Understanding Appreciation

Think of appreciation as the paper profits in real estate. Your profits exist only on paper--in this case, your deed - until you actually sell the house. If you buy a house in a rapidly appreciating area, there is no guarantee that property values will be the same or higher when it comes time to sell. The economy may sour or your neighborhood may lose its luster. If you buy at the height of an upswing when demand drives up prices, you may overpay. Just like in the stock market, the flip side of boom is bust, or at least correction. If you overpay and prices settle out 10 percent lower down the road, you may not recoup all of your investment. Appreciation is nice to have, but not what you should bank on when you buy or sell a house.

TIP: If you buy when demand is driving prices up, try to make your offer more favorable in ways other than price, such as offering to close early or reducing the number of contingencies. Be prepared to examine houses more rigorously the first time around so you'll be comfortable submitting an offer quickly, if you have to.

The Cause and Effect of Appreciation - Almost every aspect of the national economy affects real estate appreciation: employment levels, business climate, housing supply and demand, affordability and of course, interest rates. A healthy economy and low interest rates drive demand, which pushes up prices and appreciation. Regional economic changes come into play as well, at times causing housing prices to see-saw up and down.

Demographics play a significant role, too. In the 1980s, housing demand soared as the huge number of people born in the 1940s and '50s hit the market. Prices went up and many areas experienced appreciation that was greater than the rate of inflation, making real estate a profitable investment. As this group has settled into homeownership, lower demand in many areas has slowed appreciation to below inflation, making real estate less profitable than other kinds of investments such as mutual funds.

Understand the role of appreciation in your market and in the neighborhood where you want to buy:

• Look at recent sales. - CMA or an informal list of recent sales in the neighborhood. Then get a comparative market analysis from your agent or go through public records at the tax assessor's office. You should be able to get a feel for sales volume, price direction and whether final sales prices exceed asking prices (a sure sign of a hot, appreciating market).
• Pay attention to local business news.
• Monitor reported real estate trends, but also find out about new industries coming to your area or other economic changes that may dramatically affect housing supply and demand.
• Know the neighborhood.
  Research the recent appreciation history of the area where you want to buy. Have prices risen steadily, see-sawed up and down, or been stable over the years? Historically, has the neighborhood been desirable, either because of its amenities or its affordability?
• Is there a lot of new development nearby?
  A sudden glut in the supply of new housing can lower property values in existing areas.

Buying on the Upswing - If you think about buying in a rapidly appreciating area, weigh your decision carefully. Decide if you should rent or buy by calculating the after-tax cost of renting, and comparing it with the after-tax cost of owning over five years. Renting may pencil out as the better bargain for now.

If you decide to buy:

• Buy only as much house as you need.
  The bigger the house, the greater the proportion you may overpay. If you have cash left over from your down payment, invest it elsewhere.
• Avoid a low-down-payment mortgage.
  If property values drop and you have to sell, you may not have enough equity in the house to pay off the mortgage and the selling costs, much less get any cash out.

The Bottom Line - Many experts advise buyers to consider appreciation a bonus, not a sure thing. Buy a reasonably priced house in a stable and likeable neighborhood, invest in home improvements that add value (not eccentricity), and you're more likely to get your money back when you sell. You may even make a profit, especially if you avoid buying when the market is overheated. Just don't plan to retire on the profits when you sell.