Real estate appreciation is the most profound way to create long-term wealth. Appreciation can take the form of market or forced appreciation. Market appreciation is driven by market forces such as job and population growth, the economy (think of what happened during the Great Recession), and other factors covered in Chapter 3 (Macro-Economic Trends and Conditions) of our eBook - More Doors, More Profits - which can be found here. These forces are controlled by the market and are outside the control of the sponsor.
Forced appreciation is within the control of the sponsor and occurs when the value is "forced" higher by increasing the income it produces via a value-add strategy. Forced appreciation provides benefits in all market conditions. For instance, if the market goes down, then the value of the asset would likely continue to stay flat. If the market is flat, then the value of the asset would still increase. If the market goes up, the value of the asset would increase more than other comparable assets.
It is necessary to highlight that the more investment returns are based on market appreciation, the less dependable the projected returns. Investment returns that are entirely or primarily based on forced appreciation, the more dependable the returns. Investment returns that are dependent on market appreciation occurring are relying on cap rate compression to transpire. For instance, if investors are willing to pay more in the future for the same stream of income, then the cap rate has compressed. In numeric form, this would look like:
If an asset's NOI of $500,000 remains unchanged, but the cap rate has moved from 8% to 7%, then the value of the asset has increased from $6,250,000 to $7,142,857. Because the NOI is unchanged, this appreciation was due to market appreciation. This investment yielded a 14% return on investment (ROI).
Passive investors should be careful when investing in a value-add strategy that is underwritten using a lower or compressed cap rate. Sponsors that are using conservative assumptions should be assuming a higher cap rate at the end of the projected hold period.
If the asset in the previous example is to undergo a proposed value-add strategy that is projected to increase the NOI from $500,000 to $600,000 with a cap rate of 8% AND cap rate expansion of 0.10% per year for a 5-year hold, then the value of the asset is projected to increase from $6,250,000 to $7,058,824. This yields a projected 13% ROI that is based entirely on forced appreciation and, therefore, this return is more dependable because it does not rely on any market appreciation to occur. In this scenario, the sponsor is in a position to over-deliver to the investors.