Cash Flow vs. Appreciation: What Experienced Real Estate Investors Know
Apr 7, 2023
The truth is, the answer to this question requires that we first take a deep dive into each of these terms to understand their functions.
In this article, we’ll explain cash flow, appreciation and what experienced real estate investors know about these that makes them successful.
What is Appreciation in Real Estate?
Appreciation in real estate can be described as the increase in a property’s value over time.
How much a property appreciates depends on several factors including the local real estate market and any improvements made to the property.
To get an idea of how much your property is worth, you can request a free, online home valuation from SimpleShowing.
Why is Appreciation Important?
Equity is a primary driver of wealth, and appreciation is the vehicle that gets us there. When your real estate investments appreciate, your equity grows along with your wealth. Equity appreciation can make you rich in the long-term and sets you up with options, including:
- The ability to re-leverage your properties and invest the cash to expand your asset base.
- The ability to sell off your properties and exchange that equity for larger assets.
- The ability to sell off your properties, retire and leave behind some money for your children and grandchildren.
When you have assets on-hand like rental properties, these are the three basic available options real estate investors utilize to create more wealth.
What is Cash Flow in Real Estate?
In real estate, cash flow is the difference between a property’s income and expenses. You are said to have “positive cash flow” when you subtract your property’s expenses from the income it provides and are left with a profit. You have “negative cash flow” when the expenses are more than the profit. Most real estate investors aim at owning properties that have a positive cash flow.
Why Is Cash Flow Important?
Cash flow is important because it allows you to take your assets and hold on to them long enough for their value to appreciate. While appreciation takes time, you can eventually take advantage of the three options previously discussed.
However, there are things you can do to add value to your strategy and speed up the process. While implementing a successful plan of action takes time, it can be worth it in the long run.
Once you have accumulated a certain level of wealth, the value of your cash flow is such that any additional appreciation isn’t necessarily beneficial. Until you reach this point, the main purpose of cash flow is to help keep you afloat. It allows you to essentially buy time while your assets appreciate. This is also true when valuing commercial properties.
How to Calculate Cash Flow
In order to know if a rental property is a good investment, you can calculate the cash flow in three simple steps.
- Determine the gross income from the rental property.
- Subtract all expenses pertaining to the property.
- Subtract any debt associated with the property such as mortgage payments.
With these three steps, you should be able to calculate an estimated cash flow for your property and determine if it will provide a positive or negative cash flow. Keep in mind, this may not always be accurate as there can always be unexpected expenses when owning a property.
Here’s What Advanced Investors Pay Attention To The Most
Big-time investors usually aren’t concerned about cash flow or appreciation on an investment property. Instead, they tend to focus on the IRR or internal rate of return.
The internal rate of return (IRR) helps real estate investors determine how much they can generate in real wealth with a particular investment.
There are several reasons that they focus primarily on this metric, but the overarching message is that major investors aren’t worried about stand-alone income. The individuals that fall into this category have lots of money to spend. They are usually entrepreneurs, accomplished professionals, and investors who are most concerned about engaging in wealth-building activities – not just those that generate income.
The IRR tracks all of the various cash flow streams. But to accomplish this, you must also project the ending and all intermediary exits that could exist for the capital. This is important since any sales or refinancing of the assets will generate a large cash flow event within the investment cycle.
More novice investors will see a long-term hold as just another way to generate long-term cash flow. However, experienced investors know they can generate hundreds of thousands, maybe even millions of dollars in wealth, by actually liquefying the equity.
As a result, these investors need to have a clear picture of what the exit of capital will look like before they invest. They are interested in knowing how much and how soon. They care about the Net Present Value of these events, so that they can compare them to other available opportunities.
The added benefit here is that you can underwrite the entire lifespan of investment from start to finish. To work, a person will have to make their best guesses and provide projections for everything.
What Role Does Cash Flow Play in the Equation?
Although it may not seem like it, in the conversation about cash flow vs. appreciation, cash flow is still important. When it comes to income-producing investment properties, net operating income helps to set the value. To sell a property for more than you paid or to refinance, your negative operating income must increase.
The cash flow you generate will help to pay for the life of the investment until wealth is removed as a factor. Therefore, when it comes to cash flow vs. appreciation, appreciation at this point becomes irrelevant. As long as the cash flow is managed properly, the property valuation will automatically create both equity and wealth.
Understand that cash flow does not build wealth, but when you have the right kind of asset, it is key in starting you on the path to wealth. Ultimately, equity and cash flow should never be debated. There is a distinction between having cash flow for the sake of cash flow and having cash flow to build wealth through appreciating equity.
Keep More Equity When You Purchase A Property with a SimpleShowing Agent
If you’re a seasoned real estate investor or are just getting into the business, then you know how much equity is lost when accounting for real estate commissions.
Although you don’t pay out of pocket for your real estate agent, the commissions are baked into the cost of the home you are purchasing.
At SimpleShowing, we know you’re already doing the work to find the best property, so our agents reward you by sharing our commission and giving you up to 1.5% of the purchase price as a refund at closing. Our average refund is $5,000 per transaction.
As we wrap up this discussion on cash flow versus appreciation in real estate investing, it becomes clear that having a clear understanding of these two strategies is crucial for achieving your financial goals. Cash flow investing, which refers to the method of purchasing cash flowing properties for the consistent rental income they generate, offers a more predictable and often safer path to passive income. With the right property management techniques, your rental property cash flow can become a steady source of income that drives you towards financial freedom. Being cash flow positive means having more income than expenses, creating a financial cushion that can weather market fluctuations.
However, every investment strategy has its pros and cons. While a cash flow strategy may offer stability and a direct impact on your income, it does not typically offer the substantial, yet intermittent, profit that appreciation does. Appreciation-focused investing is a more long-term strategy, banking on property values increasing over time, and this potentially leads to significant capital gains. However, it’s worth noting that the capital gains tax implications might be heftier compared to the tax benefits derived from rental income and depreciation in cash flow investments.
To sum up, whether you choose to focus on cash flow properties or betting on appreciation depends on your financial goals, risk tolerance, and investment horizon. A balanced portfolio might include both: properties that provide a steady stream of rental income and properties that hold the potential for significant value increase. Experienced investors know the importance of diversifying their portfolios and the value that both cash flow and appreciation can bring to their long-term financial plan. So, whether you are a novice investor or an old hand, understanding the dynamics of cash flow versus appreciation is key to crafting a winning real estate investment strategy.