The Layers of Real Estate Appreciation: A Comprehensive Introduction

By Scott A. Stanfield

Most people think of appreciation as a very straight forward concept, however, there are specific nuances that add multiple layers of complexity. As an investor, it is worth having a deep understanding of appreciation. This article is intended to introduce appreciation and some of the inherent complexities that surround it.

Appreciation

When the value of a property increases, it leads to an increase in equity where equity is how much money you would receive if you were to sell the property. An increase in equity from an increase in property value is known as appreciation.

There are two types of appreciation. The first is an increase in property value by market conditions and the second is an increase in property value by renovating the property (forced appreciation).

Historical Appreciation Rates of Single-Family Homes

The average historical appreciation rate for single family homes in the United States is between 3.5% and 3.8% annually. With leverage from a mortgage, the first-year return from appreciation can be as high as 17.5% for a 3.5% appreciation rate and a 20% down payment. The average historical appreciation rate of return is a compound rate. Hence, the leveraged return of 17.5% in the first year will steadily increase.

In a similar fashion, if the property goes down in value, leverage will amplify the loss. For this reason, care should be exercised when utilizing a mortgage for leverage.

Cash Flow Considerations

In general, rental properties that appreciate above the national rate correspond to lower cash flow because they tend to be in established neighborhoods and cost more. Properties that appreciate below the national rate usually correspond to higher cash flow. Hence, building a portfolio comes down to balancing the properties you purchase based on your resources and goals, and the tradeoffs between cash flow and appreciation.

Main Drivers that Cause Appreciation

Changes in the value of real estate is driven by supply and demand. When the inventory is low, properties appreciate in value. Similarly, when the inventory is high, properties depreciate in value.

Many microeconomic and macroeconomic factors affect supply and demand. Two key factors include monetary policy and population growth. Monetary policy has a profound effect on buying power and can quickly increase or decrease demand. Other dependent variables include the replacement cost of a single-family home, the number of newly built properties, job growth, inflation, weather, property tax, nearby amenities, local zoning, and geographical barriers that limit growth.

Clearly the list of factors is long and how they intertwine is not always obvious. Fortunately, some of these parameters are easier to monitor and have a stronger effect on appreciation than others. For example, population growth is easily the most important consideration.

Appreciation and the Market Cycle

Appreciation is not constant every year. Instead, the appreciation achieved will correlate to market contraction and expansion, as shown in the figure below.

The figure shows the property value and the corresponding appreciation rates from January 2000 to September 2023 for Shelby County, TN 38115. As shown, the appreciation rates were around 1.2% in 2000 and peaked at 4.4% in 2005 and then plummeted to -15% in 2008. The appreciation rate then oscillated between 5 and 15% from 2012 to 2022. At the end of September of 2023, the rate is -2.8% which represents some softening in the market. The average rate from January 2000 to September 2023 is 3.71% which corresponds closely to the national average.
The long-term fluctuation of property value corresponds to the business cycle for real estate, also commonly referred to as the real estate market cycle. There are a lot of very interesting statistics for the real estate market cycle.

Buying for Appreciation

When investing for appreciation, you need a plan, preferably assembled from market generated data. The goals for this plan are to provide insight into the supply and demand of housing and ultimately provide purchasing criteria. My current plan for identifying property appreciation is a top-down approach that uses indicators to:

1. Gauge the supply and demand dynamics at the national level by monitoring

    • the real estate market cycle
    • government spending
    • government monetary policy

2. Rank the individual metropolitans by monitoring

    • population growth
    • market cycle evaluation of metropolitans with substantial population growth

3. Identify specific neighborhoods in a metropolitan area which can be an involved process.

    • For turnkey rental investing, your turnkey provider is a wealth of information on neighborhood specifics, but always confirm the information you receive.
    • Look for highly rated school districts.
    • Evaluate amenities, such as whether there is a neighborhood swimming pool, if there is parking, and proximity to parks.
    • Evaluate property-specific details such as where it is located, whether it has a privacy fence, available parking spots, square footage, and whether it is located on a cul-de-sac etc.

With so many factors at play, building a plan to capitalize on appreciation can be a challenging but rewarding undertaking.

Tax Considerations

The monthly profits from cash flow are subject to income taxes, and while depreciation can greatly reduce the impact, the taxes are still there. Gains from appreciation are not taxed unless you sell without using a 1031 tax exchange. When you refinance to receive your equity gains, you are not selling the property, hence, capital gain taxes are not triggered.

How can you incorporate this into your business plan? Appreciation can help guide your business plan to meet your goals. You might choose to reduce the taxes of your portfolio by adding a high-price point property that has lower cash flow and the potential for significant appreciation. For this scenario, your goal would be to reduce your effective tax rate to 0% without sacrificing the efficiency of your business.

Liquidity Considerations

Liquidity is simply how easy it is to convert an asset such as equity into cash. When buying for appreciation, the monthly cash flow tends to be lower or even in the negative. Which makes the funds not as readily available, unless you release the equity within the property by selling, refinancing, or using another loan product such as a HELOC. The monthly profits from cash flow are liquid, i.e., readily available to reinvest or utilize. The ease at which you can access equity mostly hinges on prevailing mortgage interest rates which is dependent on many factors outside of your control. For appreciation, the lack of liquidity represents a source of risk, which can be mitigated by having a plan.

When market conditions are not favorable, accessing your equity may be almost impossible. Even when conditions are favorable, tapping into your equity can take 1 to 2 months. In a high interest rate market, refinancing is rarely a viable option. If this is accompanied by a decrease in property value, your gains can completely disappear before you can access them. Moreover, selling the property as a solution becomes much more challenging because buyers need capital and capital is at a high interest rate. The result is fewer buyers which reduces demand which will over time reduce equity.

Liquidity also affects your compounded return on investment. For example, typical cash-on-cash return on investment (ROI) is around 8 to 10% and is a simple rate of return. However, these funds are readily available to pay bills and can be reinvested without any delay. By reinvesting these funds, you can achieve a compound return.

For equity gains, it can take a long time before these funds can be accessed. Hence, these funds cannot be counted on to pay bills, which is important if the properties you choose to target have low cash flow and high projected appreciation. Furthermore, the rate your net worth grows is directly dependent on the rate you reinvest your equity.

In Conclusion

Buying properties for appreciation is a complicated endeavor, and many times, is accompanied by less cash flow. The result is a riskier investment with substantial upside. How do you reduce the risk? By developing a plan and building your portfolio to minimize risk while still targeting appreciation.

To learn more, visit my website www.scottastanfield.com

If you have a topic that you would like to be covered or any questions, you can also reach me at scott@scottastanfield.com.

Thanks for reading.