Worshipping At the Altar of Cash Flow – II

by | BiggerPockets.com

There are many schools of thought when it comes  to investing in real estate for retirement. Two of them dominate.

One says you buy property and hold it forever. When you’ve saved up enough to buy another one you do — and hold IT forever. The idea is you allow rental income to pay off debt as quickly as possible, arriving at the point of a free and clear cash flow machine. Do this more than once and you have the basis for a nice retirement income stream. Or so the story goes.

The other says cash flow comes from the yield on either capital or equity in an asset. The larger the capital amount or equity in the asset, the larger the income in terms of dollars. The ‘yield’ itself is expressed in terms of a percentage. For example, 8%. This school says that since the yield is the same, more or less, for a larger figure or a smaller figure, why not arrive at retirement with the largest amount of capital and/or equity possible?

The ‘Buy & Hold’ school (BHS) gets you there. But in what condition, and how much cash flow relative to the ‘Capital Growth First’ school (CGF)?

Buy and Hold

  • Limited to how fast investor can save capital for down/closing on each purchase
  • Properties are old, having high maintenance/expenses when investor retires
  • 100% of income is devoid of any tax shelter —  right when they need it most
  • Properties more likely than not to exhibit functional obsolescence upon retirement
  • Older properties generally don’t compete well for highest quality tenants
  • Props are old when you retire, & only get older each year — not a good trend
  • Rents will be less likely to keep up with the competition — or inflation

That’s the short list, but you get the idea. Buy and Hold should be called Buy and Mold. 🙂

Capital Growth First

  • By ensuring a more or less superior capital growth rate — net worth increases
  • Capital growth is maintained by exchanging equities when the market dictates
  • Exchanging keeps the power of prudent leverage working
  • This results in significantly larger capital/equity base
  • Larger capital/equity base = larger income in terms of dollars using same yield % at retirement
  • Arrive at retirement with higher income, mostly tax sheltered
  • Able to execute strategies completely unavailable to Buy & Hold

Again, that’s a short list. You can readily see the advantages.

Now let’s look at an example with some real numbers for illustration.

Exploring Real World Examples

“Dan”, 72, came into my office a several years ago — a real born again buy ‘n holder. His pride and joy was the fourplex he bought when he was in his 30’s, now free & clear, generating a net income of roughly $2,900 monthly. This is in addition to two other income sources — Social Security and a taxable annuity.

He’s paying significant taxes on the income from the annuity and the fourplex — neither of which is keepin’ up with the cost of living. He retired in 2005. He bought his fourplex in 1975. We both live in San Diego, so I’ll be using that market as an example. The principle works in any market — especially over the long haul.

He paid about $80,000 back then. Upon retirement the value was 8-10 times that. Where would he be today if he’d gone the capital growth route? So glad you asked. 🙂

The market would’ve told him to exchange his enlarged equity position in the first quarter or so of 1979. Having put 20% down, his equity at that point would’ve been around $100,000 — more than quintuple his originally invested capital. His cash flow for the period won’t be added into that, except for the paying of closing costs on his newly acquired exchange property(s).

He now owns roughly $400,000 in 2-4 unit properties. He’s conservative, so due to interest rates back then, he puts 25% down. He now waits for the next time the market will speak to him. This time it’ll be longer than four years, as the recession took its toll. Meanwhile, his properties are rented, with slightly increased rents over the long haul. The recovery hits around the end of 1983. He waits to be sure. Values again begin to rise. He waits. In  early summer of 1988 he executes another tax deferred exchange with the following results.

Note: From roughly 1985 to the beginning of 1990 appreciation rates in SoCal were double digit, more or less depending what specific market. San Diego did well.

His exchangeable net equity at that point was approximately $275,000. Again, he chose to put 25% down on his exchange uplegs. (newly acquired props)

Let’s pause at this point to assess his capital growth rate. It’s been 13 years since he began with about $18,000 to close his first investment back in 1975. He now has $275,000. That’s an annual capital growth rate exclusive of tax benefits and cash flow of about 23%  — a figure nobody with a three digit IQ would predict, but historically accurate nonetheless.

Anywho, he now owns about $1.1Mil dollars of property. It not only pays for itself, but cash flows — not heavily, but enough to make him happy. For the record, he does two things consistently along the way — one I recommend sometimes, and one on which I insist. He has way more than adequate cash reserves. I call it a Sominex Account, as when Murphy visits, you can still sleep at night.

The recommendation at this point is to apply a portion of the cash flow to the loan balance. Back then it was almost a built in practice for my clients, due to interest rates 2-4 points higher than today’s. It just made sense. It’s called keepin’ your eye on the ball, which in this case is growing the guy’s capital/equity safely over the long haul with retirement in mind.

It’s at this point the S & L Crisis hits San Diego like sledgehammer hits a thumbtack. It was beyond terrible. Not only did we experience what everyone everywhere else did, we had the added excitement of losing a couple huge employers overnight. Talk about both barrels of the shotgun goin’ off. Vacancy rates went from virtually nonexistent to 10-15%, sometimes more depending upon your location. Rents tumbled even more in  some cases. Bottom line? This guy’s cash flow went from cool to break even faster than Mickey D’s makes a Happy Meal.

This forced a holding time of about a decade, more like 12 years. What’s an investor to do? Life happens. It certainly did back then. It seemed Murphy camped out in San Diego the whole time. Ever heard of O’Toole’s corollary to Murphy’s Law? “Murphy was an optimist.” 🙂

Dan executed another trade in the early spring of 2000. His portfolio by then had risen at a much more modest rate than in previous times. Real life. It’s now worth a total of $1.6Mil give or take. His net tradeable equity is about $645,000. Relatively speaking, interest rates are a tad lower, but he insists on a 30% down payment, overruling my advice to try 20% this time. It’s his money, so guess how much he put down? 🙂 He’d been made nervous by his experience of the early 1990’s. Um, me too.

When the smoke cleared he ended up with $2.15Mil in property. It wasn’t cash flowing much, give or take $25,000 a year. His retirement was, according to him, a long way off. He changed his mind about that later.

In fact, he decided in early 2004 to call me about setting in motion his transition from capital growth to cash flow — he wanted to retire no later than spring of 2005, about 30 years after buying his first investment property. After much analysis and a few meetings of the mind, Dan and I agreed — he needed a property outside of California. The prices were simply outa whack, a fact we both agreed on immediately. The search was on.

First we had to ascertain how much equity we had to trade — cue the Happy Feet music.

Seems his luck had turned around again. From his latest acquisitions in 2000 his portfolio had grown in value from $2.15Mil to the neighborhood of $4Mil. His net tradable equity was about $2.2Mil. Let’s take a pause for the cause here, OK?

Is that a white flag I see being waved by the buy & hold crowd? Just askin’…

We now didn’t care much about growth, as we wanted stable markets, not much prone to big swings either way historically. Idaho, Texas, New Mexico, Montana, Ohio and Kansas/Missouri ended up on the short list. We really liked KC though, which is where we landed. We ended up with about $5.5-5.7Mil in cash flow properties. (Larger properties this time.) The cash on cash return averaged around 7-10% conservatively. This resulted in a yearly cash flow, the majority of which was tax sheltered by the way, of $140-200,000 yearly.

For discussion sake, discount the low part of that range by half. You still end up with $70,000 a year at retirement — mostly sheltered — not in ancient properties with ever rising operating costs. Even discounting the low part of the income range by 50%, he still finds himself with just short of double the retirement income he did applying the buy and mold, um, hold school of thought.

Of course, he won’t hafta discount all that mostly sheltered cash flow. A retirement income of five figures monthly. Sweet.

Back to Dan’s current reality. He’s now retired on just under $36,000 a year from his fourplex. His SS income and annuity supplement this. However, as pointed out earlier, every single dollar of the annuity and the real estate is taxable. Ouch. Furthermore, he’s now discovered, much to his chagrin, that he didn’t retire, he just started serving a life sentence.

His option from the beginning was to end up with so much sheltered retirement income that his SS check would simply be spending money.

So I restate the principle: Worshiping at the altar of cash flow when capital growth is the appropriate approach will not have the happy ending you envision.

Next — How does the real estate investor manage to avoid capital gains taxes without always relying on a tax deferred exchange?

Photo: Tabbie-cats

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.


  1. First off, Screw you Mr. Jeff Brown!!

    Screw you for allowing me to think all this time that I was good to go with ‘buy & mold’

    Screw you for pointing out to me that I’m a complete idiot and haven’t properly thought out my future as well as I should have.

    And thank you so very much for an amazing post!!!!!! It was long, but every word of it was worth the read and by far the best post I’ve read in a very long time. I loved how you taught me a lesson within a story, I can’t thank you enough for a breath of fresh air.

    Sorry about the ‘Screw you’ stuff, of course, I didn’t mean it.

  2. As Nick said, this was truly one of the top posts we’ve seen here on BP in the almost five years this blog has been around, Jeff! Sure it was long, but anyone that cheated themselves by not reading the entire thread simply missed out.

    Thank you for keeping it real and for educating the rest of us!

  3. Jeff
    Excellent post although the title is a little misleading. It comes across, at least to me, that you are against cash flow. But as we all know, and you mention, cash flow is the FOUNDATION of all Real Estate Investing. You are correct, it is NOT the ALTAR. I remember reading a book many years ago that said to buy one rental house a year, every year. In year ten, sell that first one, and buy two or three more. In year 11, sell the year 2 house, and buy two or three more. In 20 years, owning 30-40 houses is quite feasible. In 30 years, owning 100 homes is well within the realm of possibility.

    You are also correct in stating the need to change markets. Sticking to one market is like sticking to one stock. I mean, even Warren Buffet lost $17B last year. For those that don’t know, Buffet is only invested in a handful of stocks like Coca Cola, Wells Fargo, etc… Having the ability to change markets greatly increases your chance for success.

    Many posters on here seem to ‘worship’ at the 2%/50% rule that they forget the larger picture. Personally, I would take 1% if there is a higher than average chance of 5-10% annual appreciation that would allow me to sell one and buy 3 more in 5 years.

    Very good blog, thank you!


  4. Mike — I’ve seen that formula before, and don’t disagree with it’s underlying principles. However, I’d modify the chronology. Experience has taught me to allow markets to tell us, as investors, when the time is right to exchange to more properties. I’ve had decades when I’ve had clients literally effect three exchanges using the same original ‘root’ capital. The opposite is also true. I advised about half my clients not to exchange during the entire decade of the 90’s.

    The market speaks to us as to when.

    Thanks again, Mike.
    .-= BawldGuy Talking´s last blog ..How To Minimize Your Retirement Income – A Case Study =-.

  5. Wow…when I first started reading the article, I thought that it was going to be way over my head. But I totally get it. And I feel smarter for having read it.

    Thanks so much for sharing!

  6. Jeff
    Absolutely. The idea, “buy a house a year…..”, is a CONCEPT, not a CHRONOLOGY. You may go five years and not buy a house and you may buy five houses in one year. Market Conditions will always be your indicator. If you bought a rental house in Las Vegas in 2002 and then bought one in 2007, the markets were very different. I bought a house in Durango, CO in 2001 for $130,000 and sold it for $200,000 in 2003. Today, that house may bring $150,000. This entire time, the rent would be $800-$900 a month. Who on here wouldn’t take $800 a month rent on a $130,000 house if you were guaranteed $70,000 in 18 months? Even at a 2% rent rate, you would only make $46,800 vs. $84,400 ($14,400 rent plus $70,000 Capital Gains)

    Although ‘market timing’ is tough in stocks, with Real Estate, it is much easier. If I read your blog correct, you give two main concepts: 1. Watch the markets 2. BE READY TO ACT. And I got three main ideas: 1. Understand leverage 2. Understand Tax Consequences 3. Be flexible in which market you invest.

    Again, very, VERY good article.


  7. Sounds great in retrospect to go through and pick out all the peaks. In actual practice it is much tougher and then you need to take into account capital gains tax and realtor fees when selling.

    This quote I found particularly strange:

    ‘The market would’ve told him to exchange his enlarged equity position in the first quarter or so of 1979. ‘

    What exactly does that mean? This is just a bunch of voodoo in my opinion, as all this retrospective analysis is.

  8. Jeff Brown

    Hey Peter — Merry Christmas!

    Retrospect? Pick all the peaks? Don’t wanna come off as a smart aleck on Christmas, but the first thing my mentors taught me was that buying low and selling high generally worked out best. 🙂 I lived through those times, took clients from one comma to two comma net worths, and went right along with ’em. I’m talkin’ real life here. Nobody ‘picks’ the highs and lows of the market, and those who do are not only living in fantasy land, but worse, they’re foolin’ themselves. I’ve bought one time at a low, and sold one time at a high in my entire career. Both times were pure, unadulterated luck.

    “The market would’ve told him to exchange…1979…” You ask what that means. It means what it says. When an investor’s equity position has improved to the point he/she can significantly improve that position with an exchange, the market has ‘spoken’. I should’ve been more explicitly clear on that point.

    Capital gains taxes? Realtor fees? Where I come from when ya do a tax deferred exchange there are no taxes to pay. Also, if you’ll notice in the post, there are several times where I’ve purposely used the phrase ‘net exchangeable equity’ which means AFTER costs of selling. For the record, I used an 8% sales cost in each exchange, which is plenty in my experience.

    Voodoo? Now that’s where you and I might find some common ground. 🙂 Even someone with decades of experience is still making a judgment call when it comes to the timing of buying/selling. Nobody ever bats 1.000 — in fact most don’t come close. Just getting general trends right is a major victory from where I sit. Frankly, I’m not smart enough to ‘time’ markets, never have been. For example, when I decided San Diego was simply not making any sense whatsoever, back in late 2003 or so, I began moving equities to different regions outside of California. In retrospect, I was a year or two late. The problem? My crystal ball has been in the shop since Carter was in office?. 🙂

    Thanks for the comment, Peter. Good luck.
    .-= Jeff Brown´s last blog ..Merry Christmas – Please Buckle Up Before the Ride Begins =-.

  9. Jeff Brown

    Peter — That’s a much used strategy. Sometimes with specific properties and a particular set of circumstances it makes sense, but not usually. There will be unintended consequences. First, you’ll end up on the refi prop with no tax shelter at retirement, just like the free and clear guy did. If you should realize that’s about to happen, and do exchange that equity, you will have hamstrung yourself by reducing your options through loan over basis problems. It wouldn’t affect your 1031, but it would make other options unavailable to you, or at least a bigger pain.

    Remember, though investors will quickly agree arriving at retirement with the most income possible is the primary goal, they often forget it’s the AFTER tax income they’ll be spending.

    I’ll be posting about one of those strategies very soon. Great question, Peter.
    .-= Jeff Brown´s last blog ..Merry Christmas – Please Buckle Up Before the Ride Begins =-.

  10. Jeff,

    This was probably the best post I have read this year.
    Your wealth of knowledge was clearly demonstrated through the writing of this article.

    You made me think, and opened up my eyes.

    Being a younger real estate investor, I don’t have the years of experience under my belt, that some of the older real estate investors have.

    Experience comes as we live our lives, obviously.
    So if younger investors can learn from the tips of those that have gone before them, this is a great thing.

    I have always felt that ‘churning’ real estate and capitalizing on the capital growth is the way to go.
    So many people blindly believe that buy and hold is the way to go.

    Once again, outstanding article.

    Best Regards,
    .-= Neil Uttamsingh´s last blog ..Top Blogs of the Week =-.

  11. Jeff,
    I’m a believer in the equity building strategy due to the tax deferred nature of it; however, I am unclear as to how you keep the cash flow tax free or relatively tax free upon retirement? You mention a tax shelter in your example; what tax shelters do you prefer? How do you recommend setting up one’s retirement portfolio to decrease tax exposure?

  12. Jeff,

    How does this strategy would out in our declining property value market? One could exchange all of their equity away in a few deals. Yes buy low, sell high, but where is the low in today’s market?
    I bought my investment properties for just about nothing, they were junk buildings. During the boom times they were financed 100% including all repairs, with a few bucks to spare.
    My need was for massive cash flow to pay for my children’s private schooling, and later college tuition, for this purpose the cash flow was great, leaving no school debt whatsoever.

    The need to these properties is now over, I will be selling all of my multi units and exchanging into better property in the suburbs. These units are low income and because of that are still quite desirable as investment properties, while in the suburbs prices went up to fast and cash flow was non existent. If the market value in my area was slashed by 50% I would still make a profit on the sale.

    These suburban properties have fallen in value, the enthusiasm of the boom time investors has cooled, and quite a few properties are falling into foreclosure, and this is good.
    Maybe sanity will creep into investment housing once again.

    Don’t get me wrong, your strategy is right on, but most small investors need cash flow starting off, once their reason for getting into this business is realized, they must move up and on or molder.

  13. Hey Dennis — First off, allow me to say you’ve obviously done a great job in attaining your investment goals, especially as it relates to the high cost of college.

    Your point about a downtrending market are savvy, but isn’t universally true. For example, the clients who’ve gone to Texas in the last several years haven’t lost a dime in equity. How can I say that with a straight face? Easy — the appraisals in the same neighborhoods for the same property types, sometimes on the same streets are coming in not a buck lower than they paid years earlier. It’s about serious boots on the ground research, experience, and actual expertise.

    Obviously, in your market the above wasn’t your experience, which is why you avoided certain areas. That was wise. But contrary to the mainstream media’s insistence, their data remains reliable only if they’re talkin’ about specific local markets, and not the country as a whole. But you already know that.

    Investors who simply must have cash flow due to their lifestyle choices, don’t do well with this approach. They must reach the point of their ‘day job’ buddies who don’t worry about puttin’ food on the table from the cash flow on investments. Make sense?

  14. I understand this post is old, but I am hoping someone can answer a few questions for me.

    “Having put 20% down [of $80,000], his equity at that point would’ve been around $100,000”, how does he have 100k in equity after 4 years (1975-1979)? Did the price of the 4 plex shoot up 84k to 164k in 4 years between 1975 and 1979?

  15. Dan D.

    I came across this post and it has good points, but looking back and timing the market retroactively always can produce great results… especially in CA.

    Imagine what money in the stock market would have done if it was traded perfectly in the stock market since the 1970’s. If he simply would have invested $80,000 and let “the market speak to him” perfectly monthly from 1970 to 2014, he would have had $26 BILLION dollars. He would have been way ahead.


    Of course, perfect timing is the assumption.

    On a traditional buy and hold however in stocks, he would have been around $6 million in stock from 1975-2013


    • Jeff Brown

      Hey Dan — Though it was indeed a look back in time, my experience and that of my clients were in real time. I can point to dozens of real estate investors who slaughtered their stock investor counterparts over that 38 year period. Absolutely annihilated ’em. Their timing wasn’t bad at all, but most of the time they simply listened to the market and made their move. Those, for example, who sold and moved up in the spring/summer of ’77, also did so at the end of ’78, early ’79. But they again listened to the market and didn’t get greedy, or succumb to the human nature tendency to believe the chart always goes up or down as the case may be.

      They then did the same thing in the mid-late 80’s. If they listened to me they did the same thing at the turn of the century, but then got outa CA no later than early ’04, and battened down the hatches, so to speak. There’s never been any crystal balling, just listening.

      That’s why I’m tellin’ investors now to take advantage of the once in a lifetime ‘perfect storm’ we’ve been experiencing for a few years now. It’s all positive, but won’t remain so, as it never does. Once the market begins speaking, we’ll find ourselves reassessing what makes sense.

  16. Randy E.

    Hi Jeff,

    Thanks for this article. It is an oldy, but it is certainly gold to me. While it all makes sense and is eye-opening, I can’t say at the moment that I’m immediately ready to ditch my buy&hold+refi&buy more plan, but you have certainly given me food for thought. Food and some real world numbers to crunch.

    I’m uncertain your plan works as well as it does on paper in markets that don’t have that nuclear fusion equity boost in the first five years of ownership. For those of us in steadier markets, our equity growth over the first four or five years might be more like 20% instead of the 400% in your example. Instead of having $100,000 to reinvest, non-SoCal investors might have $25,000 to invest. That’s not much more than the initial $18,000 outlay and probably won’t result in a significant bump in property acquisition as in your example. Am I missing something there?

    I’m not entirely poo-pooing your plan. Even with slower, more rational appreciation, I think the plan has merit. Especially considering the tax depreciation consequences of holding property past its depreciation window versus more recent purchases that have a long life of depreciation reward us.

    But, I’m a little confused why you said buying such properties via refinancing other properties isn’t as good an option as outright selling the earlier purchased properties and then making the new acquisitions. Is that solely (or mostly) due to some function of the 1031 exchange?

    You’ve given me some serious food for thought. Thanks for that!


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