Should I Invest for Cash flow or Appreciation?

by | Feb 20, 2021 | Investing | 0 comments

Should I Invest for Cash Flow or Appreciation?

This questions comes up all the time and it is hotly debated.  Some people believe cashflow is king. Others think appreciation is better in the long run.  The truth of the matter lies somewhere in between, and can totally depend on your financial circumstances too.

First letʻs take a look at both cash flow and appreciation, what they are and what they mean from an investing viewpoint and then look into the pros and cons of investing for cash flow and the pros and cons of investing for appreciation.

What is Cash Flow?

Cash flow is simply the extra money that comes in from a passive investment after all expenses are taken into account. For example, let’s say you own a rental property and are collecting $1000 per month in rent. Your mortgage, taxes and insurance on that property is say $600 per month, and you set aside another $200 per month for repairs and capital expenditures.

With this simplified scenario, your cash flow would be your rent that you collect minus your expenses, so:

$1000 (rent)$600 (mortgage, taxes, insurance)$200 (repairs + cap. ex) = cash flow.

Therefore your cash flow every month is $200.

What is Appreciation?

Investing for appreciation in real estate means you are investing in a property that you believe will increase in value over time. Often times when investing for appreciation you won’t cash flow on the asset and will be tying up your investment in the property until the property does appreciate, at which time you could refinance or sell the property for potentially very substantial gains.

OK, So What is Better to Invest for, Cash Flow or Appreciation?

In my opinion a good portfolio has a nice balance of cashflowing assets and appreciating assets. That said, it really depends on your situation.  For example, if you are not a high income earner and you don’t have a lot of net capital, you’ll probably want to invest for cash flow as you will need that extra cash to pay your bills and start building your war chest.

On the other hand, if you have quite a few properties already, are a high net worth individual or don’t need the cash flow, investing for appreciation might make a lot of sense. Especially if you need some write offs.

Let’s look at cash flow and appreciation over a 5 year time frame. Take our previous example above. Based on those above numbers that property would net you $2400/year. Now let’s take and add a nice conservative 2% price increase on rents every year. Here’s what that would look like:

Monthly Cash Flow (Rent – Expenses) Annual Cash Flow
Year 1 ($1000 – $800)= $200.00 $2400.00
Year 2 ($1020 – $800) = $220.00 $2640.00
Year 3 ($1040.4 – $800) = $240.40 $2884.80
Year 4 ($1061.21 – $800) = $261.21 $3134.52
Year 5 ($1082.43 – $800) = $282.43 $3389.16
Total 5 Year Return:
$14,448.48

As you can see our expenses stay consistent (we’re assuming a fixed rate loan) and the monthly rents increase year over year at a 2% click. Over the course of five years this property will have netted $14,448.48.  Now let’s take a look at appreciation.

Let’s assume that this property costs $200,000 at the time of purchase. Assuming as well that it does NOT cash flow, but instead breaks even every month. However, the property is in a hot market and it’s appreciating at 5% per year.  Here’s how that would break down:

Home Value (5% annual growth rate)
Year 1 $200,000.00
Year 2 $210,000.00
Year 3 $220,500.00
Year 4 $231,525.00
Year 5 $243,101.25
Net Growth:
$43,101.25

In this case you have a very nice equity growth of $43,101.25 as opposed to a cash flow of $14,448.48 over that same time period. So, if your finances were such that you could forego the cash flow and you were confident on the appreciation of the asset, in this situation the appreciation would be a better play.

Now, I know what you’re thinking, and you’re right. There are a million different scenarios that could unfold here. Appreciation is certainly not gauranteed, nor is a consistent 5% growth rate. The cash flowing property may also appreciate in value too, and rent growths may climb at a much higher rate than 2%.

All of these factors are variables based on the market in which you are investing.

What’s my opinion on investing for cash flow or appreciation?

I really love cash flowing assets. They don’t ever go out of style and they help to pay the bills and put money aside for the next investment opportunity that I venture into, so they are definitely the bread and butter of my portfolio. When I started investing, all of my investments were from a strictly cash flow perspective. If they didn’t cash flow, I passed them by.

With that said, it is very hard to find cash flowing real estate opportunities right now, at least in the markets in which I invest or am looking to invest. And that’s where the other arrow in my quiver comes in. All the properties that I invest in are not only cash flowing, but are also in extremely hot markets. over the last year one of the markets I invest in has seen an almost 10% appreciation rate. Another market is touching on 9%.

So, although I’m not a gambler, if my research has taken me to a market I feel strongly about and my other numbers make sense, I will still pull the trigger on the investment even if it doesn’t cash flow.

But in the end, it comes down to what is going to work for you in your situation based on your finances, goals and level of risk tolerance.

 

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