How To Decide Between An Appreciation Or Cash Flow Investment
When putting together an investment strategy, real estate investors often debate whether it’s more beneficial to focus on cash flow or appreciation. Obviously, the goal of investing is to make money, but how you make money matters. While there are benefits to each, in my opinion, new investors should focus on cash flow opportunities first. That’s because I strongly believe it can help meet your number one goal — whether it’s financial freedom or something else. When you invest for cash flow, such as turnkey rental properties, you’ll be one step closer to reaching that goal. Despite my preference, both methods are valid investment strategies and each have their own set of compromises. What I mean is that the more you focus on appreciation, the less cash flow you can expect. The reverse is also true. There are several distinct ways that each strategy will help you achieve your financial goals.
When you invest for appreciation in real estate, you are buying and holding a property that you think will increase in value over time. This appreciation strategy is often found in high-demand markets, such as San Francisco or New York. Most of the time, investors would buy a property, renovate, refinance it and then rent it out. These investments typically produce low to negative cash flow. Negative cash flow means that an investor must be willing to put in additional cash every month to stay afloat. To avoid negative cash flow, investors can increase their down payment to reduce mortgage payments. The return is typically low because of the amount of initial investment required to acquire, renovate and bring the property into positive cash flow. When it comes to an appreciation strategy, the hope is that the value of the investment property will continue to increase over time, but this appreciation is not realized until you extract it through selling or refinancing. A market crash, a pandemic or other economic forces could take away the unrealized appreciation. How do you convert that additional equity into a stream of income? If you continue to hold the property, the cash flow should improve, but the return on equity will decrease. This means as you continue to own the property, the rent will increase but the mortgage will remain the same — which will improve your net cash flow. During that time your equity is also increasing due to principal paydown and appreciation, which in turn will reduce your return on equity. Refinancing will negatively impact the cash flow. The other option is to sell and purchase a property with cash flow.
A cash flowing investment is an investment where the revenues cover all expenses — mortgage, insurance, property management and more. The revenues also typically provide leftover money at the end of each month. These opportunities are typically found in markets with sustainable growth where the demand for real estate is balanced. Some examples include the midwestern and southern regions of the U.S.
When you invest in a cash flowing property, you are sacrificing some of the appreciation in exchange for net cash flow. These properties still appreciate over time but typically not as fast as properties in an appreciation market. The returns vary, but I’ve seen investors I work with receiving around 15% in cash returns — after financing. After a few years, the property still has positive cash flow and has accumulated some equity due to mortgage pay down and appreciation. At this point, you can extract the equity and add to your portfolio or simply continue to hold. A cash flowing strategy is great for those who want to focus on achieving specific financial goals. If you’re looking to cut back on your work hours or retire altogether, a cash flow strategy can be a beneficial one. You’ll be receiving cash every month, which allows you to easily measure how close you are to your goal.
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When deciding which strategy is right for you, it’s important to note the major differences between rentals with cash flow and appreciating properties. Appreciation is more speculative since the value is completely dependent on the market whereas rentals can be more stable because tenants tend to stay in your unit and pay rent. I often compare investing for the appreciation to investing in the stock market. If you bought a stock today, you hope that by the time you need the invested money and returns — retirement age, large purchase, etc. — the stock will be worth more than what you paid for it. While there are certain factors you can evaluate before you invest in a specific stock, there’s no way to guarantee that the value of the said stock will be higher 10 years from now.
Why would someone invest for appreciation, then? This is a great strategy for building multigenerational wealth after you have reached financial independence. Another reason is the tax advantages. For instance, if someone has a significant amount of money saved and doesn’t want to keep it in their savings account or invest in the stock market, he or she may take that money and invest it in real estate. This way the gains from appreciation are not taxable. With 1031 exchanges, you can use the appreciation to buy another property and defer capital gains tax indefinitely. That being said, appreciation is not a guarantee, and in order to enjoy the benefits of appreciation, you will need to either sell your property or refinance it at some point.
Investing for cash flow is ideal for those who need a stream of income to retire and be financially independent. Additionally, cash flowing investments make it easier for you to plan your future, as you’ll be able to track your progress based on the passive income you are receiving every month. Cashflow investments enjoy the same tax benefits that appreciation investments do, but cash-flowing properties help pay for themselves during ownership and can have higher returns.
The decision of whether to invest for appreciation or for cash flow is one that will forever be debated by investors of all kinds. However, before you decide which strategy to implement, it’s important to evaluate your personal goals. As mentioned above, focusing on a cash flowing strategy is often the ideal way to achieve your goals — including financial freedom.
Cash Flow vs. Appreciation: What Experienced Real Estate Investors Know
It’s an age-old question: cash flow vs. appreciation, which is more important when it comes to real estate investing?
The truth is, the answer to this question requires that we first take a deep dive into each of these terms to understand their functions.
In this article, we’ll explain cash flow, appreciation and what experienced real estate investors know about these that makes them successful.
What is Appreciation in Real Estate?
Appreciation in real estate can be described as the increase in a property’s value over time.
How much a property appreciates depends on several factors including the local real estate market and any improvements made to the property.
Why is Appreciation Important?
Equity is a primary driver of wealth, and appreciation is the vehicle that gets us there. When your real estate investments appreciate, your equity grows along with your wealth. Equity appreciation can make you rich in the long-term and sets you up with options, including:
- The ability to re-leverage your properties and invest the cash to expand your asset base.
- The ability to sell off your properties and exchange that equity for larger assets.
- The ability to sell off your properties, retire and leave behind some money for your children and grandchildren.
When you have assets on-hand like rental properties, these are the three basic available options real estate investors utilize to create more wealth.
What is Cash Flow in Real Estate?
In real estate, cash flow is the difference between a property’s income and expenses. You are said to have “positive cash flow” when you subtract your property’s expenses from the income it provides and are left with a profit. You have “negative cash flow” when the expenses are more than the profit. Most real estate investors aim at owning properties that have a positive cash flow.
Why Is Cash Flow Important?
Cash flow is important because it allows you to take your assets and hold on to them long enough for their value to appreciate. While appreciation takes time, you can eventually take advantage of the three options previously discussed.
However, there are things you can do to add value to your strategy and speed up the process. While implementing a successful plan of action takes time, it can be worth it in the long run.
Once you have accumulated a certain level of wealth, the time paradigm can be reversed so that it actually becomes beneficial to you. After reaching this critical point, the value of your cash flow is such that any additional appreciation isn’t necessarily beneficial. Until you reach this point, the main purpose of cash flow is to help keep you afloat. It allows you to essentially buy time while your assets appreciate.
How to Calculate Cash Flow
In order to know if a rental property is a good investment, you can calculate the cash flow in three simple steps.
- Determine the gross income from the rental property.
- Subtract all expenses pertaining to the property.
- Subtract any debt associated with the property such as mortgage payments.
With these three steps, you should be able to calculate an estimated cash flow for your property and determine if it will provide a positive or negative cash flow. Keep in mind, this may not always be accurate as there can always be unexpected expenses when owning a property.
Here’s What Advanced Investors Pay Attention To The Most
Big-time investors usually aren’t concerned about cash flow or appreciation on an investment property. Instead, they tend to focus on the IRR or internal rate of return.
The internal rate of return (IRR) helps real estate investors determine how much they can generate in real wealth with a particular investment.
There are several reasons that they focus primarily on this metric, but the overarching message is that major investors aren’t worried about stand-alone income. The individuals that fall into this category have lots of money to spend. They are usually entrepreneurs, accomplished professionals, and investors who are most concerned about engaging in wealth-building activities – not just those that generate income.
The IRR tracks all of the various cash flow streams. But to accomplish this, you must also project the ending and all intermediary exits that could exist for the capital. This is important since any sales or refinancing of the assets will generate a large cash flow event within the investment cycle.
More novice investors will see a long-term hold as just another way to generate long-term cash flow. However, experienced investors know they can generate hundreds of thousands, maybe even millions of dollars in wealth, by actually liquefying the equity.
As a result, these investors need to have a clear picture of what the exit of capital will look like before they invest. They are interested in knowing how much and how soon. They care about the Net Present Value of these events, so that they can compare them to other available opportunities.
The added benefit here is that you can underwrite the entire lifespan of investment from start to finish. To work, a person will have to make their best guesses and provide projections for everything.
What Role Does Cash Flow Play in the Equation?
Although it may not seem like it, in the conversation about cash flow vs. appreciation, cash flow is still important. When it comes to income-producing investment properties, net operating income helps to set the value. To sell a property for more than you paid or to refinance, your negative operating income must increase.
The cash flow you generate will help to pay for the life of the investment until wealth is removed as a factor. Therefore, when it comes to cash flow vs. appreciation, appreciation at this point becomes irrelevant. As long as the cash flow is managed properly, the property valuation will automatically create both equity and wealth.
Understand that cash flow does not build wealth, but when you have the right kind of asset, it is key in starting you on the path to wealth. Ultimately, equity and cash flow should never be debated. There is a distinction between having cash flow for the sake of cash flow and having cash flow to build wealth through appreciating equity.
Keep More Equity When You Purchase A Property with a SimpleShowing Agent
If you’re a seasoned real estate investor or are just getting into the business, then you know how much equity is lost when accounting for real estate commissions.
Although you don’t pay out of pocket for your real estate agent, the commissions are baked into the cost of the home you are purchasing.