The Roles of Inflation & Appreciation in Buy & Hold Income

When most people think about building wealth, they envision putting money in their savings accounts or adding to their 401Ks. I think that’s awesome, but it’s slow and won’t get you very far. Let’s look at why, then we’ll get into the benefits of appreciation and how it can help you get farther in buy and hold real estate.

Inflation

The problem with any investment strategy is inflation. In the U.S. inflation (decrease in the value of money over time) has averaged about 3.2% a year since 1913. This means for every dollar you save, you lose about 3.2% of its buying power every year. Well, what if your bank gives you interest? The average savings account will give you a 0.06% return, which leaves you with a loss of 3.14% a year. You could invest in a 5-year certificate of deposit at 2% and lose 1.2% a year. If you have a 401K, you can expect more in the 6-7% yearly return over time. Now we’re getting somewhere. If you made 7% a year, you would make 3.8% above appreciation so it’s actually growing over time.

While investment accounts can give you a good return, you only get a return on what you put in. No leverage. For example, let’s say you drop $50,000 (no monthly additions) into a 401K for 20 years. At a 7% return, you would end up with $193,000. If you take into account appreciation loss over time, you would have made $105,000 in today’s dollar value or a little over double the initial investment. Can we do better than this? Absolutely.

Rich people are rich because they look at money very differently. Instead of seeing money as something you earn, save and put into retirement accounts, they try to create it from thin air. Let’s look at how that works.

In real estate if you put 15% down to buy a property, you get a return not only on that 15% but also the other 85% because of appreciation. Let’s use the $50,000 401K investment example above. Let’s say you put 15% down ($50,000) on a $330,000 investment property and appreciation stays at 5% (2% less than the 401K) for 20 years. Your property would be worth $876,000. If you include inflation loss, you will be left with a $471,000 property in today’s dollar value. With the same amount of money as was put into the 401K example above, you will have made almost five times as much return.

Appreciation in Real Estate

Most new investors value property in terms of cash flow (cap rates and gross rent multipliers) and stop there. Cash flow is getting the car started; appreciation is how much gas you have in the tank. Appreciation is the interest rate on your investment and is one of the three pieces of buy and hold income:

Loan pay down
Cash flow
Appreciation

Example 1: Good Appreciation

A $330,000 home at 5% appreciation over 20 years = $876,000.

Subtract inflation and the value of the home in today’s dollars will be $471,000.

Appreciation gain in today’s dollar value over time = $471,000 – $330,000= $141,000.

Example 2: Low Appreciation

A $330,000 home at 3.2% (equals inflation) appreciation over 20 years = $619,000.

Subtract inflation and the value of the home in today’s dollars will be = $330,000.

Appreciation gain in today’s dollar value over time = $330,000 – $330,000 = $0.

In the above scenario, an increase in appreciation of only 1.8% left the owner of the more highly appreciating house with $141,000 more than the same house in an area with lower appreciation. Let’s say you averaged $500 a month cash flow over 20 years on both houses. That would be worth $120,000 or less than what appreciation brought in. Appreciation can be a huge factor in determining the worth of your investment over time.

If you remember one thing from this article: always check inflation to see how it might impact your investment decisions over time. It’s just one more tool to help you get to where you want to be.

Einstein said it best: “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

Location and Appreciation

If you look at data from all over the U.S., you’ll notice that coastal states tend to appreciate faster than inland states, cities appreciate faster than rural areas and the west coast appreciated faster than any other area of the U.S. in the past 25 years. Grant Cardone, who has amassed over $350,000,000 in real estate, suggests investing in democratic voting areas because people living there are willing to pay more for homes/rents, and they don’t like new construction, which creates higher demand and drives values up.

Areas with higher appreciation come with a higher increase in rental rates because high appreciation is caused by low supply and high demand. I’ll admit finding something that cash flows in high appreciation areas can be impossible.

The ideal way to go about this is to find areas that are still somewhat cheap but will increase in appreciation over time. These places have all of the features that drive appreciation in your area. If you don’t know what I’m talking about, call a real estate agent and ask where they think prices are going to go up in the future and why. Leverage that knowledge from someone who does real estate for a living. Another option is to get a copy of the city’s general plan and see where they think growth will be. That’s where you want to be.

Did you take appreciation into account when choosing where to invest?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.