Is it better to invest for cash flow or appreciation when choosing your real estate investments?
In this article, we’re diving into the cash flow vs. appreciation debate to explain the pros and cons of each strategy. We’ll also show you how you can achieve both cash flow and appreciation from a single asset.
Cash Flow Defined and Explained
Cash flow is a stream of income earned from a revenue-producing asset. In real estate investing, rental properties are classic examples of cash-flow investments. As your tenants make their rent payments, you receive regular, passive income.
How Is Cash Flow Calculated?
Cash flow is simply the total income for a given period minus the total expenses for the same period.
For example, if you have a rental unit that earned $3,500 last month, and you had expenses of $3,000 (for the mortgage, insurance, property taxes, and scheduled maintenance), your cash flow for the month was $500.
Cash flow can also be projected for future periods based on estimated income and expenses. Let’s say that you want to calculate cash flow for the next fiscal year. With a monthly rental rate of $3,500, your total expected income for the year is $42,000. Your fixed-rate mortgage payments of $2,400 per month total $28,800 for the year. And you also have annual property taxes of $5,000 and insurance premiums of $1,500 to pay, bringing the expense to $35,300. Then, you expect maintenance costs to be around 5% of your PITI (principal, interest, taxes, and insurance), which equals $1,765. This brings your total projected expense to $37,065. Subtracting this expense from your $42,000 income, your cash flow should be around $4,935 for next year.
Benefits of Investing for Cash Flow
A focus on cash flow provides several advantages for investors, including
Financial predictability. Since rental rates are set by the lease, investors can generally count on receiving the expected amount each month. There may be periods of vacancy when a tenant moves out, but even this can be predicted based on local turnover and vacancy rate data.
Lower risk. Cash-flowing property continues to generate income, even during economic downturns.
Your renters build your equity. As you use rental income to cover your mortgage expense, your tenants are effectively increasing your equity in the property. This equity can be leveraged to help you qualify for additional financing to help you build your real estate portfolio. Furthermore, since the cash flow can be used as income when qualifying for other loans, your existing property could help you secure lower interest rates on additional loans.
Potential Drawbacks of Investing for Cash Flow
There are a few potential downsides to be aware of when investing for cash flow, including
Lower appreciation potential. Cash-flowing properties are more likely to be located in areas that appreciate more slowly than areas of primary residences.
Active management. While rental income is generally considered to be passive, managing rental units requires some hands-on tasks, like finding qualified renters, addressing maintenance requests, handling tenant issues, and drafting lease renewals.
Vacancy losses. Having a vacant unit can result in temporary losses. When projecting long-term income, always factor in estimated vacancy periods.
Unexpected expenses. Real estate investors will always encounter unexpected expenses. In a cash-flow property, there can be additional expenses from tenant damages or legal action taken against tenants.
Understanding Appreciation
Appreciation simply means an increase in value. Even if property values dip temporarily, real estate always appreciates in the long term because of the natural scarcity of land.
This increase in value grows your net worth and increases your financial security by giving you tangible assets that you can sell for a profit whenever you choose.
For example, you might choose to buy and hold a vacant lot on the edge of town. If your town expands, those lots can be worth far more 10 years from now than they are today.
But you don’t have to wait for real estate to appreciate on its own. Real estate investors can create “forced appreciation” by adding value to real estate through renovations and improvements. For example, if you build a structure on your vacant land, the value may increase by much more than the cost of the land and construction.
The benefits of investing for appreciation depend on your investing strategy: buy-and-hold vs fix-and-flip. With the buy-and-hold investing model, you’re planning to hold the property for the long term. The home you own as a primary residence, for example, is a buy-and-hold asset. With the fix-and-flip model, you’re looking to get a property, force appreciation as quickly as possible, then sell for a profit.
With that distinction in mind, let’s look at the advantages of investing for appreciation:
Cash-out refinance options for buy-and-holds. Assets with substantial equity can be leveraged for cash through refinancing. This can give you extra capital for projects like renovating the property or growing your portfolio with a new property.
Less active management for buy-and-holds. Long-term investments that are held strictly for appreciation, and receive no cash flow, request less management than income-producing properties because there are no tenants to manage. Vacant land, for example, could be a completely passive holding if landscape maintenance isn’t required.
Tax advantages for buy-and-holds. There are several tax benefits of real estate investing, many of which apply to buy-and-hold assets. Claiming depreciation and deductible expenses, for example, will reduce your income taxes due.
Tax advantages for fix-and-flips. You might not hold a fix-and-flip long enough to take advantage of depreciation deductions, but if the property is held for a year, your profit will be taxed at the lower capital gains tax rates rather than the higher earned income rates. Regardless of how long the asset is held, you could also benefit from deferring taxes through a 1031 exchange.
Faster profits for fix-and-flips. Flipping properties allows you to cash out quickly, minimizing the time that your investment capital is tied up in any given asset.
Potential Drawbacks of Investing for Appreciation
The possible downsides of investing for appreciation also depend on whether you’re investing in a buy-and-hold or fix-and-flip. The potential disadvantages include:
Risk of depreciation for buy-and-holds. While real estate always appreciates in the long term, it can depreciate in the short term. Physical depreciation (like wear and tear) and functional depreciation (when a property no longer appeals to current buyers) can reduce the value of the structure. External depreciation (from local economic factors like unemployment rates) can also reduce the value of the property.
Trying to time the market with buy-and-holds. If you’re betting on buying low and selling high, you’re taking the chance that market conditions won’t be favorable when you are ready to sell.
A potentially longer investment horizon for buy-and-holds. Buy-and-holds are often held for 10 years or longer. Tying up your funds for this long is a commitment (although you might be able to access some of your capital through the cash-out refi mentioned in the benefits section).
Risk of overpaying. Unlike the values of cash-flow properties, which are tied to the rental income amounts, the values of non-income properties are simply tied to the sale of comparable properties. This can make property values more volatile and can increase the risk of overpaying for a property.
Missing out on cash flow. When you hold a property for appreciation only, you miss out on cash flow opportunities.
Key Similarities and Differences Between Cash Flow and Appreciation
Cash-flow investments and appreciation investments are similar in that
Both investment strategies can grow your portfolio successfully.
Cash flow investing and appreciation investing can both be used to diversify your investment portfolio.
Real estate can be an effective vehicle for both strategies, particularly because of the inherent tax benefits of real estate investing.
The primary differences between cash flow investing and appreciation investing are:
Cash flow investing increases your available cash on hand, while appreciation investing focuses on growing your net worth.
Appreciation investing is more flexible in terms of timeframes. While cash-flow investments are held long-term, appreciation can be achieved naturally over the long term or forced in the short term through value-add projects.
Cash-flow investing is typically more predictable, while appreciation investing is more speculative.
Which Is Right for You?
A well-balanced portfolio includes both cash-flow investments and appreciation investments. With a focus on cash flow, you can generate passive income, which can be used to enhance your lifestyle or be reinvested to grow your wealth. And with a focus on appreciation, you can increase your net worth and stock up on tangible assets to be sold in the future.
If you already have an appreciation-focused asset (like your own home, for example), and you can commit your investment funds for a few years, consider investing for cash flow. If you already have income-producing assets, and you’re interested in short-term gains, consider a forced-appreciation project like a fix and flip.
It’s also possible to invest in an asset that cash flows and appreciates simultaneously! Let’s look at a few options.
Which Assets Cash Flow and Appreciate at the Same Time?
We touched on rental properties in the cash-flow section of this article. And, while the focus of rental properties is on income, it should be noted that those properties also increase in value over time. They just might not appreciate as much as your primary residence because of the wear and tear causing faster depreciation of the structure.
Single-family home rentals can be an excellent source of both cash flow and appreciation. Since existing single-family residences are located in areas that tend to appreciate faster than neighborhoods full of apartment rentals, you’ll get the benefits of SFR appreciation and command higher rents from more mature renters. This is why buying a second home as an investment property is so appealing.
Build-to-rent properties are another strong option for cash flows and appreciation. BTRs are built from the ground up, specifically for long-term renters. Real estate investors benefit from the forced appreciation of the new construction as well as the ongoing cash flows once the units are occupied!
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