Rental Property Café™ - Episode 14: What is Appreciation in Real Estate Investing and Does it Matter?
Real Estate CoachingIn this episode, Cynthia Meyer and Veronica Woods discuss what appreciation means for real estate investors and how to think about it in this market environment.
In this episode of the Rental Property Café™ Video Podcast they cover:
Takeaway Quotes:
“Use the worst case assumptions on the ARV and not the best case…you should know what the minimum is to make this a worthwhile project.” - Cynthia Meyer
“You shouldn’t be putting this current crazy market appreciation rate in your model. You should be adjusting it more to the normal appreciation for the area.” - Veronica Woods
About the Rental Property Café™
The Rental Property Café™ podcast offers a real estate tool kit for busy professionals who are building a real estate portfolio. In each episode, co-hosts Cynthia Meyer & Veronica Woods explore ways to grow a successful real estate business while growing your career.
☕ See more financial planning guidance for real estate investors from Cynthia Meyer on the Real Life Planning blog: https://reallifeplanning.com/blog
About Cynthia Meyer
Cynthia Meyer is a financial mentor, CERTIFIED FINANCIAL PLANNER™, CFA® Charterholder, real estate investor, blogger, and the founder of Real Life Planning. She offers unbiased financial planning and learning resources to real estate investors. Cynthia is a first-generation rental property owner, who built a rental property portfolio with her husband, Steve, while they were both building their careers. She lives in NJ, where she balances teenagers, her financial planning practice, and a rental property business.
About Veronica Woods
Veronica Woods of Daniel Woods Real Estate, real estate advisor and investor, is passionate about helping her clients create wealth, legacy, and lifestyle through real estate. She works with people to buy, sell, rent, and develop residential and small commercial real estate in Delaware County and Philadelphia, PA. An MBA in finance from the Wharton School, Veronica also shares her real estate wisdom with new investors on her YouTube channel.
Connect with Cynthia Meyer:
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- Email: cynthia@reallifeplanning.com
Connect with Veronica Woods of Daniel Woods Real Estate:
Transcript - Rental Property Café™ - Episode 14
[00:00:00] Cynthia Meyer: So what is appreciation in real estate and why does it matter? Hi, I'm Cynthia Meyer with Real Life Planning.
[00:00:06] Veronica Woods: I'm Veronica Woods of Daniel Woods Real Estate.
[00:00:08] Cynthia Meyer: And welcome to the Rental Property Café™. This is episode 14, where we're talking about appreciation and all things appreciation. That's a hot topic in real estate and sometimes a little bit controversial; people have different opinions about it.
[00:00:29] Cynthia Meyer: So today we're going to talk about adding value in your property; in the equity in the property, right? The potential sale value of the property. Veronica, what do people usually mean when they say appreciation?
[00:00:44] Veronica Woods: They're assuming that the prices always go up. So I guess, the simple definition is the pricing go up, but prices can go down.
So I think really this is a conversation about what is value and how...
[00:00:57] Cynthia Meyer: O.K. Good. I like that.
[00:00:58] Veronica Woods: ...assess the right value of the property and assuming that the price will go up, how should that price appreciation or raise in price over time? How does, how should that factor in your decision making about making investment?
[00:01:14] Cynthia Meyer: Yeah, because when people say appreciation, they don't always mean exactly the same thing when they're talking about it. So you're talking about the value of the property; maybe the value added for renovation. The value in a neighborhood becoming more desirable. My definition of appreciation has always been, where there are more buyers than sellers, right?
There's an increase in demand. There's also the natural price appreciation that comes with inflation, right? With the just general cost of everything going up. In your point of view what is the most important to you when you're working with investors and helping them set some expectations?
Now, if I put on my old appraiser hat and I thought I was an appraiser, but I've taken a number appraiser classes as a real estate broker; just something to keep in mind. The realtors that are a little bit more skilled in valuation tend to be either a real estate broker or somebody that has taken appraisal classes.
You can tell maybe how in depth the conversation, somebody will go about valuation just based on their skill set. It kind of comes onto like macro and micro trends. So there's things that you can do to the property to raise the value and then there's things that you, as an investor, have no control over. You don't have a control over if a Starbucks gets built down the street and all of a sudden, people with higher incomes move in. You don't necessarily also, Amazon moves in. So all of a sudden there's a huge demand for apartments. So you have no control over those things. But then the stuff with the property, like you mentioned, the value added, improvements you can make; you have control over that.
I tell people to kind of think about in those two buckets, in terms of, are you picking a location that you see signs that other people are helping the value go up or are there things that you can do as an investor to improve the individual property?
I really like that paradigm, that way of thinking about it, things you can control and things you can't control. And speaking of things you can't control, apparently my little dog is snoring very loudly in my feet. I'm wondering if you can hear him.
[00:03:23] Veronica Woods: I can't hear him.
[00:03:24] Cynthia Meyer: So, if he starts really loudly, I'll just pick him up and he can participate in the podcast.
[00:03:28] Veronica Woods: Okay.
[00:03:28] Cynthia Meyer: Where do real estate investors in your opinion, where do they go wrong when they're thinking about appreciation and the various components to creating value? I personally think that a lot of folks go wrong in setting overly optimistic expectations for increases in the real value of the property, right? Like after inflation value of the property. What's your take on it?
[00:03:53] Veronica Woods: It's interesting, you mentioned after inflation, I mean, up until a year or two ago, inflation, wasn't something that...
[00:04:00] Cynthia Meyer: It was almost nonexistent.
[00:04:01] Veronica Woods: It was nonexistent. It wasn't something a factor. But now, I would say it is. But the other point is, because we've had such a strong market, people are used to seeing double digit growth rate and prices and markets that maybe historically, maybe only grew four to 6%.
[00:04:18] Cynthia Meyer: Yeah.
[00:04:19] Veronica Woods: So I think wherever the benchmark is for the area, you shouldn't be putting this current crazy market appreciation rate in your model, you should be adjusting it more to the normal appreciation for the area.
[00:04:33] Cynthia Meyer: Yeah, so I remember when I first moved to California in the early 1990s, in the Bay Area, prices actually were just kind of lingering for a while and many real estate investors that I knew there were underwater on their buildings at the time. And of course now when we think of bay area prices, they've just gone gangbusters. I mean, it's probably 10 or 15 times higher than it was in 1992. But things don't always go up in a straight line, even if prices tend to appreciate consistently over time. And even if you've added value to the property...
[00:05:09] Veronica Woods: Yeah, I think it's just important to look at it over the long term as opposed to shorter term.
[00:05:15] Cynthia Meyer: Let's talk about the ways that people can add value to their particular property.
So the first is, I guess, would be buying something that needs a little love, putting that love or renovations into the property, whether they're minor or major renovations and the sale value of the property after those renovations. Because the investor was willing to take them on, the risk of making them themselves ends up being proportionally higher than the cost of the renovations.
Are there any ways that you see people doing that well and doing that badly?
[00:05:48] Veronica Woods: If you take on more than you can chew. It sounds nice that you buy low, you put money in it, and then you, the after repair value leaves you with $40,000 of equity, like that's built in equity is what you want to do.
Sometimes, building a project where you have to put so much into it and you don't have the skills or experience to do. People take a $20,000 budget and they end up spending $50,000 and they don't get that forced appreciation or they force the appreciation but now they're underwater with the amount of money they spent more than the project was actually worth.
[00:06:26] Cynthia Meyer: That they going to get in return.
[00:06:27] Veronica Woods: So chasing the ARV and if you overshoot it, the market or the appraiser is not going to reward you for, oh, you spent $10,000 over budget, we'll just kind of creep your valuation up $10,000. It doesn't work that way. So you have to really careful of keeping your costs below what the estimated after-repair value is going to be.
[00:06:51] Cynthia Meyer: I've definitely done renovations, but just renovate and rent. So I haven't renovated and sold. You can really hear the snoring now. I think I'm going to have to pick him up. Yeah.
[Cynthia & Veronica giggling]
When you look at like HGTV or the Magnolia Network or whatever, and people are doing these renovation shows, and there's always a little graphic at the end that said they bought the house for $200,000, they put a $100,000 worth of renovations, and then they hope to sell it for $400,000 or something like that.
A lot of times in these shows, there'll be this discussion amongst the flippers. They say, oh, I put in a hundred thousand, therefore I should get that back in the sales price and on TV, it always works out. But I'm guessing it doesn't work out in real life.
[00:07:36] Veronica Woods: No, yeah.
[00:07:37] Cynthia Meyer: Also on TV, there never seem to be any Realtor® costs, or the title costs or anything like that in the transaction.
[00:07:43] Veronica Woods: That's a blip to that a hundred thousand dollars they put in that house. I do also think a lot of times then we go back to location. So there's some locations where there's a little bit more wiggle room in the ARV for the appraiser.
A lot of times, a lot of those locations- that's part of the way that they were able to get by is that it was a really aggressive sales market; not that they did a great job managing their repair budget. But they kind of got saved.
[00:08:13] Cynthia Meyer: So they got saved by this like quick upward movement in prices locally.
[00:08:18] Veronica Woods: Right. So that's market timing, right? And that's never something that you want to go in counting on. You want to really look at solid comps and that's really the best way to kind of get a last six months of similar properties. I mean, so that's the best number to go in on now. Maybe there's upside. So let's say all your comps you see are at 250, maybe, you can get a little love 265, maybe 5 or 10,000 more, but I wouldn't stretch too far beyond that, or, wherever rough percentage it is because then you're just hoping, right? It's not really grounded by reality.
Then the other thing with multi-families. So the difference between single family comps and multi-family comps. The multi-family is a little more difficult because even if it's a small multi-family, it's just less sales for most areas and then the appraiser may have to go with a wider geographic boundary and it's just a little less science where if it's a neighborhood where there's 200 homes that look exactly alike, like you're not going to run past that sale last week, as far as thinking about the ARV.
[00:09:30] Cynthia Meyer: Yeah, no, probably not.
I know you've talked before, Veronica, about making sure that improvements match the neighborhood and the target renter, or in this case, if you're a buy and sell investor, right? The target purchaser/ buyer of the property.
If you're in kind of a middle income area and you decide to put in the Viking stove or something like that. You're not necessarily going to get that money back in the sale price. You might sell it more quickly, but you're not going to sell it for the cost of putting it in most likely.
I've also heard you say that, like, the listing agent of the property is selling the dream after-repair value, what does that mean?
[00:10:10] Veronica Woods: That's why I kind of mentioned the training that I have versus other Realtors®. A lot of realtors are a little nervous about the numbers, in general. They may do less kind of due diligence of comparable analysis to give insight. Really, it's a marketing thing because you list the price at what the value is today, but then if I'm working with a client, I'm working with a buyer and they want to know what do I think the after-repair value is?
I'm factoring that into our initial bid. Again, I want to make sure our buying costs plus acquisition costs isn't over what the after-repair value is and some just not familiar enough to give people that insight. As an investor, ask for the comps because they may not just give it to you. They're thinking about buying this house right now as opposed to what the potential could be after you renovate it. That's a different level of service or a different ask. And you just have to remember to ask that question.
[00:11:07] Cynthia Meyer: Yeah. And that also comes into play for for somebody who's trying to buy, renovate and rent; and then eventually refinance; the BRRRR strategy, if you will. Now we've had separate conversations about how it really is much more challenging to BRRRR in a rising rate environment because the numbers might not make sense at a higher interest rate to take equity out of the property; even if a lot of equity has been produced from the renovation. You always have to do the numbers, obviously. Along the lines of making sure you're not overestimating that after repair value. Do the same thing. If you're a BRRRR investor, if you're eventually going to refinance and take some equity out for your next project, right? Use the worst case assumptions on the ARV and not the best case, in my opinion, because if you get a better result in the sale, well, that's going to work out fine. But you know, you should know what the minimum is to make this a worthwhile project.
[00:12:03] Veronica Woods: Agreed. And yeah, I guess the likely case as well, I definitely wouldn't go with the best case...
[00:12:09] Cynthia Meyer: Yeah.
[00:12:10] Veronica Woods: I think looking at hard numbers, past comps, you can feel safe.
[00:12:15] Cynthia Meyer: You have some statistical evidence.
[00:12:16] Veronica Woods: The other tip would be as you're proceeding with your project and I've helped clients, have done my own BRRRRs, is constantly looking at the market.
So maybe you looked at the ARV when you purchased and then you kind of put your heads down and picked out floor tiles and stuff, but like you have to constantly be checking in with the market. So if you're planning to refinance, usually it's within six months, sometimes might be longer the nature of the project you need to like every few months, just kind of be checking the additional sales, just to see if you have new data that can give you a better estimate of what that ARV will be.
[00:12:53] Cynthia Meyer: In my business, working with real estate investors, I definitely work with more rental property owners, apartment owners, short term rental owners, et cetera, then flippers; then buy-and-sell investors. That's a job, right? To do that full time for a living.
But some people do take one on as a project or maybe they find that the rent isn't going to turn out to be all that attractive and so they decide to sell the property after the renovation. It seems to me that it's a really challenging environment right now. If you're not a skilled trades person or contractor of some kind, it's a really challenging environment to do a buy-and-sell strategy right now.
[00:13:28] Veronica Woods: Yeah. I would say that the labor affects the rent property investors too. If the property you're buying is empty and needs a lot of work, it's sitting vacant. It could be sitting vacant for six months until a tenant moved in. So it's kind of the same concept. Either you refinance into longer term debt. Whether you take money out or not, basically there's a different between short term loan and then your permanent financing with a tenant in there. If you can shorten that time and keep that budget, you originally said 20 really spent 20, so that efficiency and managing the budget really is important to either you're a flipper or a buy-and-hold investor.
[00:14:11] Cynthia Meyer: I always tell folks who are doing this for the first time, right? They're becoming real estate investors for the first time. And let's take, for example, the person who is buying another property, not a house hacker, right? Everything starts with cash flow. The property at a minimum should be marginally cash flow positive, right?
When you account for reserving for maintenance and capital expenditures, right? You should not start off cash flow negative, no matter how attractive the neighborhood is. What's your take on that?
[00:14:39] Veronica Woods: No. I agree with that. I do think what I hear from talking to clients; they're not sure what the right number is. Because they may hear people throwing out numbers in different circles, but they don't know if they paid all cash for it. So if you paid all cash, you're going to have a no debt service. You probably'll have a higher cash flow than somebody that is more leveraged, but that more leveraged person has more reserves. So who's better off overall? The person who kept their cash reserves and something happens, or the person who maximized their cash up front and then is left naked if something happens? So yeah...
[00:15:18] Cynthia Meyer: Sure. An appropriate amount of leverage can be the caffeine in the real estate investor's coffee. I don't know if that's a good analogy or not but it's the idea that it's a risk management tool, right?
[00:15:29] Veronica Woods: Exactly.
[00:15:30] Cynthia Meyer: If you take too much, it's risky, but if you don't take enough, that is also very risky. So let's just make the massive $100,000 in one property or a $25,000 down payment in four properties. And if everything's cash flowing, at least positively, even if it's not a huge amount of positive cash flow in this high rate environment, that reduces risk.
[00:15:51] Veronica Woods: And the other thing that we didn't mention, I did want to touch on the bank or the lender as a stakeholder in the value conversation.
So you can say you have an ARV. I've been kind of talking about appraisers, but the bank is usually hiring them on their behalf to make sure that they're loaning you the right money. Having that extra partner really can save you because you can't overpay in cash.
There's a lot of people buy a cheap house for cash but then can't afford to do the rehab or the rehab would take it over the after-repair value and then they end up doing part of the work and selling it. I see it on the MLS every day, a house that's like a shell & studs and they're selling it. What happened? They overestimated the ARV. That's probably what happened and they couldn't get a loan. They're asking somebody else to bail them out. That's what happens when you mess up on the ARV.
[00:16:45] Cynthia Meyer: Yeah. A good reminder to all of us. Every real estate investor needs liquidity and cash reserves. That is the financial tool that is going to help you through unexpected events, of that kind or other kinds.
In the whole history of real estate investing, what's more important cash flow or appreciation, or is it a draw?
[00:17:05] Veronica Woods: My answer is both. I think that people get into real estate investing because they know there's different ways to get benefits. There's tax benefits too and I think all them together are important. I do agree with what you said. I have heard some people on large podcasts say, "Hey, I'll go a little negative because of the neighborhood." But generally speaking, that's not really for, what I would call regular investors. It's really the fundamentals is that you want to at least cover your cash flow. There's whole loans around. There's debt coverage service ratio loans around; making sure that you are a little over like 1.25 is generally the threshold of between your net operating income and your debt service. So there is kind of like a healthy amount. It's not necessarily $500 a month, but there's kind of like a healthy amount that the bank would say, " This is a good deal." Which is why I was saying that the bank is another person at the table helping you think about is this a deal or not? If the numbers don't work for the bank, you're not getting the loan. So that should be a red flag. You shouldn't be like, Oh, if they're rejecting me, I'm going to go borrow money for my friends and we're going to pay cash." Like that probably would be a bad thing.
[00:18:21] Cynthia Meyer: The other thing I find people who hold highly appreciated properties. I find this a lot with clients in California, or in other highly appreciated urban areas like Boston, for example. Because of the demand for housing, prices have skyrocketed far beyond any other place in the country. People are sitting on possibly millions of dollars worth of appreciation, but their rental return is fairly low and they don't have a plan to monetize that. Their return on current assets is lagging because they haven't repositioned their portfolio over time. Appreciation can be a benefit in that, " Gosh, that property is really worth a lot more." If you wanted to refinance it and it takes some money out in a loan, you certainly could take out a lot more. In that situation, you have to monetize it in some way, you then to borrow against it, or maybe sell it in a 1031 Exchange.
Those are really hard decisions for people that have held on to these properties for a long time, maybe 20 years. They see them worth a lot of money, but they can't really get at it.
[00:19:18] Veronica Woods: I would say that equity, that is the definition of wealth, right? Just because you're not cashing out that is on your balance sheet. How I think about the cash flow conversation now is if the math works where you're kind of controlling your budget from acquisition to rehab. You're going in with equity, even if you don't take it, like that's wealth, like that's what we're in real estate for.
[00:19:42] Cynthia Meyer: Especially if you're going to pass it to the next generation. If you don't need to realize the appreciation meaning that you don't need to sell it or borrow again against that additional equity in order to pay your retirement cost, for example, there are lots of great ways to build generational wealth.
[00:19:59] Veronica Woods: And I was referring to you buy the property you automatically have equity. So that's just a trade off to lower cash flow but instant equity. That's another way I think about it. If I know I'm going to have instant equity based on what I see the neighborhood values, maybe I'm not planning to sell for X years, but knowing that in my head that I'm already coming out the gate after year one without equity makes me feel better about the investment.
[00:20:25] Cynthia Meyer: Yeah. So Veronica, anything else you would add to this brainstorm conversation about appreciation?
[00:20:31] Veronica Woods: The only thing that I would add that didn't come up is just thinking if you're just holding property and you're concerned about keeping your value and keeping your appreciation. You should also think about how you're raising your rents over time. Because if your rents are lagging, but you're like, "Hey, I always have the same tenant. They're long term tenants." But your rents are lagging that is a negative on how an appraiser will look at your property versus another . If the house next door is getting a thousand dollars more per month, let's say it's a multi-family in income, their property is going to be worth more than yours. So it's important...
[00:21:09] Cynthia Meyer: It's a more profitable business.
[00:21:11] Veronica Woods: Exactly. That income is a portion of creating value. The work on the house, getting people willing to pay more rent, is also creating value.
[00:21:21] Cynthia Meyer: And that's a really good way to slide into a heads up on our next conversation, which is about how to set the rent for your rental property. So, thank you so much for joining me in the Rental Property Café™ this morning. As always lots of wisdom from Veronica Woods. It was really great to talk to you.
[00:21:40] Veronica Woods: All right, same here.
[00:21:42] Cynthia Meyer: And for everybody else, please go ahead and subscribe to the video podcast on YouTube so you know when the next episode has come out. Feel free to share it and send us either on social or at podcast@reallifeplanning.com, send us some ideas about some topics that you'd like to hear.
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