Appreciation: Forced vs Market - What's the Difference
A property is always doing one of two things: appreciating or depreciating. As investors we all hope that our properties appreciate, we hope that they gain value therefore adding to our bottom line and our portfolio's worth. There are different forms of appreciation and this does make a difference, and one is better then the other.
Forced appreciation is the increase in the value of an asset based on the deliberate or accidental actions of the investor. This type of appreciation is not related to the market and is controllable. For these reasons it is the better, more desirable of the two. This is made possible by a basic dynamic of commercial real estate: its value is based on its income. (Note that this is not the case for residential properties (1-4 units). These properties values are based on comparable properties, value could be forced in different ways such as renovating the property but the ultimate value will still be influenced by market comparable properties.)
Because the value of the property is based on income if we can find ways to increase the income not only will the cash flow be better but the property will be worth more. This is another great incentive to find ways to increase the income the property produces! Some ways to increase your properties income include:
- Raising rents
- Adding late fees
- Adding pet fees
- Adding a pay for laundry room if units do not have a washer and dryer
- Add carports to a section of the parking lot for a monthly rental fee
- Add optional services such as trash valet
- RUBS system (if allowed and accepted in your area)
This is important because we can find ways to increase our properties value despite where we may be in the market cycle. This appreciation is also nice because its predictable. Before even purchasing the property you can underwrite some of the things I have listed above. Say you know the property is on average $100 below market rent per door, once you purchase the property you can begin increasing rents therefore increasing the properties value!
You will notice that this is all about the Net Operating Income (NOI). While underwriting your property or reviewing the underwriting to a property you are thinking about buying look at all of your expenses, compare them to the income. Do they make sense? Expenses vary greatly by location and asset class but on average you can assume that they will be 45-55% of the income. If the expenses are lower then the aggressive projection may bite you when you find you cant actually reduce your expenses to that level and increase the value of the property for you and/or your investors. Many times it is best to be on the conservative side so that you don't loose money in the long run.
Market appreciation is just that, it is the increasing value of a property based on the market. This value can increase or decrease very quickly and sometimes without warning. There is no sure fire way to predict the market although a lot of people will try and tell you that they can.
The market is driven by a lot of external factors such as economics, interest rates, the movement of people, emotion, sale comparables and other things. The individual cannot control any of these factors and cannot control the market.
That's not to say that market appreciation is bad. Market appreciation is great! It increases the value of your property and the value of the properties around yours making the area more desirable for people to live, work and invest, further increasing the values. Although we hope for this, we cannot control it so we don't want to count on it. When purchasing a property you don't want to assume that in 5 or 10 years the property will be worth more, with the economic swings its possible that the value stagnates, increases or decreases. We all hope that the market appreciates and if it does chalk it up to bonus profit.
If you are lucky you will benefit from both of these types of appreciation simultaneously. On our last property we were lucky to be in a great market that was going up in value and be able to force value by increasing the properties income. Although luck plays into this you can hedge your bets by completing the proper research prior to purchasing anything.
Look at the market, what trends to you see? Are businesses moving in? Are people and families moving into the area? Many times we look for a minimum of a 2% increase for each of these metrics over the past few years. If you see that type of increase its a good sign! Also is the local government passing legislation and dumping money into projects focused on growing their population and community? Check into the local schools, the crime rates and other demographics of the area to get a clear picture of what you are getting into. Although you cant control the market you can at least control which market you put your money in.
Hopefully you are the owner of an appreciating property, ideally from both the market and forced varieties, but if not what can you do to change that? Most likely there are ways to force it higher. Think about the options that you have and figure out how to raise the value of your investment property. It is not as hard as it may sound, it just takes a little time and a little work but the payoff can be huge!