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Appreciation: An increase in the value of an asset over time.
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THE TWO TYPES OF APPRECIATION
There are two types of appreciation: organic appreciation (sometimes referred to as natural appreciation) and forced appreciation.
Organic appreciation, simply put, is the rise in a property's value over time due to market conditions outside of one's control. As real estate investors, we love the concept of organic appreciation. The idea of buying property, holding onto it for years, and then selling it at a higher price than what we bought it for sounds attractive. And it is! However, since we cannot control market conditions, buying with the "hope" of our property appreciating naturally is not a viable investment strategy in the long run. Above-market returns typically occur when both types of appreciation are at play, so let's look at why forced appreciation is so valuable in commercial real estate.
FORCED APPRECIATION
Forced appreciation occurs when an investor/operator adds value to a property by increasing the net operating income through business plan execution. Typically, an operator adds value to a property through renovations and/or operational improvements. As we learned in our blog post about cap rates, we know that a property's value is derived from the net operating income and the cap rate. The formula to calculate a commercial property's value is as follows:
Net Operating Income: The annual income left over after subtracting all operating expenses.
Cap Rate: The rate of return that is typically generated by a specific commercial real estate investment asset.
*To obtain a market cap rate, you can ask your broker, lender, property manager, or appraiser.
LET'S LOOK AT AN EXAMPLE
Assume you're evaluating a fully-occupied, 200-unit apartment complex, but with the opportunity to add value, i.e. it has below-market rents, outdated exteriors/interiors, and some deferred maintenance. You pay $10,000,000 to purchase the property and save $1,500,000 for renovations. The in-place rents are at $500/month per unit, and to keep things simple, let's assume there is no other income produced by the property. The total revenue is (200 x $500 x 12 months) = $1,200,000. In addition, let's assume the operating expenses are 50% of the revenue which is $600,000 ($1,200,000 x 50% = $600,000).
Currently, this generates a net operating income of $600,000: ($1,200,000 - $600,000 = $600,000). With a net operating income of $600,000 and a purchase price of $10,000,000, the going-in cap rate is 6.00% (Cap Rate = NOI / Purchase Price).
During the next 12-24 months, you complete a series of extensive renovations including the following:
Interior:
Adding granite countertops
Replacing outdated cabinetry
Adding stainless steel appliances
Replacing carpets with wood flooring
Adding a fresh coat of paint to the interior walls
Exterior:
Adding a fresh coat of paint to the exterior walls
Upgrading the landscaping
New signage and branding
As you finish the renovations, you begin leasing each unit at the current market rent of $650/month. The new revenue for your apartment complex is $1,560,000 (200 x $650 x 12 months = $1,560,000). Assuming your operating expenses remain at 50% of the total revenue, the property's net operating income is now $780,000 ($1,560,000 x 50% = $780,000; $1,560,000 - $780,000 = $780,000). If we assume the cap rate remains at 6.00%, the new value of your apartment complex is $780,000 / 6.00% = $13,000,000, a $3,000,000 increase!
See below for a quick summary:
THE TAKEAWAY
You bought the apartment complex for $10,000,000; over 24 months, you spent $1,500,000 to complete your renovations. Upon completing renovations, you were able to confidently mark each unit to market by increasing rent to $650/unit/month. By doing so, you increased your property's net operating income by $180,000 and consequently "forced" a $3,000,000 increase in your apartment complex's value!
Have you ever wondered how the rich continue to build wealth despite market fluctuations? Well, this is how real estate investors leverage forced appreciation to build their wealth and we hope you leverage the power of forced appreciation in your real estate investments too!
We hope this blog helped to show you the power of forced appreciation and the value-add model when investing in commercial real estate.
If you're ready to capitalize on the value-add strategy and leverage forced appreciation in your portfolio, click the button below to set up a time with our team here at One-9 Holdings. We're excited to connect with you soon!