The Price of Appreciation

[Dan DiFilippo]

Appreciation is not the most tangible or stable factor in real estate investing.  Its effects are varied throughout the different markets around the country and it is less concrete than cash-flow.  There are arguments to be made regarding appreciation as a result of half a century of sustained debt-based monetary expansion in concordance with demographics.  And how the coming end of that growth cycle is signaled by interest rates being at civilizational lows (even pre-COVID).  These are certainly legitimate arguments and I have made them myself on these forums.  And are worth any investor's comprehension.

However, I would like to review appreciation on a secular basis.  Because even on this level, I think the concept is sorely underappreciated.

Many people take appreciation for granted, but I would argue that there is a "price" that must be paid in order to "gain" an appreciation of value.  I will demonstrate using a breakdown of some capital-related costs.  Keep in mind, I operate in the Fayetteville area in North Carolina.  I will be using revenue and cost numbers that pertain to that market.

Assume a rental home worth roughly $100,000 that rents for $1,000/month (not uncommon here in Fayetteville). It may be a 3/2 around 1,250sqft. Not everyone agrees on how to even approach CapEx, but many investors will simply underwrite some 5% of gross receipts for CapEx. $50/month in this case. Let's see if this is enough. Major concerns will be HVAC, roof, flooring (especially carpet), and paint. HVAC might last 10-15 years. I tend to go with 12. Roof will maybe get you 20. Floors will probably need some redoing closer to 15 years out. And the walls will need a repaint every, maybe 10 as well. So what do we have in those cases? 12 years by a $6,000 HVAC installation. 20 year roof for $6,000. A mix of refloorings at an average $4/sqft all throughout the home over a 12 year period will cost $5,000. And then $2,500 to paint, figuring every 10 years.

Taken over 30 years, we are looking at $15,000 on HVAC, $9,000 on roofing, $10,000 on floors, and $7,500 on paint.  Or $41,500.  If you want your home to appreciate in value, you're going to have to pay this.  Otherwise you are leaving your home in a worse shape than you bought it in and it will fail to meet appreciation targets.  Almost $1,400 each year.  Just under 12% of gross rent.  This figure is reckonable and, I believe, under-accounted.

[Adam Schneider]

@Dan DiFilippo I'm glad you raised the issue of "under-appreciated" analysis of appreciation. When new investors talk about wanting to be Buy/Hold investors, I ask them why. It's important to understand the incentive for investing, and I think it generally breaks down into one of these buckets:

1. Expected Appreciation

2. Cash Flow

3. Equity or forced equity

4. Tax Strategy

5. (smaller group) Using and Earning income (beach property or kid is a student at college)

The different strategies will take the investor down different paths in terms of the ideal property and ideal geography.

On the appreciation topic, you peeled back the onion really nicely regarding the factor of the upkeep and expenses. The NPV (net present value) needs to be predicted alongside the assumptions of appreciation. 30 years is so far away (the last 6 months during CoVid feels like it has been 15 years)! If you ran your Fayetteville example at $100K at a 3% appreciation per year, your value is $242K. If the appreciation rate is 2% instead of 3%, that changes the value to $181K. In other words, a very narrow miss on the appreciation rate over a long time changes the equity by an incredible (roughly)$61K, or 25% miss. And, if inflation is tracking at the same rate as the appreciation, then the NPV is (obviously) impacted.

In Fayetteville, which until very recently hasn't been a big appreciation market (feel free to disagree if you see it differently), the topic of appreciation doesn't pop up much. But if you are in a big city with some incredible appreciation numbers....where it feels like people sometimes are playing with monopoly money...houses have appreciated by incredible amounts -- so much so that the CapEx piece of the equation is almost a rounding error.