Skip to content
Welcome! Are you part of the community? Sign up now.
x

Posted over 8 years ago

Appreciation: The Icing As Thick As The Other Guy's Cake

The other day, I was talking with a friend who is just beginning to consider investing in real estate, and we got on the topic of property appreciation. We both recited what we'd heard from multiple guests on the BP podcast and other reading: that appreciation is the "icing on the cake." It is a bonus that we should not include it in our calculations. That is certainly true, and I would never advocate buying a property based on the assumption that it will appreciate steadily and reliably. However, for a buy and hold investor who plans to hold on to a property for 20+ years, appreciation should be a VERY exciting "bonus."

According to Nate Silver (who is pretty good at numbers), before the housing bubble beginning in 1996, housing prices in the Unites States grew basically at the rate of inflation. Money growing at the rate of inflation is not very exciting, but housing growing at that rate is. Leverage makes it so.

Disclaimer: I cannot emphasize enough, especially to newbies, that the example given here is nothing close to realistic. It is used to illustrate the power of appreciation over the long term. Do not buy anything with the assumption that it will look anything like the example in years 1 and 2.

But here is the example:

Let's say you did nothing fancy, just paid 25% down and took a conventional loan for the rest. The purchase price was $100,000, so you paid $25,000. Your investment is $25,000, but you benefit from appreciation of the entire $100,000. If inflation is 2.5% (higher than 2012-2014 but lower than historical averages), you gained $2500 in equity: a 10% return on your $25,000 investment. That's equivalent to a decent year in the stock market, and that's only your bonus! But wait, it gets better.

Unlike your cash-on-cash return, appreciation, like inflation and stock returns, does compound. The same force that has us paying $2.50 for a bottle of Coke that sold for 5 cents in 1955 is working for us in real estate. So in year two of this terribly inaccurate model that no one should rely on but everyone should consider, your house is worth $102500, and appreciates another 2.5%. The return in year two is $2562.50, and you still only paid $25,000 for the property, so you just made 10.25% on your original investment. Like compounding interest, this pattern repeats indefinitely. These numbers start to look a lot better when you use creative financing, but you can do your own math on that.

As long as you are buying properties with two-digit cash-on-cash returns, which hopefully we all are, then you are crushing the stock market over a 20-30 year period, even if you believe in 14% stock market returns.

What do you think? Please leave comments! Be nice; this is my first blog post.



Comments (6)

  1. Not sure that I agree that appreciation (always) compounds, or that cash-on-cash return can't compound. All it takes is for another bubble to burst, and there goes 10 years (or more) appreciation out the window! In the meantime, your cash-on-cash return can just be left in the bank for accrued interest (low though that might be)...


    1. You are absolutely right, Brent. This post was meant more of a thought experiment than practical investing advice. 


  2. Thanks @Dusty Ackerman.  Happy investing!


  3. Interesting read Kevin. Thanks!


  4. Hi Kevin,

    As a newbie, but schooled by two horrible investments and the great education provided by BP, I agree that appreciation would be the "icing on the cake", but I would never buy a property (again) on speculation.  

    Interesting though, an article I read recently, stated that over a 100 year period inflation-adjusted real-estate prices have remained relatively flat.

    Do you think this matters to a buy and hold investor?


    1. Yes, the inflation-adjusted number was Nate Silver's point in his real estate chapter of The Signal and the Noise, which offers just more evidence that buying a residence is not a great investment.  However, when you leverage your property and your tenants are paying your mortgage, the bottom line is that you're actually making 4x the inflation rate.  You could make much more if you are using other types of financing while maintaining 100% ownership.