One of my favorite reasons to use real estate as an investment vehicle is forced appreciation. In real estate, there are two types of appreciation. There is market appreciation, or the value that is gained because the whole market goes up. Then there is also forced appreciation, which is value that is gained because the property is improved.
Market appreciation is the gradual increase in value of every property in the market. It is driven by large macroeconomic factors such as population growth, job growth, unemployment, taxes, and other factors typically outside of the direct influence of the investor. That is not to say that an investor cannot and should not seek to understand these factors and how to invest in a way that gives them the highest probability to benefit from market appreciation.
One way to think of market appreciation is that it is similar to how buying a stock or ETF would rise and fall typically as the whole market goes. A single stock could increase their value by increasing their net income or growing faster than projections. These actions are out of the influence of almost all single investors though.
While market appreciation is a gradual increase in value, forced appreciation comes in a much shorter timeframe. It is appreciation that comes from improving the property or improving the management of a property. It is value that is created by improvements made in the property. While market appreciation is an indirect effect on the property, you have direct control over forced appreciation.
There are a variety of strategies you can use to cause forced appreciation. Being able to cause more appreciation than additional capital expenditure is the challenge. So choosing a strategy wisely and executing it dilligently is critical.
Working on a forced appreciation strategy is like jumping in the driver's seat of your investment. You are going from a passive investment to an active investment, and that has many benefits. Depending on the strategy, you are not permanently making your real estate an active investment. Usually the strategy is a short term push or project that will increase the properties value and then you can return to managing passively.
What About the Long Term?
Forced appreciation typically is incremental and occurs with bursts of activity. You might argue that the ideal path to wealth is built slowly and over time. This can be true, but you can think of utilizing forced appreciation similar to climing stairs. It is not an activity to be done once, but an activity to be repeated over and over through your career. It can even be paired with market appreciation for more dramatic results.
Consider the example of an apartment building purchased in distress. Lets say it was 60% occupied at purchase and was worth 1 million at purchase. Through renovations and improved management, you were able to get the property to 80% occupancy. Lets further assume, unfortunately all the expenses grew exactly in proportion to the increase in revenue. We know this is not very realistic as many expenses are fixed in nature and would not go up based off of occupancy.
The property would then be worth 1.30 million, because the income from the occupancy grew by roughly 30%. $330,000 would have been created through forced appreciation. Now lets say you continue to hold the property for 10 years, where it increased an average of 3%. The compound interest would put the value at 1.75 million, for an additional $450,000 in value and a total of $750,000 in increased wealth.
Without the forced appreciation aspect a million dollar property with a 3% market appreciation for 10 years would be worth 1.35 million. Creating only $350,000 in value over the course of 10 years. I hope this is starting to get you thinking about how combining both forced appreciation and market appreciation can lead to much greater wealth.
Forced Appreciation is Like Climbing the Stairs
In the previous example, we overlooked another great aspect of forced appreciation. Forced appreciation is repeatable. By creating 30% of value, that is something you can then go to a bank and refinance based off of. You can then put much of that increased value back into your pocket to invest again. Just vizualize the growth that can occur by being able to repeat the investment over and over again.
This is in contrast to only relying on market appreciation. With market appreciation, you would have to wait years and years before enough equity has accumulated that you could refinance and purchase another similar sized investment.
It gives you options as well. You do not have to refinance, you can just enjoy the additional cashflow for years. You could also sell the property, locking in the gain and giving opportunity to move into another investment.
Forced Appreciation in Multi Family Vs Single Family
Forced appreciation benefits both multi family real estate investors as well as single family investors. The way forced appreciation impacts both investments is different though, because the way value of multi family and single family properties are calculated is different.
With single family, homes are valued against the neighborhood comparable sales or comps. This means they are valued based on their location and ammenities. They are not valued based off of how well they are cashflowing or what a great investment they may make. This means, to increase the value you must improve the property itself. Things like updating the kitchen, adding a bathroom, adding floor space, and finishing a basement. To perform well as a single family investor, the name of the game is identifying what features you can add or update for less invested than it raises the value.
Multi family properties are different in that they are valued based off of how well they are performing. They are valued using what is called a cap rate. The formula for this is:
Current Market Value = Net Operating Income / Capitalization Rate
A cap rate is typically somewhere between .03 and .12 depending on the type of asset. This means gains in net operating income can result in tremendous gains to the value of the property.
There are many strategies and business plans that can be executed to increase the net operating income. One typical one involves improving the units so that they can support a higher market rent. Another would be to remove inneficiencies in property management. In the case of acquiring a mom and pop property, there is often the opportunity to raise rents to reflect current market environmnets and perhaps improve the way vacancies are advertised. This can often increase the income without increasing expenses much at all.
Forced Appreciation Gives you Tax Planning Opportunities
Since the driving force of forced appreciation is you, you are directly responsible for when the influx of equity occurs. This also means, you can plan for it and plan your exit accordingly. Exit options include selling, 1099 exchange, refinance, and the non-exit renting and holding long term.
Each of these strategies has a specific timing where they will work the best. You can sell in an up market, 1099 exchange and trade up in a declining market, refinance in a steady market, and hold strongin a market with low liquidity or unfavorable rates.
Technically all of those options are available to you with a market appreciation investment as well. However, it may take considerable time before you can capture any significant gains on any of these. Making the majority of your income in the short term rent income which is taxed.
This is in contrast to being able to refinance on a forced appreciation deal. If you are able to refinance, that money is not taxed. This is because it is simply a loan which you have to repay. Sure it is based on collateral that has gone up in value, but the IRS does not tax on current value, it taxes on realized gains through a sale.
This means you are able to recieve an influx of capial, without paying taxes on it, while still maintaining control of the asset. That is a win in my book.
Forced appreciation is a great tool for the real estate investors toolbelt. It does not mean you cannot still reap the benefits of market appreciation. Using forced appreciation properly can get money back into your pocket to put into other investments. It is not a long term strategy in itself, but can be deployed in a repeatable manor inside a long term strategy.