Cash Flow Pays Bills, Appreciation Builds Wealth
“Twenty years from now, you’ll be more disappointed by the things you didn’t do than by the ones you did do.”
Before I start with today’s topic, I want to share a client’s comment concerning the blog I wrote last week - Are Townhomes Good Investments in Las Vegas? He shared an interesting finding of a mega investor focusing on apartments and townhomes. The insight was that when the investor surveyed his tenants, most of those renting apartments did not consider their apartments to be their home, whereas most renting townhomes did consider their rentals to be their home. Although I knew apartments and townhomes were different, I had never heard it explained so clearly. It explains the difference in tenants’ behaviors across these property types. This clarity will alter my view from now on. Thank you, S.T.!
Now, onto this week’s blog.
Many investors focus on cash flow. With the current economic turbulence, they view immediate cash-flowing properties as “safe” investments. However, buying properties solely for initial cash flow can be one of the worst investment decisions you make.
In today's high-interest-rate environment, properties offering immediate cash flow are typically found in cities with declining populations and high crime rates, resulting in low property prices. Below, I'll explain the likely outcome when you invest in such properties/cities.
Before I do, what determines property prices and rents?
What Determines Prices and Rents?
The imbalance between supply and demand determines prices. When there are more buyers than sellers, prices rise until they reach a balance. When there are more sellers than buyers, prices decrease until they reach a balance.
Property prices drive rental rates. When prices are high, fewer people can afford to buy homes, forcing more people into the rental market. This increased rental demand drives up rents. Conversely, when property prices are low, more people can afford to buy homes, which reduces the number of renters and causes rental rates to decline.
Rents follow property prices, though rents typically lag prices by two to five years, depending on the city.
Property prices vary significantly between cities due to long-term supply and demand patterns. Cities with consistently low prices typically reflect years of limited housing demand, resulting in low property prices. In these markets, without sustained appreciation of existing homes, rent increases remain minimal or nonexistent. To achieve immediate cash flow, investors must buy in cities with low prices—places where rents are unlikely to rise fast enough to offset inflation.
What Will Happen to Your Income (in Low-Cost Cities)
Let's say you buy in a city with immediate cash flow because prices are low. With little appreciation, rents increase slowly, if at all. Suppose rents only increase on average by 1% per year while inflation averages 5% per year. If your initial rent is $1,000 per month, what will its buying power be in 10, 20, and 30 years, compared to what $1000 will buy today?
- After ten years: $1,000 × (1 + 1%)^10 / (1 + 5%)^10 ≈ $678. Although your rent increased by 1% per year, since this is below the inflation rate, $678 is the amount of goods and services the “increased” rent would buy today.
- After twenty years: $1,000 × (1 + 1%)^20 ÷ (1 + 5%)^20 ≈ $460
- After thirty years: $1,000 × (1 + 1%)^30 / (1 + 5%)^30 ≈ $312
As you can see, the buying power declines every year because rents do not outpace inflation, which means you will eventually need to return to work to maintain your standard of living.
What would be the situation if you bought in a city with rapid and sustained appreciation? For this example, suppose rents increase by 8% per year and inflation averages 5% per year.
- After ten years: $1,000 × (1 + 8%)^10 / (1 + 5%)^10 ≈ $1,325
- After twenty years: $1,000 × (1 + 8%)^20 ÷ (1 + 5%)^20 ≈ $1,757
- After thirty years: $1,000 × (1 + 8%)^30 / (1 + 5%)^30 ≈ $2,328
When buying property in a rapidly appreciating city, should you expect immediate cash flow? Probably not. You'll need to wait for rents to catch up. However, the key advantage of high-appreciation cities is that rents will continually increase while your operating costs stay relatively static.
What Will Happen to Your Equity (in Low-Cost Cities)
Let's say you purchased a property for $200,000 in a city with immediate cash flow. You put 25% down, so your starting equity is $200,000 x 25% = $50,000. With little to no appreciation, how much equity will you have in your property (your wealth) after 5 years?
If there is no significant appreciation, your equity stays the same, $50,000, but due to inflation, the value of $50,000 has decreased.
Even if there is a moderate appreciation of 1% per year, your equity after 5 years would be:
$200,000 x (1+1%)^5 - $150,000 (loan balance, assuming no principal pay down for simplicity) ≈ $60,202.
If the average inflation is 3% per year, the purchasing power of $60,202 in 5 years would be $60,202/(1+3%)^5 ≈ $51,893.
If the average inflation is 5% per year, the purchasing power of $70,216 in 5 years would be $60,202/(1+5%)^5 ≈ $47,155
Your equity would have barely increased, or even decreased depending on the inflation rate.
Buying in High-Appreciating (Higher Cost) Cities
Now, what if you purchased a property in a high-appreciation city for $400,000? Let’s again assume you put 25% down. Your starting equity is $400,000 x 25% = $100,000. The compound annual appreciation rate for our target property profile in the last 10 years is 9%. (see our 2025 Investor Outlook). But let’s use a 7% rate to demonstrate the concept.
Your equity after 5 years would be $400,000 x (1 + 7%)^5 - $300,000 (loan balance, assuming no principal pay down for simplicity)≈ $261,021, not adjusted for inflation.
If the average inflation is 3% per year, the purchasing power of $261,021 in 5 years would be $261,021/(1+3%)^5 ≈ $225,000.
If the average inflation is 5% per year, the purchasing power of $261,021 in 5 years would be $261,021/(1+5%)^5 ≈ $204,000
Your equity would have more than doubled in 5 years. This is the way to increase your wealth.
As your equity grows, so do your options. You can use a cash-out refi to buy more properties and scale your equity appreciation with limited additional cash from your savings. How would that work? Note, I will assume the original mortgage remains constant at $300,000 to keep the calculation simple. Also, I will assume you will refinance with a 75% cash-out refinance.
- $400,000 x (1 + 7%)^5 x 75% - $300,000 = $120,766.
Using a 75% cash-out refinance after 5 years, you will have $120,766 for acquiring your next property. This is the power of rapid appreciation combined with cash-out refinancing.
This is why I titled this article: "Cash Flow Pays Bills, Appreciation Builds Wealth."
Final Thoughts
Ask yourself this question: Is immediate cash flow worth the long-term loss?
Real estate is a long-term proposition. Do not evaluate any opportunities based solely on the immediate cash flow. The long-term prospects of the city’s economic growth and housing supply and demand outlook are far more critical.
