With US house prices drastically on the rise in 2018, the term real estate appreciation is finding its way into every real estate investing discussion imaginable. Real estate appreciation is definitely something that you should take into consideration when buying investment property.
While you have probably heard many times that real estate appreciation is one of the major benefits of real estate investing, have you ever wondered how to calculate real estate appreciation? Do you know exactly what real estate appreciation is?
What Is Real Estate Appreciation?
Real estate appreciation is a simple concept. It refers to how the value of an investment property increases with time. This kind of natural real estate appreciation is a great (and not to mention effortless) way of making money in real estate and getting a good return on investment when you decide to sell the investment property. On the other hand, a real estate investor can also consider forced real estate appreciation. This is when the value of an investment property increases once repairs or renovations are carried out. Looking at these two types, real estate appreciation depends on not only the state of the local market but also any repairs done on the rental property.
Before looking at the actual formula for how to calculate real estate appreciation, it’s important to understand one of the major variables: the fair market value of a real estate investment property.
What Is Fair Market Value?
The fair market value of a rental property is the price that an investment property will sell for in the real estate market. The fair market value, by definition, depends on a few different factors:
- A real estate investor selling or buying investment property has the necessary knowledge about the potential real estate investment
- Each real estate investor is acting without pressure, for his/her own interest
- The real estate transaction occurs in a reasonable amount of time, allowing for due diligence and proper decision-making for both parties involved
These conditions, while possibly ideal, amount to the “fair” aspect of the fair market value of rental property. While some argue that these conditions are hard to account for in the market, a proper real estate market analysis will return the fair market value of a rental property. This will allow for an accurate calculation of real estate appreciation.
Real Estate Market Analysis
The fair market value of rental property is found through real estate market analysis (also known as comparative market analysis, CMA). This can be done either by a real estate investor or a real estate agent. Basically, at least 5 real estate comps are found in the location of the investment property. These investment properties need to be as similar to the investment property in question as possible. Using their prices in the market, the fair market value is found.
The easiest way to get a comparative market analysis done? Find real estate comps using Mashvisor’s investment property calculator. It can return different real estate comps in the same location as your investment property immediately as you are using the platform to search and analyze investment properties.
Fair Market Value vs. Market Value
Just to clear things up, fair market value is different from market value. The market value of an investment property is simply the price listed. It is easily found, but it doesn’t always represent the fair market value. Sometimes, an investment property is listed below market value; other times it is overpriced. This is why a comparative market analysis should be done to find the fair market value when selling or buying investment property.
Fair Market Value vs. Appraisal Value
Sometimes, the appraisal value of a rental property is used in place of the fair market value. This is the opinion of one appraiser on the fair market value. Usually, when institutions like banks or hard-money lenders look for the fair market value, they use a few different appraisers to get a more accurate fair market value.
How to Calculate Real Estate Appreciation
Now that you understand the basics of real estate appreciation and fair market value, it’s time to move on to how to calculate real estate appreciation. There are two steps to calculating real estate appreciation:
Future Growth= (1 + Annual Rate)^Years
The first step involves calculating future growth in the value of real estate by figuring out the annual rate. This is where you will have to do a little extra research. The annual rate of the real estate appreciation growth is easily available for the national market. The US house price index reveals that house prices have increased by 3.4% a year (since 1991). This is what we’ll be using for the sake of our example.
However, local real estate appreciation rates differ from the national rate. Zillow is one platform that can show you the predicted growth rate for at least one year (both for the national real estate market and any local market you choose). You can use those values if you choose or research even further for other platforms that offer predictions for more years into the future based on their real estate market data.
To the national annual rate (0.034), add 1. For the years, consider how many years you plan on holding onto the investment property. With this, you will have the future growth rate of value.
Future Value= (Future Growth) x (Current Fair Market Value)
Once you have the future growth, multiply it by the current fair market value from the real estate market analysis to see the future value of a real estate investment property
Comparative market analysis returned a fair market value of $150,000 on a potential investment property. A real estate investor plans to hold onto the rental property for 5 years before selling. Let’s see how much the future value of real estate will be thanks to appreciation:
Future Growth = (1 + 0.034)^5
Future Growth = 1.18
Future Value = (1.18) x (150,000)
Future Value = $177,000
In five years, the investment property will be worth approximately $177,000.
Finding Out the Value of Forced Real Estate Appreciation
As mentioned, there are two kinds of real estate appreciation: the one that occurs naturally over time; and the other which depends on repairs done on the investment property. For this, you will have to find the after-repair value. This is simply done with real estate market analysis. Look for real estate comps that have similar accommodations that you plan on adding in renovation and find out the fair market value which will be the after-repair value.
Related: How to Easily Find Real Estate Comps
Remember, Real Estate Appreciation Is Just an Estimation
Calculating real estate appreciation, while helpful when making real estate investing decisions, isn’t a real estate metric to completely rely on. Simply put, real estate appreciation is an estimation, a good estimation, but still just an estimation. No one can predict the future state of the real estate market or what exactly will happen to house prices. While looking at past market data can help us predict future trends, no one can predict the future!
Don’t Forget About Positive Cash Flow
Ultimately, a real estate investor should choose a rental property that has a positive cash flow as well as the potential for real estate appreciation. For instance, an investment property may have negative cash flow (and you have no positive cash flow properties to cover it) but reveals good real estate appreciation in the future. It may be a bad real estate investment if you have to hold onto it for many years to get a good return on investment.
When learning how to perform investment property analysis and real estate market analysis, take the extra step of learning how to calculate real estate appreciation. It’s easy and can provide you with further insight on what makes for the best real estate investments.
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