Investing in real estate is one of the best ways to create real wealth that lasts for generations. There are many strategies to invest in real estate, and you can flip properties, you can buy and hold properties, you can do short-term rentals, Airbnb, etc. As you can see, there are many strategies to choose from when it comes to investing in real estate. Therefore, the next thought is should you invest for cash flow or appreciation? If you are new to investing, you may be wondering what the difference is or why does it matter? My goal for this blog post is to explain the difference to each approach and to help you choose which strategy makes the most sense for you.
Investing for cash flow vs. appreciation
The majority of investors choose the strategy of investing for cash flow because it enables them to pay all associated operating expenses with the property and put positive cash flow in their pockets on a monthly basis. One of the most popular books ever written on real estate investing is “Rich Dad, Poor Dad”, by Robert Kiyosaki. One major takeaway from his book is that an asset is something that produces income, and a liability is something that costs you money. One thing that the wealthy people do is they purchase assets that produce passive income that will give them net spendable cash flow to pay for their liabilities. This is a major reason why you should invest in income-producing assets like real estate, and they give you the ability to live the life of your dreams!
Investing for appreciation is a good strategy for investors that don’t necessarily need to live off the cash flow the properties produce. Investing for appreciation is a lot different from investing for cash flow because you are not getting surplus cash flow every month. Rather the property is breaking even or has modest cash flow associated with the property. You may be wondering why an investor would choose this strategy right. Well, the answer is this investor probably has a higher risk tolerance, and they are typically speculating that the property’s values will increase at an accelerated rate over the next 5-10 years. They are more interested in getting the big payday at the end of their hold period rather than getting monthly cash flow. There is no right or wrong strategy; each investor has their own investment requirements and risk tolerance. The danger with this strategy is if the market implodes or rather crashes, the value they were banking on can be wiped away overnight.
Let’s take a more thorough look at what investing for cash flow is all about. In its simplest form, cash flow is the profits real estate investors collect from leasing their rental property to tenants. Cash flow is calculated by taking the gross income and subtracting the expenses associated with the property. The money left over when all expenses are paid is the cash flow the property produces. Take a look at the graphic below:
These are the most common expense associated with a rental property. Depending on the asset class and the size of the property, the number of expenses will vary. One major expense missing from this list is the mortgage payment. This is typically the biggest expense associated with the property.
As you can see, your cash flow is directly impacted by the income your property produces and the expenses paid out. You have to really do your due diligence on the front end before you decide to purchase a property for cash flow because if you miscalculate just one expense, it could cause your passive cash flow property to become a negative cash flow property. Therefore, instead of purchasing an income-producing asset, you just purchased a liability because you have to take the hard-earned money of your pocket to keep this property afloat. I promise you, and you will only make that mistake one time.
Real estate calculations
So, what are some calculations you should use to help you decide if you are purchasing an asset or liability? The first thing you have to do is verify all income and expenses in your target market. A good property manager should be able to assist you with this. Once you have verified the financials, you can start making sense of the numbers. The following list are the calculations you should run to evaluate any property you are considering purchasing.
- 1% rule: The one percent rule is a rule of thumb to quickly analyze a property to see if the rent is equal or greater than one percent of the purchase price of the property. For example, if a property is for sale for $100,000 it should rent for $1,000 or more a month. ($100,000 * 1% = $1,000) You should be able to find these types of properties if you are investing in cash flow markets.
- 2% rule: The two percent rule is a rule of thumb to quickly analyze a property to see if the rent is equal or greater than two percent of the purchase price of the property. For example, if a property is for sale for $100,000 it should rent for $2,000 or more a month. ($100,000 * 2% = $2,000) It is hard to find these types of properties unless you are investing in the hood.
- 50% rule: The 50% rule is another way to help you quickly analyze a property by taking the gross income and dividing it by 50% expenses. (Gross Income $100,000 * 50% expenses = $50,000 NOI) If the property still cash flows, you should take a closer look.
- Net Operating Income (NOI): Net operating income is a calculation used to analyze the profitability of an investment property. NOI equals gross income minus all operating expenses necessary to run the property. NOI doesn’t consider debt service, capital expenditures, and depreciation. NOI = Income – expenses
- Cap rate: Used widely in commercial real estate. The capitalization rate is a quick way to measures the value of the property without using debt. It is a good way to compare properties in the same market. NOI / cap rate = value $100,000 / 8% cap = $1,250,000
- Cash on Cash (ROI): Cash on cash, also known as return on investment, calculates the cash income earned on the cash invested in a property. Put simply, cash-on-cash return measures the annual return the investor made on the property in relation to the amount of mortgage paid during the same year. NOI – DEBT SERVICE = CASH FLOW / TOTAL CASH INVESTED = CASH ON CASH RETURN.
- Debt coverage ratio: This is the most important calculation that banks use to determine if they are going to lend money on your deal. Anything less than 1.0 means you will lose money every month. The banks like to see a ratio of 1.20 or higher. NOI / annual debt service = DSR $120,000 / $100,000 = 1.20 DSR
As you can see, the calculations needed to analyze an investment property isn’t rocket science. You just need to take some time to memorized these calculations, and you will be well on your way to finding some income producing assets that kick off net spendable cash flow.
Now that you know what cash flow is all about and you know how to calculate if a property will be a good investment based on the numbers. Let’s talk about choosing the market you should invest in. This is where you have to decide if you want to invest for appreciation or cash flow. An easy approach to determine if you’re looking at a cash flow market or appreciation market is to look at the average price of homes in that particular market. If you’re looking at a market like San Francisco where the average price of a home will set you back $769,600, it’s going to very hard to find a property that will past the 1% rule test. Investors that are buying in this market are banking on appreciation. Now, if you look at a market like Indianapolis, Indian, where the average home price is $148,700. You are going to have a good chance to find a property that passes the 1% rule test.
Another important factor you want to consider when choosing a market is the population and job growth. You want to pick a market that has population growth meaning more people are moving in than are moving out. One quick hack is to look at google markets with most population growth. This market should also have a diversity of jobs, meaning no industry should take up more than 25-30% of the job market. Think about a market like Detroit; the great recession destroyed the job market, which in turn caused people to leave in search of job opportunities. When the population begins to shrink, it also causes your potential pool of renters to shrink, which causes you to offer more concessions and rent decreases. And as I mentioned before, the value of the property is highly dependent upon the NOI, which is directly impacted by the top-line number gross rents.
In conclusion, you can win with both strategies investing for cash flow and investing for appreciation. I have shown you the calculations needed to assess the true value of an income property. I also shared with you the importance of choosing a winning market. There is no right or wrong strategy; each individual investor has to assess their own investment goals and make the choice that will help them achieve generational wealth. As you might have ascertained from reading this article, I highly favor investing for cash flow because it pays for your liabilities, and it can enable you to live the life of your dreams if you do it right! If you want to discuss how you can partner with Onyx Capital Investments to achieve your financial goals visit us on our website: https://onyxcapitalinvestments.com/