You may already be familiar with the concept of cash flow and the important role it plays in helping identify attractive commercial real estate investment opportunities. Positive cash flow means earning money now and on an ongoing basis throughout the life of your investment.
But while a steady cash flow sounds wonderful (it is) and may get the bulk of our attention, it’s not the only factor that you should consider. When evaluating investment properties, another critical factor investors must understand is appreciation — or the profit you can earn at the end of your investment upon disposition of the property.
In this article, we’ll dive further into what commercial real estate appreciation is, what influences it, and how to estimate it.
What is commercial real estate appreciation?
Real estate appreciation is the increase in the value of a property over time. You buy a property today and later on it’s worth more money than you paid for it.
Sounds pretty easy and appealing, right?
The problem is that, while real estate generally does appreciate over time, it’s not guaranteed. And, just as many factors determine your cash flow, appreciation is also affected by many different variables.
If you can understand these variables, there’s the potential for money to be made – with or without positive cash flow. For instance, you could lose money or just break even on rental income every month but then earn a large profit from appreciation upon sale of the property.
What influences appreciation?
One major factor that influences a property’s appreciation is the state of the national economy. Macroeconomic forces such as the employment rate, taxes, and interest rates have a strong impact on the income of many real estate buyers and sellers. These forces have a knock-on effect with property values.
The highs and lows of the economy are out of an investor’s control, and fluctuations are inevitable. However, history has shown that real estate tends to rise in value over time with less volatility than the stock market.
The property’s location is important too because the local economy and demand for real estate in that area will play a role, if not a bigger one, as well. For example, if many new jobs are being created in the area, housing demand could rise, and the real estate would gain value.
This means a savvy investor could take a property with neutral or even negative cash flow and turn a profit over time due to improvements in its surroundings. In fact, that’s a key aspect of our investment strategy at Birchstone Investments. We look for up-and-coming neighborhoods with strong potential for growth. Yet, while this is something investors can research and plan for, it still carries some inherent risk.
One factor that investors do have control over is the value gained by making improvements to a property. For example, say you own an apartment building. You can take all of your ordinary units and turn them into luxury housing (with features like high-class appliances, countertops, etc.). Now each unit would be able to demand more rent. And the higher rents will increase the property’s valuation and thus its appreciation.
Can you estimate appreciation?
While no one can predict a property’s appreciation rate with 100% accuracy, investors and investment firms can use historical data to estimate a reasonable figure.
In order to estimate appreciation within an acceptable range, you’ll need the knowledge to compare historical rates of property within the same class and pair that with an understanding of your local market’s rates and trends. Frankly, it’s not an easy task —there’s a great deal of quantitative analysis and qualitative reasoning that goes into building an accurate estimate.
Based on historical ranges for commercial real estate appreciation rates and taking into account both ups and downs in the market, a conservative number could be 3 to 4% each year. However, an optimistic range for a hot local market could be as high as 5 to 10% or more. Lastly, a 4% appreciation over a 3% rate may sound trivial, but it makes much more of a difference over 30 years than it does over 5 years.
For example, a 400,000 property at a 4% annual return would be worth $880,000 after 30 years. At a 3% appreciation, the same property would be worth $760,000 in the same time period, for a $120,000 difference.
Our advice on appreciation
While potential cash flow plays a role in commercial real estate returns, an investor must also take a property’s appreciation into account, especially if they will hold the property for an extended period of time.
Depending on your investment situation, such as the projected length of investment time and your working capital, appreciation might be a good reason to buy a property that’s lighter on cash flow, neutral, or even negative, depending on its projected higher value in the future.
It’s important to keep in mind that appreciation is only an estimation and doesn’t provide any guarantee of the future value of any real estate investment.
At Birchstone Investments, we seek out investment properties that strike the perfect balance between optimal cash flow and a strong potential for sizeable appreciation. If you’re looking for more information about appreciation and how it can help you make the most of your real estate investment dollars, or you want to discuss investment opportunities with us, get in touch with our team.