Article #3: "Four Elements of Return" for the Real Estate Investor

Topic: Third "Element of Return" for RE Investors--Equity Growth from Appreciation

Ok, so we have discussed the first two elements of return for real estate investors and now we are ready for the third element, “Equity growth from appreciation”.

Equity growth from appreciation results from two factors: (1) Inflation and (2) Demand

Inflation appreciation is the increase in a property’s value due to inflation. This is the same phenomenon you see in the supermarket prices. Prices of items tend to go up every year. This appreciation rate is related to the general inflationary rate of our overall economy; however it can differentiate based on the market. Two components make up the value of any piece of property: the structure itself and the land. Although land never wears out, structures do. Inflation affects the cost of both of these items, but this component of appreciation can be stagnant when it comes to the structure. This is because the structure is deteriorating (as 2X4s do over time) at the same time the property as a whole may be appreciating. Therefore, the factor that makes the biggest difference in inflationary appreciation is the value of the land itself.

To see how this can affect the increase in value on our Boardwalk property we will assume that the inflation rate is 2.5% and that there is no inflation for the structure because of the offsetting depreciation. The total value of our property is $220,000, the structure represents 80% of that value or $176,000 and the land’s value is $44,000. Therefore, our return on the land is $44,000 X 2.5% = $1,100. Remembering we had initially put down $30,000 as a down payment, so our appreciation return from inflation is: $1,100/30,000 = 3.6%

Our second component, Demand appreciation is related to four different economic principles. They are (1) Scarcity, (2) Transferability, (3) Utility, and (4) Demand. The combined effect of these four economic components pushes property values up at a greater rate in some areas while pushing values down in others. Let’s QUICKLY look at each component.

The scarcity principle can best be seen when comparing a metropolitan area with a rural area. There may be very little undeveloped land available in a metropolitan area whereas a rural area tends to have large amounts of vacant land. The greater availability of land makes it a lot easier to find willing sellers and lower prices.

Transferability refers to the ease of buying and selling a commodity. Unlike a stock or bond, real estate can’t be transferred as fast. This fact is usually related to the number of potential buyers and the ability-or lack thereof-to find adequate financing.

Utility refers to the usability of the property. The value of the property is directly related to its highest and best use. Therefore, apartments close to downtown or large employers have higher value.

Demand is the last economic principle that drives prices. Demand correlates to the upward desirability of the property. Demand can increase or decrease due to general trends in the economy. Many investors move from one investment vehicle to another based on the investment’s ability to produce a profit. When stocks are hot, their money is there. When real estate is moving, they start buying. This increase in demand for a limited supply causes the appreciation rate to increase.

**This is why the time is NOW to buy real estate..ahead of the recovery..and before prices begin to go higher!

Now, let’s figure out our DEMAND appreciation on our Boardwalk property. When we bought the property for $220,000 our rental income was $26,400. If we have higher demand for our units (driven by better management, upgrades, etc.) we can charge higher rental rates. If we raise the rents from $550 to $575 a month, our annual rental income becomes $27,600. Before, we had paid $220,000 for a property producing $26,400 or a “Gross Rent Multiplier” GRM of 8.33 (220,000/26,400). Now the property is worth $229,900 ($27,600 (new income) X 8.33 (GRM)= $229,900). This represents an increase of $9,900 after one year. Therefore our return from DEMAND appreciation is $9,900/$30,000 or 30%.

By adding the two components of return together: Inflation appreciation of 3.6% and Demand appreciation of 30% our Boardwalk property has earned a total return from “Equity growth from appreciation” of 33.6%!

To recap: We have now determined that our Boardwalk property will earn a return during the first year of: 4% from Cash flow, 1% from Loan reduction and now 33.6% from Equity appreciation…but we are NOT DONE yet, next month we will discuss the fourth and final component of return from real estate, TAX SHELTER BENEFITS.

Have a MERRY CHRISTMAS and Happy New YEAR,

BILL