Market Appreciation vs. Forced Appreciation and How They Contribute to CRE Returns

Commercial real estate investment returns come from two sources, income and price appreciation.  Income is derived from tenant rent payments and it is distributed periodically throughout the investment’s holding period. For the most part, it provides a stable, if not spectacular return for investors.

However, when steady income is combined with natural appreciation, investment returns can get a significant boost.  Price appreciation is the difference between a property’s purchase price and its sales price.  In a typical commercial real estate investment, there are two types of appreciation that can be potentially realized, market and forced.  In order to understand what they are and why they are important, it is first necessary to understand how commercial investment properties are valued.

How Are CRE Assets Valued?

Unlike residential real estate, which is valued based on comparable sales, commercial investment properties are valued based on the amount of Net Operating Income (NOI) they produce.  Net Operating Income is calculated as a property’s Gross Income less its operating expenses.

The majority of a commercial property’s Gross Income comes from the monthly rent paid by tenants, but there may be additional sources of income from things like late fees, pet rent, parking, or billboard rentals.

Operating expenses are the costs associated with running a property on a day to day basis.  They include things like real estate taxes, property management, insurance, utilities, and maintenance.

When operating expenses are subtracted from Gross Income, a capitalization rate (cap rate) is applied to the resulting Net Operating Income to create an estimate of a property’s market value.  

There are two important points to remember about Net Operating Income:  (1) The more there is, the higher the property’s value; and (2) there are two drivers of Net Operating Income, market dynamics and management practices.

What is Market Appreciation?

Market Appreciation happens when a property’s Net Operating Income or value rises due to “market forces.”

How Do Market Dynamics Contribute to Price Appreciation?

There are three ways that market dynamics can cause the value of a property to increase:  rising rents, lower cap rates, or both.

In a market with strong demand and a limited supply of rentable space, the laws of supply and demand dictate that rental prices will rise.  This is very favorable for property owners as it increases the amount of income that a property produces.  As long as expenses stay the same, Net Operating Income will rise in tandem.

A rental property’s capitalization rate is the expected rate of return assuming an all cash purchase.  Thus, when an investor is willing to accept a lower return, it means they are willing to pay more for a property.  Strong market demand and limited supply can also lead to declining cap rates, which is favorable for increased prices.  To illustrate how these concepts work, assume that a potential rental property produces $100,000 in Net Operating Income.   

In a market with strong demand, rising rents may cause Net Operating Income to increase to $110,000.  Assuming a 7% Cap Rate, the property’s value rises from ($100,000/7%) $1.42M to ($110,000/7%) $1.57M.  Another way to think about this change is that a $10,000 increase in NOI causes the property’s value to increase by ($10,000/7%) $142,857.  Breaking it down even further, every $1 increase in NOI causes the value to rise by $14.28.

Now, assume the same $100,000 in NOI, but strong market demand has caused market cap rates to go from 7% to 6%.  This means that the value would go from $1.42M to $1.66M without any change in NOI.

In an ideal situation, there is a combination of rising income and falling cap rates.  Imagine a scenario where a property’s NOI rises from $100,000 to $110,000 and the cap rate falls from 7% to 6%.  This means that the value would go from ($100,000/7%) $1.42M to ($110,000/6%) $1.83M.  This is a material change and can be a major contributor to an investment’s profits.

What is Forced Appreciation?  

“Forced” appreciation happens when a property’s Net Operating Income/value rises due to actions taken by the property owner/manager.

How Can a Property’s Value be Forced to Appreciate?

The valuation concept behind forced appreciation is the same – the goal is to increase net operating income – but the method used to get there is different.  Because a property owner has direct control over the operating budget, there are steps that they can take to “force” Net Operating Income to increase. 

On the income side of the ledger, a property owner could incorporate new fees for things like parking or they could simply lease vacant space to increase occupancy.  Or, and this is common in multifamily properties, they could convert unused space into storage units and charge to rent them.  Whatever the method, there are unique and creative ways that property owners can attempt to increase income.

In a typical commercial investment, the place that the property owner can have the most impact is on the expense side of the ledger.  An effort to reduce expenses typically includes a top down review of each expense line item to determine if there is an opportunity to reduce them without impacting the quality of the tenant experience.  For example, one of the things that we do at First National Realty Partners is to insource all property management activities.  Not only do we believe that we can do it better, this action serves to eliminate this line item on a property’s income statement, which immediately increases Net Operating Income, cash flow, and value.

The valuation example is the same as above.  Assume that a property has NOI of $100,000, but a number of steps are taken to reduce expenses, which causes NOI to rise to $110,000.  Assuming the same 7% cap rate, the value of the property would rise from $1.42M to $1.57M without any changes in rental rates or cap rates.  Forced appreciation is commonly overlooked as a major benefit of commercial real estate investing.

What Does FNRP Do To Maximize Both Forms of Appreciation?

The holy grail of commercial real estate investment returns is a combination of market appreciation and forced appreciation and we strive to accomplish this goal with each investment through several key tasks:

• Thorough market due diligence prior to selecting an asset, which includes a deep dive on the supply and demand of commercial retail space and a thorough review of historical absorption rates and rental price movements.
• Detailed review of a property’s historical income statements and identification of potential areas for costs savings.
• Analysis of the physical space to determine if there are opportunities for expansion.  For example, we may look to develop an outparcel on a property, which will produce additional rental income.

Through years of experience and dozens of transaction repetitions, we have developed a formula and investment strategy to identify the ideal conditions for both market appreciation and forced appreciation to deliver a strong return on investment.

Summary & Conclusions

Commercial real estate assets are valued based on the amount of Net Operating Income they produce.  Net Operating Income is calculated as a property’s Gross Rental Income minus its operating expenses.  The higher the Net Operating Income, the higher the property’s value.  There are two drivers of Net Operating Income, market forces and/or management practices.

In markets that have limited supply and/or strong demand, the natural result is rising rental prices.  These price increases impact the Income side of the NOI calculation and can improve it without any direct intervention from the property owner.

Or, a property owner can proactively take steps to “force” Net Operating Income to increase.  These steps could include things like:  implementing new fees, converting unused space into storage lockers, developing excess land, or cutting operating expenses.

In an ideal scenario, a property benefits from both market appreciation and forced appreciation to accelerate investor returns. 

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.