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“Buy land; they’re not making any more of it.” This famous quote attributed to Mark Twain evinces a very simple yet profound idea regarding real estate investing. Since time immemorial, land has been an irreplaceable asset. Land cannot be created or destroyed, and therefore its value has almost always increased over time. Land has gone up in value nearly every decade for as far back as we can find records. Economic recessions may fluctuate the demand and therefore create a temporary and transient price reduction, but this is always corrected in the long term.
This concept of land and real estate value increasing over time is known as appreciation. When defining appreciation, there are two major types to consider. The first is natural economic appreciation, and the other is forced appreciation. The main differentiating factor between the two is the ability to control and influence the speed and magnitude of the appreciation. Appreciation is a vital key to every real estate investor’s portfolio.
Natural Economic Appreciation
Let’s assume your family has owned the home you grew up in since you were a kid. Nearly every home in America is worth more than it was 30-plus years ago, and there are endless anecdotes about homes tripling in value over a few decades. This is what’s known as natural economic appreciation.
This type of appreciation is not controlled by the owner or investor. The land will increase over (long) periods of time as a result of the demand without a change in supply. They aren’t making any more land, so basic supply and demand arguments reveal why land is more valuable than when the national population was half its current capacity.
Population growth is the major driving factor for natural economic appreciation. As the demand (increase of population) continues to rise while the amount of land remains exactly the same, the desire and need for land will drive the price of real estate up for the foreseeable future.
Forced appreciation is the holy grail of short-term real estate plays. Many investors will take a piece of real estate as small as a house or as large as an apartment complex and force appreciation. This can be achieved in a variety of different ways all with one common goal: to increase the value of the property. Forced appreciation is the one type where the investor can (mostly) control the speed and magnitude of appreciation.
An example would be a fix-and-flip house when viewing the small scale, and a full multimillion-dollar renovation for an apartment complex when viewing a large-scale example. In both examples, the investor will infuse capital to improve the property in some aspect and can therefore expect the value to increase as well.
Renovations, for instance, can appreciate a property in a controlled period. Upgrading features, amenities and desirability based on a strategic rehab on a property will lead not only to an increase of rental income, but also to an even more powerful increase in property value. This yields the opportunity to sell at a higher price, after forced appreciation, for a healthy profit. This is how an investor can control and force appreciation to bolster property value.
Which Type Of Appreciation Is Better?
When it comes to appreciation, why only choose one type? Some of the best real estate investments create opportunity on both natural economic and forced appreciation fronts. Many investors in the apartment investing industry desire a property that is located in an upscale area with the room to upgrade the physical asset. When an investor finds a property with room for improvements, they may then force appreciation on the property through renovations. It’s even more powerful when this property going through renovations is in an attractive area.
In addition to the forced appreciation, an investor is much more likely to receive natural economic appreciation at a faster rate with a B or C class apartment complex that is located in an A or B class area where there are other local renovated comps performing at higher rates. This means that the market is already delivering the result on properties that would be similar to our investment property after the upgrades. This gives a glimpse into the future of what that market may produce and the magnitude of rental income increase, which directly impacts appreciation and property value. Never choose just one when you can leverage both natural economic appreciation and forced appreciation.
Strengthen Your Future With Appreciation
A great way to start an investment portfolio is with properties that have room for improvements, known as value-add properties. These create an opportunity to take advantage of forced appreciation. As a less experienced investor, learning the basic methods to improve a rental property will drive a higher rent per unit and therefore directly increase the annual rental income. This increase of income will generally lead to an increase in net operating income (if expenses are reasonably maintained), and the purchase price/property value is determined by dividing the NOI by the cap rate.
In the abstract, strategic improvements to the property will lead to an increase in rental income and therefore force appreciation into the property. Essentially increasing the income while maintaining reasonable expenses allows the property to become more profitable, and this is driving force behind short-term appreciation. If this value-add property was wisely selected in an area that will increase in value over time, then the investor will reap the benefits of both natural economic appreciation and forced appreciation. This is a solid investment vehicle to create generational wealth and continue to produce income whether the investor is on vacation or traveling abroad, and even decades later for their heirs.
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