What is forced appreciation?
When discussing appreciation of healthcare real estate, like all commercial real estate, natural appreciation is distinguished from forced appreciation.
Natural appreciation occurs when rising market conditions result in rising rents or a valuation of the property that is higher than when the investor purchased it. Land can neither be created nor destroyed and although economic conditions may cause real estate prices to dip, over time, real estate tends to increase in price, or appreciate. The law of supply and demand controls natural appreciation. Because there is a fixed amount of land, over a long period of time, population growth results in an increase in demand for real estate thus contributing to rising real estate rents and valuation.
Forced Appreciation. In addition to natural market appreciation, investors can force appreciation of healthcare real estate—intentionally and proactively increasing the value of the property by increasing its net operating income. Net operating income is the income remaining after operating expenses are paid (and before debt service is paid). An increase in net operating income increases the value of the asset.
How to force appreciation?
An investor can force appreciation—increase the value of the asset— by increasing income or decreasing operating expenses. Depending on the asset, actions to increase income could include:
- Increasing rents upon lease expiration;
- Converting a gross lease into a NNN (triple net) lease;
- Leasing vacant space or rental units;
- Adding parking fees and charging extra for premium spaces;
- Adding a pet rent or fee (if a multi-family property);
- Installing coin or card-operated vending machines or laundry facilities;
- Converting unused space into rentable storage units or meeting space;
- Adding a co-working suite to unused space;
- Offering concierge-type services (e.g.— doggie daycare, housekeeping) negotiated at a lower bulk rate with the vendor;
- Executing strategic capital improvements.
Strategic capital improvements, such as renovating common areas, upgrading electrical systems or replacing dated infrastructure, may also lead to higher rent rates and thus increase the income of the property.
There are similarly various ways to reduce expenses. A thorough audit of a property’s expense statements over time will identify areas in which an investor can reduce expenses. These reductions could include, for example:
- Creating efficiencies in maintenance and management operations;
- Negotiating prices with service providers;
- Contesting property taxes;
- Reducing or regulating energy or water use (e.g., water conserving plumbing fixtures, energy-efficient HVAC equipment)
- Sourcing cheaper labor and supplies;
- Billing back utility costs to tenants.
How to forecast a property’s future value after forced appreciation?
So how do you calculate the property’s new value after you’ve forced its appreciation through value-added activities that resulted in an increase in net operating income? To do this calculation, we need to start with the following key terms:
Net operating income: As mentioned above, net operating income (NOI) is calculated by subtracting operating expenses from operating income. It does not include debt expenses.
Capitalization Rate (Cap Rate): A capitalization, or “cap,” rate is calculated by dividing a property’s net operating income by its sales price (value). This percentage measures the property’s performance. In other words, it estimates an investor’s return on investment at a moment in time. It is also a measure of risk: the higher the cap rate, the higher the risk. Investors can use a property’s cap rate to compare it to other investments.
Below is a very simple example.
Let’s say you purchased a medical outpatient building for $1,000,000, and the building produces $100,000 in net operating income a year. The cap rate for the building is calculated as follows:
Cap rate = NOI/Sales Price (Value)
$100,000/$1,000,000 = 10% Cap Rate
The cap rate for the building is 10%. As a sidenote, a 10% cap rate would generally be considered a high rate and this investment therefore carries more risk relative to one with a lower cap rate.
For simplicity’s sake, let’s stick with the same example to determine the property’s increase in value after you’ve forced appreciation.
Once you know the going cap rate for your property, you can determine the property’s new value after you’ve forced appreciation. By leasing some vacant space, increasing rents on expiring leases and adding parking spaces and fees, you’ve increased the building’s net operating income by $50,000. Using the same metrics from the cap rate formula, you would calculate your increase in value as follows:
Sales Price (Value) = NOI/Cap Rate
$150,000 (increased NOI after value-add activities)/10% (cap rate) = $1,500,000 (new value)
Increasing the medical building’s NOI by $50,000 increased its value $500,000 to $1,500,000. The increase in value makes this a good time to explore a disposition, even if you ultimately determine to hold the asset.