Appreciation or Cash Flow?
I am regularly asked whether investors should buy high cash flow or high appreciation properties to maximize property accumulation and future cash flow. It depends on your investment goals and time frame. In this article, I will explain why an appreciating market is the key if your goal is to scale up your portfolio as fast as you can and have a medium to long-term investment time frame (7 to +10 years). Before I continue, a quote from Albert Einstein,
“Everything should be made as simple as possible, but no simpler.” ... Albert Einstein
Appreciation vs Cash Flow
I oversimplified the following example to the point where Albert would not be happy. But the calculations are only intended to illustrate the concept.
My assumptions:
- Property A appreciates at 7% annually, but has zero cash flow.
- Property B has a 7% cash/cash return but zero appreciation.
- Combined state and federal income tax rate is 30%.
- Purchase price: $400,000.
- Down: 25%
- Acquisition cost: $100,000 (25% X $400,000)
- No inflation
- No rent increases
- No loan costs
- No closing costs
- No renovation costs
- No vacancies
- No maintenance cost
- No management expenses
- No principal pay down
Below are the two models.
| Property A - No Cash Flow | Property B - No Appreciation | ||
|---|---|---|---|
| Appreciation | 7% | Appreciation (%) | 0% |
| Market Value | 400000 | ROI (%) | 7% |
| End of year 1 | 428000 | Annual cash flow | 7000 |
| >End of year 2 | 457960 | Taxes (@ 30%) | -2100 |
| End of year 3 | 490017 | Annual after tax cash flow | 4900 |
| End of year 4 | 524318 | Investable Cash after 5 Years | $24,500 |
| End of year 5 | 561021 | ||
| 75% cash out refi at the end of year 5 | 420766 | ||
| Pay off existing loan | -300000 | ||
| Investable Cash after 5 Years | $120,766 | ||
At the end of 5 years, you have $120,766 you can reinvest due to appreciation. With cash flow, you only have $24,500. This is why, in a high appeciaiton market like Las Vegas, appreciaiton is the way to make money and grow your portfolio with the least additional capital.
With Appreciation Comes Cash Flow
If you have measles, the spots that appear on your skin are not the virus. The spots on your skin are a symptom of the virus. The same applies to appreciation. Appreciation indicates strong demand, rising population, job growth, increasing household income., everything you need for a location to do well for the foreseeable future. This also means that rents will follow appreciation. According to studies, rents lag appreciation by 2 to 10 years, depending on the market. What you were seeing happening with appreciation today is what rents will do in the future. So buying a property in a higher appreciation location almost guarantees your rents will increase rapidly as well. So, focusing on appreciation is only for the initial conditions.
In Summary
Simplifying, if you have 7% rent growth per year, that is 7% x $7,000 = $7,490. If you have 7% appreciation, that is 7% x $400,000 = $428,000. Plus, you can do a cash out refi without paying tax on the loan. Focusing on appreciation instead of cash flow is the fastest way to grow your portfolio and future income.