Due to inflation and a host of other factors, asset values tend to increase over time. This benefits people who own assets such as multifamily real estate because they gain wealth via the equity gained in their assets. This rise in value is called appreciation and this process is passive. Because of that, the rate at which it happens is out of our control. Or is it?
It can take years or decades to see the biggest impact. But don’t worry, while you’re waiting on appreciation there are multiple other ways owning real estate will pay you. Appreciation is still appealing as you get the equity/ wealth without doing any additional work. In a way, appreciation is a reward for being an owner of a desirable asset. But, if you’re not the waiting type, there is a way to actively speed up the process via forced appreciation.
What is Forced Appreciation?
Forced appreciation is the process of actively improving the operation of a property in order to increase income generated by the property. Multifamily apartment communities are businesses. Like businesses, they are valued based on how much income they generate. The faster you increase the net income the property generates, the faster you can increase its value. This means you can shave years or even decades off of the time needed for the property to appreciate to a certain value by forcing it to increase faster. How much time exactly? Well it depends.
“The faster you increase the net income the property generates, the faster you can increase its value. “
How do Value add investors force appreciation?
Value add investors specialize in forcing appreciation. The value-add investment strategy is based on one tenet. How can I add to the value of this property? Under-performing properties are ideal for forced appreciation. These are properties that are not generating as much income as they have the potential to generate. Value-add investors optimize the performance of these properties and are able to quickly increase their value in months to a few years. If a property is already optimized and there aren’t any ways to increase the income generated you may not be able to force appreciation. You can decrease expenses however there is a limit to how much you can decrease expenses because operating expenses are part and parcel of operating a business.
” Under-performing properties are ideal for forced appreciation”
What is the easiest way to force appreciation?
The most common method used by value-add investors to force appreciation is increasing rental income. This can be done by renovating outdated units or upgrading amenities offered at an apartment community such as a dog park, fitness center, or business center. Doing this makes living in the apartment community and the apartment itself more valuable to prospective residents. They in turn are willing to pay more to live there. This increased rental income, a rent premium, increases the total income the property generates as well as the value of the property. You can also replace non-paying residents with more credit-worthy paying residents. This doesn’t increase your income generating potential directly, but does increase the amount of that gross potential income you actually collect.
How do you increase value when income is maxed out?
Decreasing expenses also forces appreciation. When expenses are lower, there is more net income that property owners receive. This makes the property more valuable. Some ways value-add investors decrease expenses are by sub-metering or individually metering utilities. This shifts the cost of utilities from the owners to the residents. Expenses can also be decreased by grieving taxes to lower tax bills, installing energy efficient fixtures or renegotiating contracts such as insurance, landscaping, garbage removal or pest control.
How does forcing appreciation increase property value?
All of these methods for forcing appreciation can be done relatively quickly and have a multiplied effect on the value of the property. The amount that income gets multiplied by is called a cap rate. To better understand this concept, let’s look at one way multifamily properties are valued. A multifamily property is valued based on its net operating income. The net operating income is the income left over after all expenses have been paid. Net Operating Income = Operating Income – Operating expenses. The NOI is divided by the cap rate to estimate the value of the property. The cap rate is determined by the market you invest in and is fairly stable over time. It effectively represents the percentage of return an investor would accept relative to the risk they are taking when purchasing and investing in an apartment community.
“ Property Value = Net Operating Income ÷ Cap rate “
If the cap rate stays stable then the greater your Net Operating Income gets the greater your property value will get. Let’s put this into perspective
You purchase a 100 unit apartment community in a 5 Cap market. Each unit rents for $1000. Your annual operating income is $1000 *100*12 = $1,200,000
Your expenses are $550,000.
$1.2m - $550,000= $650,000
Your NOI is $650,000
You force appreciation by renovating all 100 units for $3,000 each. That is a total of $300,000 for all 100 units. This takes 18 months but they now rent for $1,100. An increase of $100/ per unit/ per month. And 12*100*100= 120,000 increase in income per year. Now you might say, what a waste? I spent $300,000 and only make $120,000 per year. Remember, the goal of forcing appreciation is to add value to the property. So how much value did we add? We input the net income generated and the market cap rate into the valuation formula
$120,000 ÷.05 = $2,400,000 of value created
In only 18 months we added $2,400,000 in value to the property, assuming expenses remain the same. Now considering we spent $300,000 and made $2.4m that is an 800% return. Not too shabby for 18 months? If we relied on a conservative 3% organic rent growth annually and did not use forced appreciation it would have taken almost 4 years to get the same results. A full 30 months longer. This is the power of forced appreciation and it is the super power of value-add investors.
$2,400,000 ÷ $300,000 = 8
How does force appreciation benefit you?
” You’re forcing appreciation, building wealth and multiple streams of income that otherwise would have taken years or decades to attain.”
By adding value to the property and forcing appreciation you now have equity you can tap into. You can sell the apartment community and cash in on the increased value. Or, refinance the property, receive a portion of the money you initially invested back and use it to acquire more assets. Now you’re cooking with gas because you have just used your first property to buy your second one. You’re forcing appreciation, building wealth and multiple streams of income that otherwise would have taken years or decades to attain. The subtle key here is that the sooner you start the greater the long-term benefits because you will have both organic appreciation and forced appreciation working on your side.