Real estate holds multiple, very powerful financial perks. Not only does the value of real estate often appreciate over time, it can be used to produce income and can be depreciated to lower your tax bill when using it for rentals. Let’s look at appreciation in greater detail below.
What is Appreciation?
What does it mean for real estate to appreciate? In short, it means it grows in value over time. If someone buys a home for $100,000, and then sells it many years later for $250,000, that house has appreciated $150,000.
The extra appreciated value is typically yours to keep. You can tap into it through a loan or by selling the property. Buying a property under market value can create some instant “appreciation” on the property as well, since the property’s value will be greater than what you bought it for.
Appreciation can be a bit hard to control, but it can take an investment to the next level. Some real estate investor, namely flippers, rely almost solely on appreciation because of how powerful it can be.
What Causes Appreciation?
How does someone earn appreciation? This is impossible to guarantee, but there are a few things that usually drive appreciation on a property. Some are rather controllable, others are more a result of broader economic or market factors.
Forced Appreciation
Forced appreciation refers to the value added to a property from making improvements to it. Successful rehabs and renovations can be used to effectively drive the value of the property up.
A common example would be buying a rental property that has not been updated in many years. An investor can pour money and labor into the property to raise rents up to market value. This increase in rents and the quality of the units will help to drive the building’s price up.
In certain cases, changing the zoning restrictions can help drive appreciation on a plot of land. For example, if you buy some vacant land right next to a planned state-of-the-art shopping center development which is currently zoned for industrial, and if you successfully change it to, say, multi-family, you may see a spike in the land’s price. People are going to want to live next to the new development, so you drive the value of the property up by getting the local government to change what the land can be used for.
Unfortunately, trying to force appreciation can be very expensive, and sometimes unsuccessful. It is important to understand what exactly your market is looking for so you can provide what it wants, rather than simple doing a needlessly expensive project that does not bear fruit.
Even if your attempts to force appreciation do not work, real estate tends to go up in value over time through general market appreciation.
Market Appreciation
There are many economic forces influencing market appreciation on real estate. Here are a few notable factors:
- The neighborhood around a home becomes nicer and more expensive
- Rent increases in an area so rental properties become more valuable for owners
- Population increases in an area but less new units are made to offset the growth
- The law changes to where certain areas are no longer allowed to be redeveloped or existing structures are somehow protected
All of these factors driving appreciation have to do with supply and demand. When more people want to live in an area, housing costs in that area increase. People can increase demand by making their current supply nicer and more desirable, like by making renovations. If the supply does not change at the same time, but quantity demanded keeps increasing, then price is sure to keep increasing.
As you can assume, as more people force appreciation on their properties through renovations, the area becomes more desirable as whole, typically. Prices everywhere start to appreciate as consumer demand to live in the area also increases.
Since there is only so much land to go around, and an ever-increasing population, appreciation is usually likely for real estate over the long run. Likely, but not guaranteed. Each geographical is different, after all, which can lead to significantly different results for investors.
Appreciation is Never Guaranteed
As as with any investment, betting on appreciation in the short run is a very dangerous ordeal. Make sure that you are willing to handle the short-term risks and possible costs associated with something not appreciating. If you can’t handle these risks, you probably should not make the investment.
Many investors describe appreciation as the “icing on the cake,” while income is their primary goal of investing. This is probably the best approach to take, at least over the short-term. Market forces can change for the worse quite quickly, and, without having a consistent income outlook on a property, hoping for appreciation will not be reliable enough to save the deal.
The Advantages of Appreciation
But, when a property does appreciate, an investor has more flexibility.
Not only can the investor refinance or take out additional debt on the property, perhaps through a HELOC or equity loan, he or she can also sell the property for a profit. In either case, the extra funds can be used to invest in other projects, including more real estate deals!
When investing in real estate, have a plan for as to what to do if the property appreciates significantly. Also have a plan for as to what to do if the property decreases in value. In either case, you may find that the answer is usually to hold the investment for the long haul as you continue to pay down the mortgage, bring in cash flow, and enjoy the tax benefits. Either way, be sure to consult a licensed financial professional if you are unsure of what to do.
Conclusion
Appreciation is one of the three main perks of investing in real estate. While property values usually appreciate on their own over the long-term, investors can force appreciation on their properties through renovations, zoning changes, and other updates to their buildings.
Appreciation, in any scenario, is never guaranteed. That said, it can, and often is, a massive benefit to investing in real estate, at least in the long run. When combined with the income potential and tax benefits that come with owning real estate, an investor can enjoy the full power of real estate investing.