There are two ways that the value of your investment properties will appreciate: Forced Appreciation & Market Appreciation. But only one of these is within your control. Can you guess which one?
Watch the video below (or keep reading).
Market Appreciation
The market is unpredictable. It will go up and just as quickly, it can go down. We saw that in the example of the great recession. The market went down, everyone was scared, and property values plummeted.
The market is partly driven by comparables. Both properties for sale and properties for rent are impacted by the prices of the properties that surround them.
Let’s look at sales comps, for example. When a property located near your property is sold, the value of that sale now dictates what your property is worth. Now, rental comparables work the same way. If nearby rents are between X and Y, you know that the rental rate for your property is going to be similar.
These are examples of market-driven forces. And there are various factors that affect market appreciation (or depreciation, for that matter).
Take migration as an example. Baby boomers are moving from colder climates to warmer climates. This change will affect the market of both the cities they are moving from and the cities they are moving to. When looking at the recipients cities of these migrating boomers, the more people moving into those markets will slowly drive rents up and keep the vacancies as low as possible.
We made a video on this topic not too long ago, where we talked about the various macro-economic forces that impact a market. You can check it out here: Why Apartment Demand is Growing
Forced Appreciation
Of the two methods, forced appreciation is the only one that is in your control. Unlike the market, forced appreciation happens when you force the value of an apartment building to go up. But how?
Let’s say you own 2 multifamily properties on the same street, located right next to one another. In all aspects, they are identical. They were built the same year, have the same specs and the same number of units. BUT, there is one major difference. The building on the left is worth $1 million and the building on the right is worth $1.5 million.
How can 2 identical buildings, in the same location, have a half million dollar difference in value? Simple – the value of apartment buildings is driven by the income it produces. So the building on the left is producing less income than it’s twin on the right.
In order to make the $1 million property appreciate $500,000 in value, you have to make it produce more income. Period. My firm favors a value-add strategy that uses a forced appreciation model to make a property appreciate, regardless of what the market does.
- If the market were completely flat, the value of the building would go up.
- If the market went up, the value of the building would go up even more.
- If the market went down, then the value of the building would not go up as much as if the market were steady. But it won’t go down.
Essentially, YOU are controlling the value of the building and that's why it’s called forced appreciation.
Predictability & Business Planning
Unfortunately, no one has a crystal ball that can predict the future value of a market or a property. But, you never want to go blindly into a deal. You must do your research to hedge your bets.
My firm plays the game by studying migration patterns. We also look at the economic forecast of a city through key indicators like job growth etc. We are trying to make predictions by pinpointing markets that are growing and improving. But…
The real magic happens when we can do both: Find a market that's improving and force appreciation in that market.
Obviously, forced appreciation is much more predictable than market appreciation. You can create a business plan that takes 18-24 months to execute. If you execute on that plan, it's going to have predictable results.
For example, let’s say you have a property earning $100 a month less, per unit, than the two properties next door. These other properties look a little nicer. So you know that you can get that $100 bump if you put some money into your property and make it more pleasing to the eye.
You might plan to put $5,000 into each unit to bring your building up to par (and write the improvements off as expenses!) Presumably, if you do this, you’ll be able to increase the rent as well. This is why forced appreciation is very predictable and surprisingly accurate.
And as I mentioned before, if the market continues to go up in unpredictable ways, it will only enhance your business plan. If the market doesn't quite cooperate, you might not be able to get a $100 rent bump, maybe you’ll only get $75. But you are still forcing the appreciation according to your business plan.
Speaking of business plans, a good one will articulate the problem and solution very clearly. You want to make it easy for an investor to understand your strategy, how you intend to add value, and ultimately force appreciation. For example: “The units don't look as nice as the ones next door, therefore the rents are lower.” This makes sense.
If someone is promoting a business plan that isn’t clear and doesn’t make sense, as an investor, you should be suspicious. Ask a lot of questions about the ability to force the appreciation of that asset.
Conservative Underwriting
As a passive investor, you want to be conservative in your underwriting. When you're looking at deals and evaluating an investment, you want to see how they're being underwritten. Now, underwriting is a fancy word for:
- What assumptions are they making?
- Are those assumptions reasonable given what you're being told?
- Do they appear aggressive?
Understanding Cap Rate
Before we move on, let’s address cap rate. We know that an apartment building is worth more, the more income it produces. The question becomes, how much more? That’s where the cap rate comes in.
A cap rate is essentially a multiplier, and the multiplier determines how much more something is worth based on its income. Cap rate has an inverse relationship to value. The lower the cap rate, the more something is worth. The higher the cap rate, the less something is worth.
The cap rate varies by market and is determined by comparable sales. (I don’t want to go too much into cap rate. You can get the cap rate for a particular market from a broker or an appraiser.)
If you’re reviewing a deal with a current cap rate of 6.5% and the deal is projecting that in the future the cap rate will be lower, this is very unlikely to happen. Why? Because the low cap rate is based on low interest rates. It's possible that interest rates will drop, and therefore the cap rate will go lower, but it's not likely and, therefore, it’s not a very conservative assumption.
When predicting the sales price of a unit, you should always assume a higher cap rate. Which means, you’re assuming in five years cap rates will be higher and the real estate will be valued at a lower price. That is an example of a market predictor that is conservative versus aggressive.
Net Operating Income
On the forced appreciation side, it's all about net operating income. What is being assumed about income? How conservative are the projections?
If a deal is projecting expenses of 38% of income, that's really aggressive. Typically, you’ll see expenses between 50% and 55%. The lower the expense ratio, the more aggressive the projections.
Another example of an aggressive projection would be a high rent bump in the first year. In year one, you're going to have higher turn-over and increased vacancies because people are going to move out when you take over. So, a $150 per unit rent bump in the first year does not seem very likely.
When it comes to projecting net operating income, make sure that you look closely at the predictions for both rental income and expenses. Ask yourself these questions:
- How realistic are they?
- How aggressive are they?
- How conservative are they?
- How believable are they?
- How much margin for error is built in?
A prediction that the cap rate is going to be higher in five years has a margin of error built in. If it stays exactly the same, you’re going to do better, right? But if for some reason, interest rates do start going up, then your business plan is still going to be on track because you built in a margin of error.
How to get started with Passive Investing
If you're new to all of this, and you want to learn more about how apartment investing through syndications compares to investing in the stock market, check out the free report at:
www.themichaelblank.com/report
If you’re interested in hearing about how you can invest in apartment syndication deals, go to:
and set up a call with us to see if it would make sense for us to work together on future deals.
