Cash flow is king.
Well, it used to be king. Now, it might be a lord or duke, but I’m not sure investors see it as king anymore.
In the stock world, share prices for many firms are no longer based on actual profits; instead, they are based on speculation of the earnings the company could produce. Tesla is a great example of a company that is valued based on its profit potential instead of its actual earnings. As of June 30, Tesla was valued at $668 billion with a net income of $1.14 billion for the quarter. For comparison, General Motors was valued at $88.75 billion with a net income of $2.8 billion for the same timeframe. Yes, despite delivering close to 2.5 times more profit, GM is valued 7.5 times less than Tesla.
In real estate, this speculative investing isn’t as dramatic, but investors are drifting away from fundamentals with their eyes on the future possibilities. Many investors have accepted lower cap rates for the opportunity to buy a property where they can create value and deliver future returns. This means that they are willing to pay a premium and receive a lower return if they feel the upside is strong. This approach has gotten so popular in recent years that some investors are only focused on appreciation and dismiss cash flow altogether.
In their minds, cash flow has been dethroned. Appreciation is the new king.
Appreciation is simply the increase of the value of an asset over time. It can be organic, rise with inflation, or be stimulated by new developments and increased demand. However, instead of waiting for values to increase organically, investors look to force appreciation through strategic improvements and efficient operations. The ability to force appreciation is one of the reasons real estate is so attractive to investors. However, appreciation alone comes with great risks. It does not factor in the fundamentals of the investment in the same way Tesla’s value doesn’t factor in the actual profitability of the company. More importantly, it’s based on future assumptions that can easily change.
Market conditions play a major role in appreciation and anything from new developments, policy changes, renter preferences, and yes, global pandemics can impact the appreciation potential for a property. While we invest with appreciation in mind, these factors make it unreliable to serve as the primary reason to invest. It also leaves investors exposed in case of a down market. I know many coastal investors who are losing money on their properties but assume the values will appreciate over time. This is a dangerous and speculative approach.
Savvy investors know appreciation is a complement to cash flow, not a replacement. Together, you get risk mitigation and upside potential. And while they work well as a team, many investors are still going to prefer one of the components when making decisions. Determining which one you should focus on more is a personal decision. However, the fundamentals of evaluating opportunities and the value that can be created need to revert to the cash flow that can be created.
Markets change, preferences change, but the desire to earn a profit will never change. At some point, Tesla will be treated like every other company, judged on its actual performance, not what it could be someday. Apartment investing and commercial real estate are the same way. When reviewing investments, be sure the cash flow is sufficient for your investing goals, and don’t speculate on the appreciation. It’s important, but cash flow is still king (even if it has to share governing powers).
About the Author:
John Casmon has helped families invest passively in over $90 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Target Market Insights: Multifamily + Marketing. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
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.