When making real estate investment decisions, one of the most frequently asked questions is whether it is better to invest for cash flow or appreciation. In this article, we will examine what expert investors have to say about these two investing strategies.
As an investor, you should understand that both strategies are valid and can be combined when evaluating a trade. Therefore, it is important for you to know how to determine the real estate cash flow rate and the property appreciation rate.
With COVID-19 and the consequent eviction moratorium, many investors have had to deal with reduced or negative cash flow while appreciation rates are through the roof. So, should one invest for real estate cash flow or for property appreciation?
Real Estate Cash Flow Strategy Overview
A cash flow strategy offers consistent cash, typically in the form of rent, to real estate investors. Over time, the property may also benefit from appreciation. With equity accumulation, an investor could refinance, sell, and use returns from cash flow and appreciation to invest in new properties.
But it is not always as simple as this. In many cases, you choose one or the other. You could have high cash flow when you buy property in a low-cost neighborhood and improve it with some sweat equity. On the other hand, in more developed areas like San Francisco and Washington, D.C., you might find it difficult to find cash flow investments, and therefore have to rely on appreciation.
Reasons Investors Opt for Cash Flow
1. If you’re cash-flow positive, rent covers your expenses, e.g., mortgage payment, monthly maintenance fee, insurance, and property taxes, and provides you with extra cash.
2. Conventional loans are readily available for cash flow investors. Cash flow is not only used by investors to evaluate deals. Lenders use it too, as mortgage payments will make up a large part of the property’s costs and will definitely affect your cash flow. Lenders use the debt service coverage ratio (DSCR) to determine if, after mortgage payments, a property will be cash-flow positive. To calculate your DSCR, you need to know your net operating income (NOI).
3. Investors who desire financial freedom, passive income, and early retirement will opt for a cash flow strategy because steady cash flow helps you reach your financial goals faster.
4. Rental property cash flow offers more versatility. Instead of a conventional long-term rental strategy, you could place your listing on short-term rental websites like Airbnb. You could also make monthly income through systems like house hacking. On a larger scale, you could build a portfolio of both multifamily and single-family properties and earn steady rental income.
5. Your cash flow grows over time as you pay down your mortgage and build equity.
The Downside of a Real Estate Cash Flow Strategy
It is more difficult to find cash-flow positive properties, especially in today’s market as prices have appreciated at unexpected rates. In many markets, you’ll readily find cash-flow neutral (property profits can only cover running costs) or cash-flow negative (investor spends some money out of pocket on property maintenance) properties.
Also, cash flow depends on market performance and tenant quality. If there is a real estate downturn, real estate cash flow gets hit. And bad tenants will cause you to lose money.
Real Estate Appreciation Overview
While there are straightforward approaches and formulas for measuring real estate cash flow, measuring real estate appreciation presents a challenge. This is probably the main reason why many investors opt for a cash flow strategy.
The best way to measure the current market value of your property is to look at comps (comparable properties) in your area.
How Much Does Real Estate Appreciate on Average?
On average, appreciation rates for real estate in the U.S. have stayed between 2% and 4%. In a market crash or downturn, property prices could depreciate as they did during the 2008 recession. But in a real estate bubble, as we’re currently experiencing, investors could greatly profit from appreciation.
According to an article on Millionacres:
“Over the past year, the average appreciation of real estate has increased 14.5%, a staggering number compared to historical performance. While many homeowners and real estate investors look to the average home-price valuation as an indicator for future value, it’s important to remember that housing prices and the rate they appreciate can change dramatically year over year — the current average appreciation rate is 14.5%, a stark difference from 4% in 2019.”
As mentioned before, you can combine real estate appreciation with a rental cash flow strategy. Rents typically grow over time, leading to increased cash flow. So, a negative cash-flowing property could turn positive over time and also allow you to make a significant profit through appreciation. Essentially, the way to make money with appreciation is when the property is sold. Hence, it is playing the long game.
Reasons Investors Opt for Real Estate Appreciation
1. Appreciation is a conservative way to make money as an investor. Real estate values usually increase over time, so if you make sound investments, you can sell them for a profit. This chart from the Federal Reserve Bank of St. Louis shows how average home prices in the U.S. have grown since 1963.
2. Appreciation is a great way to pass on real estate wealth to younger generations. Hence, lots of people who have already achieved financial independence invest in real estate majorly for appreciation.
3. As a new investor, you can make quick profits via fix-and-flips. You purchase a property and tune it up to make it appreciate in value. Then you sell. You can also buy and hold, make positive cash flow in the interim through rents, then sell.
4. You can defer taxes on real estate sales through 1031 exchanges. Although under President Biden’s new policies, 1031 exchanges would only be available to investors making less than $400,000 in annual income.
The Downside of Relying on Appreciation
When relying on appreciation, you’re making a bet on the market. You have to dig into the city plans, study municipal data, and invest in places close to transport facilities. In other words, you have to keep an eye on where and to which areas people are moving en masse. All the same, you might make a wrong guess. No one can predict a market crash or what happens when a pandemic hits. Check out some strategies real estate professionals recommend during a market crash.
With both types of rental strategies, you have to worry about depreciation. This PropertyCashin article touches on three main types of depreciation you may have to deal with:
1. Physical depreciation — caused by wear and tear.
2. Functional depreciation — occurs when a function of the building becomes outdated or obsolete. For example, an old multifamily building with no elevator and laundry facilities located in the basement has functionally depreciated in value.
3. External depreciation — the result of an adverse neighborhood or local economic conditions. For example, the closing of a corporate headquarters in one city contributes significantly to the external depreciation of nearby office buildings.
Overall, if you employed an appreciation strategy, you would need to keep your property in pristine condition since you are practically betting on it. And you would most likely have to spend out of pocket on maintenance and tech.
Cash Flow vs. Appreciation: What Investors Say
President, The Cauble Group
“We never invest for appreciation since that is out of our control. Our team selects projects where we can create value and force appreciation through value-add or development from scratch. Any appreciation is just icing on top.”
CPA, Owner of Young and the Invested
“I readily admit to any hesitation I may have as a real estate investor for buying properties with the explicit intention of reselling them in the next few years. I say this because of the tremendous growth we have seen and the specter of rising interest rates in the not-too-distant future as the economy recovers and the Federal Reserve attempts to normalize interest rates.
“For people interested in investing in real estate at this time, I would advise caution or a strategy that involves bidding below what it would have cost to buy a home even three months ago. The inability to purchase a home in this market has caused many potential buyers to walk away. This could present some softness in weaker markets, allowing buyers to bid below asking prices, renovate, rent, and ultimately sell for a profit in the future.”
Principal Broker & Owner, Venture DO LLC
“There are multiple ways to answer your question due to the plethora of variables, and all of them may be viable solutions for different investor strategies. But in general, appreciation (not forced) is hypothetical and dependent on the local market, while cash flow is real and more stable.
“If an investor is focused primarily on appreciation (again, not forced), and ‘hopes’ the property’s value will continue to increase, just because their property increased in value yesterday, then yes, their return may be higher, but they will also have more risk. And many suggest that ‘hope’ is not a viable strategy at all. Typically you will see investors use both metrics, but a property that cash flows with an opportunity for appreciation is a solid investment overall and if appreciation does not happen, you’re still protected by cash flow.
“Now, on the other hand, there are many different variables, but the cornerstone seems to be the investor’s personal financial situation and the desired outcome for the investment. Investors with less capital to invest generally focus more on cash flow, so they can supplement income, but as their passive income grows, their focus tends to shift more into a balance between the two. Some investors even focus primarily on appreciation only as a place to park capital. So, it’s hard to say that one method is better than the other, and many investors use both measures within their investment strategy.
“Keep in mind that the same property with the same purchase price can have very different cash flow scenarios depending on the investor’s location, mortgage rates, holding time, money down, tax protection, deductions, expenses, renovation plans, etc. With all these considerations, most investors should focus on their desired overall return on investment (ROI) or internal rate of return (IRR) to determine if their strategy is best for the given investment, rather than just looking at cash flow vs. appreciation.
“Many investors will also look for opportunities to force appreciation by reducing expenses and increasing income, through renovations, restructuring, rent increases, etc., to eliminate some of the risks around speculated future appreciation. One good thing, though, is that if a property appreciates in value, the rents typically go up, and if your property’s value increases, you may be able to borrow against that equity without even selling, and stack leveraged equity to invest in more investment properties.”
Principal, FTW Investments
“Primarily, we employ a value-added strategy. In today’s market, these transactions are not priced for immediate cash flow, but we typically target 8%–10% cash on cash within 12–24 months of acquisition. For us, appreciation is about adding value by addressing deferred maintenance, improving the look and feel of the properties, improving lighting and security, employing best-in-class management, increasing revenues, and reducing operating expenses. Capitalization rates are very low, and we typically underwrite very conservative reversionary cap rates, which means that appreciation comes down to operations, not financial markets.”
Julius Mansa, M.Fin.
Investment Analyst and Lecturer
“I have always been a strong proponent of developing and maintaining long-term passive income opportunities from real estate, especially since net rental yields can often be more predictable than equity markets. While I agree that taking advantage of current market trends can yield excellent short-term capital returns for investors, the net cash flow from rental units can provide an excellent source of income for investors that are seeking to expand their real estate businesses even further.”
Principal, JB2 Investments
“I would say: always cash flow — but inevitably, increased cash flow is followed by appreciation.”
There is neither a winner nor a loser. At the end of the day, real estate entrepreneurship has many paths. Both real estate appreciation and real estate cash flow complement each other, especially in situations where it is difficult to predict the future. Owning investment properties that produce income based on both strategies is a good idea.
About the Author:
Agnes A Gaddis is a writer for Inman News, Influencive, and the TSAHC (Texas State Affordable Housing Corporation). She has over 7 years of experience writing for the real estate industry. Connect with her on Twitter: @Alanagaddis
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.