Appreciation is an increase in the value of an asset over time.

A property's value may increase for several reasons; supply, demand, interest rates, cap rates, and investor appetite.

Appreciation on single-family homes happens over time, dictated by supply and demand. It's averaged between 2 and 5% depending on the location since 1950 or so. This is a correlation between interest rates (which we'll talk about under "leverage" and "risks''), replacement cost, the desirability of the city, and just long-term inflation. The value isn't always tied to rental rates or income on homes. It's all about comparables and previous sales nearby.

Just because a home is worth X to everyone else doesn't mean it's worth X to you. You can house-hack, turn it into a short-term rental, furnish it well, market it well, and find other ways to increase income and make it worth more to you than an appraiser might say it's worth. But unfortunately, in the single-family home asset class, an appraiser doesn't look at how much money it makes; he or she looks at the local market and what everyone else is paying for similar properties.

Other asset classes (commercial) are valued based on how much money they make (NOI) and investor appetite (cap rates). If NOI increases and investor appetite remains the same, value increases. If NOI decreases and investor appetite remains the same, value decreases. 

I like this game. I can control NOI of my property and my business a lot easier than I can predict market trends in my neighborhood and what the guy down the street pays for his four-bedroom, three-bathroom house.

Sometimes investor appetite increases over time. I like to think of this phenomenon as "tailwinds". If a city is growing and people are moving in, all landowners are likely to prosper.

A huge tailwind, and the largest of them all, is the interest rates. If investors can borrow money and the interest rate on that money is lower, they can afford to pay more.

This increases appetite because the same NOI yields a larger cash return because the debt service is lower. We'll learn all about this in the "leverage" section of this course.

Unfortunately, we can't guess what interest rates will do. We don't know if they'll drop and our assets will get more valuable or they'll go up and our assets will get cheaper.

Cap rates are very closely linked to interest rates. When you can borrow at 3% interest rates a 5% cap rate isn't so bad. When you can borrow at 4% interest rates a 6% cap rate isn't so bad. When they go up to 8% you may not be able to pay any more than an 11 cap, and the value would go way down.

Sometimes investor appetite decreases over time. Think of malls in Cleveland. Cleveland was the fastest-growing city in America in 1910. Then the population got cut in half between 1920 and 1960. In this town, not only is the NOI likely going to drop as a result of supply and demand, but investor appetite also may decrease. Cap rates may go up from a 7 to a 9, meaning the same NOI is worth less money to an investor. This is an industry "headwind."

Now let's talk about NOI, or profit, and look at commercial real estate as we would any business. More profit -> more value. Less profit -> less value.

As a commercial real estate owner, you are running a business.

You have customers (tenants), and you have owners (you and your partners). You provide a service to your customers (giving them space to live or run their business or put their stuff). You are managing your expenses (utilities, property taxes, etc.).

Sometimes the expenses like utilities, taxes, insurance, and maintenance can be passed on to the tenant. This is called a NNN lease (triple net). In this type of lease, which is common in fast food, restaurant, industrial, office, medical, and many others, the tenants are responsible for paying all operating expenses on a property. 

Your primary variable in a NNN situation is leasing expenses and vacancy when calculating NOI. How much are you paying to get new tenants in? How are you doing it? How long is the property vacant until you fill it with tenants? How long are the leases? What is turnover like?

All of those things go into operating industrial and these other types of real estate. Even NNN type real estate can have operational advantages and disadvantages. Who manages the property?

Let's use a 200,000 square feet industrial warehouse as an example. If you follow @fortworthchris on Twitter, you will have a little familiarity with the asset class. He runs an industrial portfolio in Dallas / Fort Worth. 

They self-manage, which means they manage their own properties. The other option, of course, is to hire a management company to manage your real estate. This is true passive investing. You sit back and get reports and cash checks (if things go well).

So back to Chris's industrial warehouse. There may be 20 tenants in a 200,000 SF warehouse, each leasing an average of 10,000 SF on a NNN basis. It takes a lot of work to keep up with the turnover in a business like this. You have to cash rent checks, get new tenants, negotiate contracts, pay bills, pass them along to tenants, etc. An entire business is built around maintaining the property, repairing it, and building it out, so it works for certain tenants. Chris's company does that, too!

These things are opportunities for Chris to do things better and gain a competitive advantage and (you guessed it) increase NOI and make his building worth more.

A lot goes into this stuff!

In an asset class like multifamily (if you follow @moseskagan on Twitter), you have a property management company as well. They deal with tenant requests, maintenance, remodeling, leasing, and more. They do the work and act as an intermediary between the tenant and the owner. They answer questions, pay bills for the owner, and give the owner a report every month.

Moses self-manages as well because (you guessed it) it is an opportunity for him to create a competitive advantage for himself. His company is good at remodeling buildings, leasing units for a great price, minimizing vacancy, and doing maintenance.

A management company is generally a different company than the LLC that holds the real estate. The real estate LLC generally signs a management agreement with the other (branded) management company LLC. They can often have different owners. Most of the time, the management company, even if it's a "self-managed" property like mine, Moses's, or Chris's, charges management fees to the property-owning entity.

As you grow and scale, self-managing gets more and more attractive. This is because you have data, a brand, and can grow your competitive advantages. Suppose you know more about the market than other landlords. In that case, you can maximize revenue and minimize expenses and (you guessed it) maximize NOI.

It's all about NOI.