If you’re like most investors starting out, you’ve run a few numbers and come up with an acceptable price, condition, and location for an investment property. The next step is to set up an internet search that emails you when these properties come available. Piece of cake. Now all you have to do is just sit back and wait for good deals to come your way, right?
Wrong. The problem with armchair investing is that everyone else is doing the same thing. We all use the same numbers, come to the same conclusions, and access the same software to do searches. In general, if it’s easy, more people will do it, increasing competition and driving down profitability.
This is why you need to consider investing in properties that do not look like good investments. Of course, you can’t just invest in any old property. You need to know what to look for.
Once you find a promising property to invest in, you need to focus on things that will allow you to increase the value of that property. Smart investors understand how to add value to an asset, therefore forcing appreciation.
What is forced appreciation?
Forced appreciation happens when the investor (you) controls the value of an investment property due to the increase in net operating income (NOI), which is the money your property generates. You increase NOI in one of two ways:
- Decrease your operating expenses
- Increase your rental income
Basically, forced appreciation is buying something that’s not a good real estate investment property and making it into a good investment. Armchair investors are not looking for or bidding on these homes, which reduces competition and increases profitability.
Now that we’ve defined forced appreciation, let’s compare it with natural appreciation.
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Natural appreciation vs. forced appreciation
Natural appreciation is fully dependent upon the market. Your investment property will not naturally appreciate unless the demand for property in your investment’s location goes up.
Although you have no control over the natural appreciation for your investment property, you could come up with a rough guess about the outcome by researching and watching the market. It is definitely a gamble, though.
On the other hand, forced appreciation is something you, the investor, can control. You can turn a larger profit with forced appreciation, and the process is much quicker than having to wait years and years for natural appreciation to possibly happen.
In short, natural appreciation is a long process and is risky because it is dependent upon the market, whereas forced appreciation allows the investor to have control over the amount of time and the increase in value on an investment property.
The benefits of forced appreciation
Let’s look at the following example of forced appreciation.
If you were to increase your monthly rental rates by $25 in a 100-unit property, and your capitalization rate, or cap rate (the expected rate of return on a real estate investment), was 6%, the value of your investment would increase by $500,000 in one year. In just four years, your property value would have increased by $2 million!
The increase in real estate value means better cash flow and tax advantages for you, the real estate investor. Forced appreciation is actually the number one way that real estate investors become millionaires.
Additionally, since armchair investors are not looking to bid on these investment properties, which are not considered great investments, you will have less competition.
Another benefit of forced appreciation is not waiting for multiple years to have your investment appreciate solely based on the (fluctuating) market. Instead, since you control the appreciation, your property appreciates quickly.
The drawbacks of forced appreciation
The main drawback of forced appreciation is that it’s typically a one-time benefit. You won’t see the bulk of the financial return until you sell the property. However, forced appreciation is not only limited to property value—as discussed—so it also could be seen in smaller increments based upon increased rental income.
Another drawback is the amount of time spent analyzing potential properties. Learning what works in your area takes a lot of boring analysis. But once you figure it out, you’ll be able to easily repeat the process or move on to finding other ways to force-appreciate properties. Very few people do this and miss out on great opportunities.
The third drawback is the required specialized knowledge of forced appreciation. Think of the cliché, pithy statement your parents would quote to you as a kid: “Money doesn’t grow on trees!” In this context, it means if you want to get a good return on your investments, you have to be willing to put in the effort and time when researching potential properties and their locations.
You have to account for the cost and time it takes to do the research. You will want to learn from real estate mentors and understand the intricacies of finding the right property for a forced appreciation investment. You don’t want to jump into this and learn as you go—that would most likely turn into a HUGE financial problem for you.
Now that you understand the good and bad of forced appreciation, let’s discuss the role of rental income.
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How to increase rental income through forced appreciation
At the beginning of your goal to force appreciation, you will want to start by increasing the rent of your properties. There are several solutions for making this happen.
Increasing the monthly rent
After a year, you want to look at increasing the monthly rent of a tenant. You will want to update your rent charges based upon the improvements you’ve made to the property and upon the relativity of the current market.
Look at the rates your competitors charge and adjust your rates accordingly. You don’t want to charge a rate that’s too high, obviously, because you would be stuck dealing with vacancies.
Minimize your vacancy rates
Keep in mind that the more you charge for rent, the more you are at risk for vacancies. It’s worse to have no income from a vacancy than too little amount of income from a lowered rate.
If you find your rates comparable to competitors in the area, you may just need to work on promoting your rental units. Potential renters may not know your property, especially if you renovated or restored a previous property.
You can use the internet to market your properties or perhaps place enticing advertisements around the community where potential renters are sure to see them.
Provide more living space
If you convert a basement or an attic into an additional rental unit, you could potentially bring in twice the amount of rental income. Additionally, if you make more spaces inside a unit by adding a bedroom within the larger, existing space, or converting a garage into additional living space, you could charge more rent for your unit. Features like carpet and drywall significantly increase rents as well.
Even if your square footage stays the same and you convert a one-bedroom apartment into a two-bedroom apartment, people will be willing to pay more rent to have an additional separate room.
You always want to have your renovations and additions checked by licensed professionals to ensure your spaces are up to code and considered legal.
First, make sure short-term leases are legal in your state and that the property is a good choice for an Airbnb-type rental. Once you’ve determined it is, make sure the property is in a prime location for attractions and positioned in an appealing neighborhood.
Airbnb rentals are great investments because, like a hotel, especially one located by attractions, you can charge much more rent per night than you would make from a monthly rental property.
While amping up your rental income is one way to generate forced appreciation, you can also increase your property value.
How to increase property value through forced appreciation
The best thing about forced appreciation is that you are not under time constraints or having to wait for your property to simply appreciate based upon the market. You can make additions or renovations to the property to increase its value, moving along at your own pace. Here are several modifications to consider.
Rather than squeezing an extra bedroom into a large, already existing space, you can consider just building onto your rental property. The increase in square footage makes your rental more valuable in the long run and allows you to increase your rental rates immediately.
In addition to bedrooms, you should consider adding more bathrooms to your property. Generally, people choose units that include multiple bathrooms as opposed to an option with just one. You especially want to consider this if your investment is located in a highly competitive area.
Curb appeal is another thing to consider. People rent and buy based on emotion. You don’t want their first impression of your unit to be disgust because it is covered in trash, weeds, junk cars, or chipped paint. You definitely want a fresh, clean look to impress.
Another option is to rehab a cheap duplex while living there and then increase rents. Multifamily properties are valued based on the income they generate. Not only will you increase rental income, but also property value.
Now that we’ve discussed some strategies for increasing your investment property’s value, let’s discuss how to determine your forced appreciation.
How to calculate forced appreciation
To figure out your forced appreciation, follow this formula:
Forced appreciation = Net operating income (NOI) / cap rate
You can calculate the cap rate through another mathematical formula:
Cap rate = NOI / current market value (CMV)
Cap rates are established by the other surrounding real estate properties in a particular geographic location relative to the amount of income generated by those properties.
Real estate properties in Seattle, for example, may have a low cap rate of 3% because buyers are willing to purchase properties that won’t have a good cash flow.
Typically, a good cap rate you want to look for before finalizing your investment is between 8% and 12%.
I know an investor who would almost exclusively buy large three-bedroom homes that had no chance of cash flow. She would then create two more bedrooms (moving walls or converting garages) and one more bathroom in the house. At an average price of $500 a room (college students) in our area, she was able to turn a breakeven house into a $1,000-a-month cash flow with no competition. She has been buying at least one home a year for over 20 years just on the income from forced appreciation.
If you can master forced appreciation in your area, you will be your only competition. Every property will become a potential investment.
What Is Forced Appreciation — And How Can Investors Use It? is written by Brett Lee for www.biggerpockets.com