When investing in rental income properties, two sources of income come into play in determining an investor’s total ROI (return on investment). One is the cash flow return on investment and the other is the appreciation rate of return. The cash flow is determined by total income from rents minus all expenses and the appreciate is determined by how much the property increases in market value over time. In many States throughout the Midwest and Central East a typical cash flow return might be 10-12% while the appreciation is only 2-3% creating a total ROI of 12-15%. In other States, especially the west coast and sunbelt areas, the cash flow return may be much lower such as 6-8%, but the appreciation can be as high as 5-15% annually, creating a ROI of 11-23% depending on the state of the economy in those states. These areas can also depreciate the same amount at times where the value of the properties drop dramatically.
Some investors are more interested in the cash flow return so that when house prices drop they still receive a good return on their investment. Other investors speculate on house prices going up rapidly and aren’t as concerned with the amount of cash flow return on investment from rents because they are banking on making a great deal from appreciation. This will be the case as long as prices are going up, but if the economy shifts and prices drop then those investors will not make out as well as investors who make sure the net rental income returns are healthy.
So, what effects appreciation rates in different areas. The simply answer is supply and demand. As more buyers move into a market place with the same amount of properties available, the prices will increase. When people hold off on buying and lots of homes are being manufactured, the prices will start to come down. Highly desirable areas, like sunbelt and coastal regions, attract more migration and higher demands when the economy in those areas is good and there are plenty of jobs. Smaller towns, with harsher weather, have less growth and can even decrease in population as people move out to find more pleasant environments. But these trends go in cycles with people moving to the fair weather States when prices are deflated and moving back out when prices become too expensive; opting for less pleasant weather as a trade-off for a lower cost of living.
Building trends also effect the economy. When large builders stop developing new subdivisions because of a stagnant economy, supply lessens and demand eventual catches up with it. Then as buyer’s confidence in the economy returns a buying frenzy can pursue driving the prices up rapidly in areas of high demand. The reverse also happens when builders start constructing massive subdivisions, adding a multitude of homes to the market, and the stock market drops or interest rate raise causing investors to become apprehensive of the future thus holding off on purchases. Then prices can drop rapidly because supply out paces demand.
So take appreciation into your financial scenario when determining the overall ROI of an investment, but remember that cash flow will continue pretty steadily in any area, whereas appreciate can fluctuate drastically in areas where it has a tendency to go way up or down.