Calculating an Asset Value Escalation Rate
Updated: Feb 2
"The financial modeling of a potential real estate deal is only as good as the inputs used."
Calculating an Asset Value Escalation Rate
The financial modeling of a potential real estate deal is only as good as the inputs used. Most inputs are simple and tangible (i.e. rent rates, maintenance expense, financing costs, etc.). These factors are easy to incorporate into a financial model because they are readily available and are common business concepts.
In this post, however, we want to talk about the one modeling concept that is the least tangible and therefore one of the most difficult to project: the asset value escalation rate (which we will refer to as AVER). So what value should be used for an investor’s AVER? If it’s not entirely clear what is driving the change in current change in asset value then how is an investor supposed to make a bet on its future value? While there is a short list of items that will impact the AVER of any piece of real estate we would like to focus on three components: appreciation, inflation, and interest rates (obviously the first two have an inverse action (depreciation and deflation) but the stated forms have been more common lately).
For the purpose of this discussion we are going to define these components as follows:
Appreciation – An increase in value caused by local supply and demand factors.
Inflation – An increase in value caused by supply and demand factors on the US Dollar.
Interest Rate – The cost of money charged by a lender.
In order to calculate an AVER, let’s explore these three components further.
I think most of us intuitively refer to appreciation when we discuss how to model the future value of an asset. It is easier to connect to because the factors are move visible and local to a particular piece of real estate. Demand factors like population growth and business relocation announcements are published. The supply factors vary widely based on factors unique to a particular location but can still be distilled down to simple bets. For example, the supply of office buildings can increase in downtown Wichita much easier than it can in downtown San Francisco. Even with several moving parts, evaluating the future equilibrium point isn’t a daunting task.
Image 1: Do you remember this supply and demand graph from Econ 101?
Inflation on the other hand is more complicated. It’s based on the same supply and demand principles that we discussed with appreciation, but it’s one step removed. Instead of the supply and demand factors that directly affect your asset, it is the supply and demand factors on the US Dollar used to trade your asset. The variables that affect inflation are all subjective constructs. This is definitely not a space dictated by anything tangible. To avoid a headache, lets simplify the supply and demand factors of the US Dollar in this way. The supply is set by the Federal Reserve Board, and the demand is based on a global perception of trust. Inflation could therefore increase with additional supply provided by the Federal Reserve Board or a decrease in demand caused by a weakening global perception.
Lastly, we will evaluate interest rates. Interest rates play an important role because real estate is commonly traded as an investment rather than just as the utility that the real estate provides. Since interest rates are the price of money, they also serve as a hurdle rate for any investment. If an investment can yield a return higher than the interest rate then it is viable. If the return is lower than the interest rate then it will lose money (at least in nominal terms). Investors will therefore continue to push the returns of all investments down to the interest rate plus some implied risk premium. If interest rates increase, then investment real estate will lose value because it must clear a higher return threshold. Conversely, if interest rates decrease then investment real estate will increase in value since the hurdle rate is lower. Interest rates should be set with supply and demand forces, but the Federal Reserve has largely taken over as the decision maker.
Calculating the AVER
It is easy to get overwhelmed with all the variables in these three components. Layer in the fact that a lot of these factors are difficult to predict and it is no wonder most people either ignore them entirely or use a generic AVER. Although it can be a challenging task, we do think there is value in giving it some thought.
Before your next investment, give the below exercise a try. The table below encompasses the components that we have discussed. The most direct and local variables (appreciation and interest rates) are allowed a point scale of +/- 3, down to the least direct and vague variables (inflation rates) having a scale of +/- 1. Plug in your forecast for each component as it relates to the investment being analyzed. The summation of the five factors will give you an annual AVER.
We feel that the resulting number, alongside your hunches and insights that lead to this number should impact the immediate investment decision and future asset strategy.
Image 2: Here is an example of the Asset Value Escalation rate exercise described above.
The table above is also available in the Excel file attached to this post.
Disagree With Us
This article was written by the investment advisors at SNC Group. We understand that some investors may disagree with some of the definitions or interpretations that we have made. We welcome any discussion on this post. Please reach out to us at email@example.com to setup a time to discuss the factors you think affect AVER and your own investment goals.