One of the reasons that a rental property can be a great investment is that an investor not only earns returns from the rental income, but also earns a return from the property’s value appreciation over time. While the rental income is easier to track, the returns generated from the property value appreciation can be tougher to measure.
With rental income, investors receive regular cash deposits that are easy to quantify and track over time. If you spend $100,000 buying a rental property and receive $6,000 in rental income in a year you know that your annual cash yield was 6%. Pretty straightforward.
Estimating the gain from asset value appreciation can be much harder. Thats because the asset value appreciation will be an estimate based on what someone else is willing to pay for the property. And you don’t know how much someone will pay until you try to sell it!
Complicating things further, the amount a property has appreciated is actually different from the appreciation of the investment value! This is because most rental property investments (like Arrived’s) are financed with debt, which means that there is a loan on the property which magnifies the effect of appreciation on your investment returns.
In this article we’ll review why equity appreciation is different from property appreciation, and review the estimated appreciation for Arrived’s current properties.
Property Appreciation vs Equity Appreciation
First it’s important to understand the difference between property value and your investment equity value. The property value is the current market value of the entire property. The investment equity value is how much money your ownership in the property is worth.
Let’s assume you purchased a $300,000 home and you used a 50% loan from the bank to finance the purchase. Using a loan to finance the purchase means you don’t need as much cash to invest into the property. The home would be purchased with $150,000 from the bank and only $150,000 of your cash.
Using a loan also means that the financial returns from the property are leveraged and the investment returns are magnified.
Let’s look at two different scenarios using the same example where you buy a $300,000 property with a 50% loan.
If the property goes up 10% in value, then the property is now worth $330,000. The size of the bank loan is fixed and hasn’t changed – it’s still $150,000. The new value of your equity in the property is $180,000 ($330,000 – $150,000 = $180,000). That $180,000 of equity value – or your investment value – represents a 20% increase from the original investment of $150,000. This is incredible! The property value went up 10%, but the value of your equity investment is actually up 20%!
This incredible magnifying effect goes both ways. If the property value were to go down 10%, the investment would be worth 20% less. However since real estate values have tended to appreciate in the long-run, many people will take a long-term approach to real estate investing.
Even if values dip in the short term, the property can still generate cash flow if it’s leased. This is a huge reason why investors love real estate – the asset can still generate income even if the property value decreases temporarily.
Since the magnification effect of real estate debt is so strong, Arrived uses only a moderate amount of debt (55-70% of the purchase price) on our properties. Banks can be more aggressive in lending, and give buyers up to 85-95% loans on their properties. We believe that moderate debt is the right mix of upside potential while limiting downside exposure.
Valuing Your Investment Equity
Now that we reviewed the difference between property values and investment equity values, let’s talk about how to estimate changes to your investment equity.
The first step is to have an estimate of the property value. Many investors use 3rd party data sources like Zillow or Redfin to see the change in property values since their purchase.
Zillow and other sources are measuring the value of the property itself. Since the change in equity value is different from the change in property value because of the financing, we can use the below tables to estimate the change in equity value.
Let’s review some hypothetical values for The Soapstone from the table above. In this case the purchase price was $220,000 and the property has a 58.3% loan.
So how much is The Soapstone currently worth? Again it’s hard to know until the property is sold, but we can get some insights into the directional value. While it is just an estimate, the Zestimate for the Soapstone as of July 1st 2021 was $278,400 with a Zestimate range of $264,000 and $292,000. Below we talk through some investment returns at different potential values.
$275,000 – Let’s round down to $275,000 from the July 1st property value Zestimate of $278,400. Using the chart above, we can see that at a property value of $275,000, the equity in the home would be worth approximately $149,850, which represents a 50% gain. Because of the leverage on the property, a 25% gain in property value could equate to 50% gain in investment value!
$209,000 – On the flip side, if the property value dropped down to $209,000 from the $220,000 purchase price, then the change to the equity value is -16%. This is due to both the magnifying effect of leverage plus the initial real estate transaction costs.
Remember that the final appreciation can only be calculated after the property is actually sold. The table shows the estimated value of an Arrived investment at the different hypothetical changes in property value. Keep in mind that this value includes the cash reserves for the investment and that there are no selling costs factored in.
It’s important that real estate investors understand how rental income and property value appreciation both contribute to total investment returns. Given most rental property investments are made with some form of debt, that leverage magnifies the impact that property value changes will have on your investment return.