The practice of Forced Appreciation is one of the greatest advantages of commercial real estate.
This article is going to cover what it precisely means, how it works, and why it benefits you.
So let’s go:
What Is Forced Appreciation In Real Estate?
It is an action taken by the property owner that increases value via greater net operating income (NOI). This is achieved either through higher revenue, lower expenses, or both.
The main idea is that you don’t wait around for your property to be worth more over time.
You either entice the renters to pay more, or you operate more efficiently.
How Is Appreciation Specifically “Forced”?
Commercial real estate allows more control over the value of your investment than nearly anything else out there.
Appreciation is forced in many ways:
You can improve a property’s appearance, its amenities, its customer service, its mechanics, its operations, its finances, etc.
And thus, you improve its value by raising the rents and automatically improving your NOI.
The elite operators have realized that there is a difference between hard value (the actual cost of an improvement) versus perceived emotional value (what residents or potential residents feel is “worth it”).
The secret lies in understanding that a million dollar “improvement” to a property may go unnoticed by residents. Whereas a simple item from the local hardware or electronics store allows you to charge way more rent per month. All based on how bad the residents want it, or how much they notice it.
“Value” is perceived in different ways by the people living in different areas, and at different stages in their life.
But a few examples of the tried and true ways of raising perceived value are:
- installing washer and dryer connections and sometimes even the actual appliances
- installing or improving a dog park
- adding covered parking
- installing an Amazon Hub
- including a backsplash into your kitchen renovations
- refreshing exterior paint, parking lot lines, and varnish on the handrails
Basically, it is a mix of routine maintenance that has been ignored or deferred by the previous owner, or basic amenities that match the current trendy desires of renters.
When getting into a real estate deal, you will want a sponsor that has a master list of all the Forced Appreciation techniques, and they hand-pick the best ones that match the desires of the chosen area.
Like we said above, you could also lower expenses.
That may mean low-flow toilets, more efficient lighting, etc. But of course, a savvy operator would make sure this would be virtually unnoticeable to the residents.
Advantages Of Controlling The Appreciation On Your Investment
The obvious advantage is that you can charge more money per unit.
This increases your cash flow, and of course ensures the property is worth more when you sell it.
But let’s explore the practice in a bit more detail:
A property’s value is based on the Net Operating Income. NOI is the difference between the Net Income and Expenses of a property, not considering the debt service.
The value is also based on the Capitalization Rate (Cap Rate). Which is the unlevered operating return an investor can expect when owning a property.
It’s worth pointing out that, while Cap Rate is one of the major talking points in real estate investments, it is only ONE of the return components that are enjoyed by investors. There is also capital appreciation, equity build, and tax advantages. But for the sake of this article, let’s get back to Cap Rates.
The property value is calculated by dividing the property’s NOI by the market Cap Rate.
For example, if a multifamily property has an annual NOI of $100,000 and a Cap Rate of 5%, then the value of that property is $2,000,000.
Now imagine you are one of the owners of the $2,000,000 multifamily property.
Let’s say we increase the property income by $100 per month through any of the methods we mentioned above.
The value of the property is now calculated as NOI = $101,200 / .05 = $2,024,000. You have just improved the value of the property by $24,000!
Through this example, you can see how a diligent sponsor would be able to exercise a great degree of control over the value of your investment.
Over the life cycle of the business plan, there would be thoughtful improvements to both the community amenities and the interior units.
This is one of the most impactful ways that you earn amazing returns in commercial real estate!