Appreciation vs. Cash Flow

One of the biggest questions investors need to ask themselves when defining their investment goals is appreciation or cash flow. There is a tug of war that exists between these two forms of return leading to a trade-off in any given investment opportunity. With that being said, one can be either invest for appreciation or cash flow and be a successful long-term real estate investor. This post serves to expand upon the trade-offs and what an investor needs to consider before making their first investment.

Appreciation

Appreciation is the increase in value of the asset over time caused by, among other things, market supply/demand dynamics and inflation. When acquiring real estate the purchaser is usually getting two assets, the structure and the land it sits on. Generally, for long-term investors, the structure will depreciate over time while the land on which it sits will appreciate.

Let's take a look at how appreciation drives a return over time. In our example, Jane purchases a property for $100,000 at the beginning of year 1 and rents it out. After 10 years of dealing with tenants, she decides she has had enough and would like to sell the property. Jane made a wise decision by purchasing an asset in a quality location and has realized a 5% per year growth in her property's value.

Purchase Price: $100,000

Appreciation: 5% / year

Leverage: None

Sale Price: $100,000 * (1 + 0.05) ^ 10 = $162,889

Profit: $162,889 - $100,000 = $62,889

Ignoring transaction costs for simplicity

Another key point to be made when discussing appreciation is the effects that leverage can have on profits. In our previous example, Jane realized a 63% profit after 10 years because she purchased the asset with cash and no debt. However, real estate is a tangible asset that holds value well allowing investors to apply ample leverage that would not be safe in other asset classes. Let's see how Jane would have faired if she only put 20% down and took a mortgage for the rest.

Purchase Price: $100,000

Down Payment: 20%

Interest Rate: 4%

Remaining Mortgage: $63,027

Profit: $162,889 - $63,027 - $20,000 = $79,862

In the case where Jane applied leverage, she made a 400% return on her investment. However it is very important to note, there are risks to applying leverage to any asset including real estate. Additionally, this is only a look at nominal appreciation and we will discuss the effects of leverage on the holistic return picture later in this post.

Cash Flow

We discussed the appreciation of land in the previous section, now let's discuss how an investor can make money on the depreciating structure. Many people are familiar with dividends in the stock market. A company paying a 3% dividend will pay you as an investor $3 on every $100 you invest each year. Cash flow in real estate is similar to a dividend in the stock market. By renting out the property a tenant pays you a monthly rent which after deducting all operating expenses (think maintenance, taxes, insurance, and more) and servicing the debt returns cash to the owner.

An example will make this easier to understand, let's look at Jane's cash flow from her previous investment.

Rent: $1200 / mo

Operating Expenses: 50% of Gross Rent

Un-levered Cash Flow: $600 / mo

Mortgage Payment: $382 / mo

Levered Cash Flow: $218 / mo

Real estate investors look at a metric called cash on cash return to figure out what yield they are receiving on their invested capital. The metric is simply the cash flow divided by the total cash invested. Here is Jane's cash on cash return.

Un-levered Cash on Cash: $600 * 12 / $100,000 = 7.2%

Levered Cash on Cash: $218 * 12 / $20,000 = 13%

As with appreciation, leverage all can play a role in driving up the cash on cash return for real estate investors. In later sections, we will discuss how to look at how appreciation and cash flow play hand in hand.

Which is Better?

As mentioned in the introduction, cash flow and appreciation are typically trade-offs, and finding the right mix is dependent on the investor's goals. To best explain these trade-offs, we will look at a few different aspects of real estate and financial principles that break down the advantages and disadvantages of each.

Asset Quality

As most can guess, appreciation in property values is dependent on the quality of the market the asset resides in. Real estate like every other part of our economy is a market with buyers and sellers, if more people are buying than selling then typically you see faster appreciation (a very simplistic take). Popular metropolitan areas have expensive property values for a reason.

Typically home prices appreciation on average somewhere in the 3-5% / year range. However, without getting too deep into the weeds, higher-quality markets such as New York, San Francisco, and recently Austin have experienced well-above-average home price appreciation. One important additional note, location is both macro and micro dependent. For example, the Washington, D.C metro area is a rapidly appreciating market, however not every neighborhood is equal and any investor needs to also evaluate the merits of location on the micro-level.

Lastly, rents don't scale with home prices! A lot of the fastest appreciating highest value real estate markets have the lowest, and in many cases, negative cash on cash returns meaning you have a pay to maintain and service the debt each month rather than be paid by the asset.

Time Value of Money

A very important concept in finance is the time value of money. Simply put, a dollar today is worth more than a dollar in ten years. Inflation erodes the value of money over time and earning a return on your money via various investments helps fight the impacts of inflation.

Outside of cash-out refinances and home equity lines of credit, appreciation is typically realized at the time the property is sold. Meanwhile, cash flows are realized on a month-by-month basis. This is where the time value of money plays an important role in judging the merits of any real estate investment. In the next section, we will see this concept in action.

Internal Rate of Return

Internal rate of return is a typical metric used to judge the merit of an investment by comparing cash flows in and out of an investment over time so that the net present value is equal to 0. Let's look at how this is applied to two different investment properties. Please note, these are made-up examples, but should well illustrate cash flow vs. appreciation in real estate returns. Both properties were purchased for $100,000 and are un-levered.

Property 1:

Appreciation: 2% / year

Cash on Cash: 10% / year

Property 2:

Appreciation: 6% / year

Cash on Cash: 5% / year

The IRR on property 1 is 14% (higher cash on cash) vs. 12% for property 2 (higher appreciation) even though the total profit on property 2 is greater. Money now is more valuable than money later.

Our Philosophy

At PeerInvest we look to find investment opportunities that suit our investors' needs. This means striking the right balance between cash flow and appreciation. With that being said, we tend to lean slightly more towards the cash flow metrics as higher cash flows tend to leave an additional margin of safety when it comes to cover unexpected expenses and servicing the asset's debt obligation. Sign up and check out our investment marketplace for a list of opportunities!