Why Banking on Appreciation is Unwise

Over the years, I have looked at many Private Placement Memorandums and investment prospectus documents from those trying to raise money for investments. Many of them will show modest investor returns for the first 5 years. At the end of that period, they show a sale or refinance based on the property appreciating, creating a big payday for investors.

Once that big hit is considered, the investor rate of return looks very favorable. I take on a different approach when presenting a deal. Although I expect appreciation, I have never projected it in my presentations to investors. Today, I want to talk about why I use this strategy, why I expect appreciation anyway, and why I never project it, even though it lowers the projected returns for my deals.

Alternative Strategy

So, in a competitive world of real estate fundraising, why would I sell myself short when many other offerings show reasonable numbers for appreciation each year?

The biggest reason is that I want to make projections based on what I can control. I can’t control appreciation. My projections include profits from the cash flow from the property, that’s it.

If I am on top of my rental projections and my expenses, I can usually meet or exceed my return on investment projections for cash flow. Our payouts match our projections, which keeps investors very happy. Once we sell or refinance at the end of the investment term, any increase in value is gravy for us and the investors (on top of their dividends).

Why It’s Risky to Project Appreciation

In this business, it pays to know what you can control — and what you can’t. Some things you can control that affect your profit in a buy and hold transaction are:

• Rents (make sure they are close to market rate)
• Expenses (make sure they are not excessive)
• Debt terms (interest rate, term, etc.)
• Maintenance strategy (rate you pay your staff and labor/materials cost)

And, of course, there are other things that a landlord can control. What you don’t see up there is what the property will be worth in 5 years. Although most investors like to show returns for their projects in the high teens due to lots of increase in property value, it’s 100% speculative.

Calculating the CAP Rate

The main driver for value in investment real estate is the CAP (Capitalization) Rate. For those unfamiliar with it, the CAP rate is a percentage you divide into the Net Operating Income (NOI). To determine the value of a property, you can use the following equation: rent minus vacancy minus operating expenses not including mortgage payment.

Value = NOI / CAP Rate. The lower the CAP rate, the higher the value.

There are other factors that affect property value, like location, condition of the property, market conditions, but all of these are really just changing the CAP rate of the property. Some properties have very low CAP rates because of their location, stability, etc. If you looked at buying a building leased to Walgreens for the next 15 years ,and they paid all expenses, including real estate taxes, insurance and maintenance (called a Triple Net Lease), you would pay a very low CAP rate for that investment.

If you bought a multifamily with some vacancy in a C+ neighborhood, you would want a much higher CAP rate. Are you all with me so far? Ok, good. Even if CAP rate is not the driving factor for your investment, there is a number underneath it that affects everything in real estate.

The Going Interest Rate

That number is the going interest rate to borrow money for an investment. Even if you are not using a mortgage and don’t care what the current interest rates are, others in your marketplace are using mortgages. Indirectly, interest rates drive the investment real estate market’s appreciation. Some have said that the acceptable CAP rate for an investment is a certain percent above the current interest rate.

So what’s my point? I’ll tell you. Although we can borrow money at 4 – 5% for real estate transactions from banks currently, there is no telling what money will cost 5 years from now. I’d like to think that it will be around the same range as what we pay now, but I wouldn’t bet on it.

No investor knows; all they know is what they project their Net Operating Income to be. If interest rates are higher 5 years from now, the acceptable CAP rates for ALL investments will be higher also, lowering prices. If rates are lower (they can’t get much lower than they are now), then CAP rates overall will go down, raising prices.

The Bottom Line

Bottom line? When an investor projects the value of their building in the future, they are forced to use two rules of thumb, which is risky.

• Rule of Thumb # 1: Real Estate values will go up 3% per year on average. 3% per year over 5 years equals a 15% increase in value. That creates a nice return to investors over 5 years, right? Yes, it sounds good on paper, but has no real backing to support it.
• Rule of Thumb # 2: Use today’s CAP rates to determine the value in 5 years. Not a bad strategy, and it’s very commonly used, but I still don’t like it. You can come up with a fairly solid projection of the Net Operating Income in 5 years if you project a modest rent increase and stable expenses. It’s very tempting to use today’s CAP rate to determine the new value, but as I already said, it’s not a solid number to use.

So, for all the reasons above, I don’t project appreciation when talking about potential profits. With all that said, I DO expect it.

Why I Expect it

Ok, so I am not about to contradict my whole position above, I swear! I do expect my properties to go up in value over time, though, for two reasons. These may sound cocky, but they are not intended to. They are just methods I’ve seen work in staying ahead of changes in market prices.

• Reason # 1 – Our Purchasing Strategy: I only buy properties that are undervalued to begin with. Any of my purchases are either mismanaged and have vacancies or are in need of repair due to a bunch of deferred maintenance. I don’t buy the Walgreens on a Triple Net Lease because there is nothing I can do to increase its value or its revenue while I own it. I want the half-vacant apartment building, so I can lease it up, thereby increasing its Net Operating Income and its value in today’s market. Yes, its value will change with the overall real estate market, but based on the value when I purchased it, I am ahead.
• Reason # 2 – Our Management Strategy: My management team is very thorough, and we have a fairly high standard for condition of our buildings. I am not trying to be a real estate snob, but when I look at a property to purchase, it’s rarely in the condition I would accept as our in-house standard. That means that over time, we end up raising the condition of the building to standards above the average of the marketplace. This allows us to lease or sell at or above the market in the future.

So, for these two reasons, I expect my properties to go up in value over time. By how much? I don’t know. But I do know that as long as we keep our management strategy in place, we will stay ahead of the current market value — whatever it is.

Conclusion

Here is a final reason I don’t focus on appreciation: I don’t think about it too much because I am a long term buy and hold guy.

I’ve only sold a few of our rental properties in the 12 years we’ve been in business. Two were because we moved out of the area, and the third was because it had a major fire, and I didn’t want to deal with the repairs. I believe wealth is built by holding properties long term and selling when it makes sense given the current market.

I would also only sell for two reasons – one would be to trade up into a larger deal (1031 exchange), and the other would be to get an investor out of a deal if that’s what they need. Other than that, I would rather cash flow long term.

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