EP 142: Cash Flow vs Appreciation

In this episode, I discuss the difference between cash flow and appreciation as it relates to buy-and-hold real estate. I recently had a conversation with one of my coaching students regarding the business that he intends to build. He has chosen to invest in rentals. I am now educating him on the difference between cash flow and appreciation goals.

I have spent the first quarter of this year building relationships and getting financing together for buy-and-hold real estate. I had to think about whether or not I was more focused on cash flow or appreciation potential. This is an issue that’s in the very forefront of my mind as I move forward and acquire rentals.

As I said, I have a coaching student who I am advising about his business. He is in a unique situation because he does not need outside funding to build his rental portfolio; he has a certain amount of funds available to him within the family. His issue is that he requires a certain amount of cash flow in order to achieve his goals. I don’t want to talk specifics regarding this particular person, because I have not asked for permission to share his personal story. It really isn’t necessary to go into more detail. The bottom line is that, in his situation, it is going to make more sense for him to focus on cash flow rather than appreciation.

You might be asking why you have to choose between cash flow and appreciation. The answer is that you don’t necessarily have to. You can choose to split the difference, and try to find properties that are a good mix of cash flow and appreciation. However, I’m suggesting that there are two opposite ends of the scale: one being ultimate cash flow, and the other being ultimate appreciation. It is next to impossible to achieve ultimate appreciation and ultimate cash flow at the same time; the two are not necessarily mutually exclusive, but it realistically is next to impossible to achieve both.

I will give you an example using the area of the country in which I live– the Midwest, and specifically Michigan. I think it holds true for most cities in most states. Usually, in any given city or suburban area, there are neighborhoods where it is difficult to sell houses and there is very little (if any) appreciation historically. These would be neighborhoods that are better for cash flow. Because there is very little appreciation, house prices tend to be much lower in these neighborhoods, hence better cash flow. It is true that because the houses cost much less, rents are also lower, but usually not proportionally so. In other words, if I buy a house for $50,000 in a non-appreciation neighborhood and I rent it for $800 per month, that doesn’t mean that, a few neighborhoods over, I could buy a house for $100,000 and be able to rent it for $1600 a month. In fact, usually I would only be able to rent the $100,000 house for about $950 to$1100 per month. So the cash flow is going to be much better with the $50,000 house.

However, even though those houses will cash flow well, they’re never going to be worth much more than what you paid for them. If appreciation is your goal, then you are probably going to end up spending a little bit more to own property in a more desirable neighborhood. You may not enjoy the same net cash flow per month, but over the long term your house will appreciate well.

Generally speaking, cash flow models work better if the investor does not intend to hold the real estate for more than 10 to 15 years, or even less. If you are going to hold the house for more than 15 years, the appreciation model might be more in line with your long-term goals. Ultimately, it comes down to personal preference. Both models are valid, but as an investor you should understand the type of property that you’re purchasing, and what its potential is in the long term.

 

About the author, Mike

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