property’s appreciation by pushing up its value. “How do we do that?” - You may ask. There are actually multiple ways to do it.
1.A property may appreciate in value if we increase property’s income. Let’s look at an example. Whenever we are looking at a potential apartment complex to buy, we look to do the following:
a) The simplest way to force appreciation is to increase rents. Are the rents below the market rents, and if so, by how much? For instance, let’s say, we’re evaluating a property of 100 units to buy for $2,000,000 at a 6% cap rate. Let’s say for simplicity sake, the current rents are at $100, which is 10% below the market for this area. If we were to increase rents by a mere 10% to $110 for all 100 units and turn it around in 2 years, the NOI (Net Operating Income) for the property value would increase from $2,000,000 to $2,200,000 a year. Imagine what increasing rents even higher (if the market allows of course) could do to a property value.
b) Next, let’s explore how we can add additional stream of income. A good example would be to charge for covered parking in a sunny climate area. For instance, if a property currently has only open parking, we could add covered parking; let’s say one for each of the hundred units at $50 per spot per month. This additional stream of income would allow us to make $50 * 12 months * 100 units = $60,000 of extra income a year. Which would result for our NOI to go to from $120,000 a year to $180,000 a year. This NOI increase would result for value of our property to jump to:
$180,000 / 6% cap rate = $3,000,000
Can you imagine the value jump by $1,000,000 by simply adding 100 covered parking spots?! What other industry allows you for such miracles (actually it’s quite a lot of hard work) to happen!
c) Let us look another example of additional stream of income. For instance, if this property has storage that isn’t being used. It’d be a good idea to convert it to a legal apartment with the same $110 rent a month. This turnaround would allow us to increase property value by $22,000.
Here’s how: $110 * 12 months = $1,320 a year extra income.
NOI = $120,000 + $1,320 = $121,320;
Property Value = $121,320 / 6% cap rate = $2,022,000.
2.Another way to appreciate property’s value is through a decrease in expenses. Reviewing a few examples should help.
a) Let us say the current owner is paying the water bill for the property at $50 per unit per month. This expense alone means that the owner is out of $60,000 annually ($50 * 12 months * 100 units). Let’s say we sub-metered the water bill and transferred the responsibility to each tenant to pay for their own water bill. By adding back this $60,000 to a current NOI we get NOI = $180,000 ($120,000 + $60,000).
This NOI increase would result for value of our property to jump to:
$180,000 / 6% cap rate = $3,000,000. Can you imagine the mere $60,000 decrease in the expenses would allow for our property value to jump by a $1,000,000.
b) Another example would be a property management fee. Let’s say the current owner is paying 10% property management fee.
So, this results in Property Management Fee to be $12,000
($100 rent * 100 units * 12 months * 10% = $12,000). Let’s say we found a new management company that will get compensated 7%. The difference of 3% will bring us back $3,600. Let’s review the calculations.
($100 rent * 100 units * 12 months * 7% = $8,400); The difference is $12,000 - $8,400 = $3,600
Our new NOI will ten become $120,000 + $3,600 = $123,600.
This will raise our property value by $60,000. Let’s review the calculations:
Property Value = $123,600 / 6% cap rate = $2,060,000. Can you imagine that?!
3.What if you were in a position to do both: increase income and decrease expenses?! Imagine the possibilities!
By using the examples above, if we were able to increase rents by 10% and decrease the expenses by transferring water bills to the tenants, we will increase the property value as follows:
NOI = $120,000 + $60,000 + $60,000 = $240,000
Property Value = $240,000 / 6% = $4,000,000.
Can you imagine increasing the property value by $2,000,000?!
Appreciation is one of the biggest and most fascinating ways to build wealth via real estate, and you don’t have to be an opportunist to take advantage of it. It can occur by the overall market increasing or through the actions of the owner, called forced appreciation. Choosing the right property, property management, and making small improvements over time can have exponential results. Appreciation is the number one way that millionaires are made in real estate.