No doubt, the point of investing is to receive income.
Why else would you invest? You want to put your money into a property or a project or a stock or a thing or whatever will earn you some cash. It’s the whole reason for investing- to turn a smaller amount of money into a larger amount of money.
How does one do that? There are a few ways that earning money can happen with investing. The simplest to understand is interest. If you loan someone an amount of money and attach a set interest rate to it, that person will pay you that interest on top of what you originally lent.
Your investment income then is that interest they pay you. You get your initial investment back plus that interest and that is your return. Great money! The nice thing about earning interest is that it’s defined up front with no unknown variables. The only risk in loaning money like that is if the person stops paying on the loan.
Even if you take that person to court, it doesn’t guarantee you will see that money again because if the person truly doesn’t have the money to pay you, the best you can get is a lien put on them saying as soon as they do have the money they will pay you. From personal experience, don’t hold your breath waiting to see that payment show up on your front stoop.
What about earning returns in ways more specific to real estate investing? Like, by owning actual real estate. Flipping houses is very popular. If you flip a house, you buy a house cheap with your own money, fix it up, and resell it at a higher price than what you initially paid for it plus what you had to put into it for the rehab.
When you rehab a house, you force appreciation. It’s a cool play actually. What about straight rental properties though? Rental properties are a long-term hold model versus flipping which is shorter-term with forced appreciation (usually). Since nothing is being forced for a rental property, how do the returns work on it?
Two major things contribute to earning returns on a rental property: 1. Cash Flow and 2. Appreciation.
Buying for Cash Flow vs. Appreciation
When you set out to buy a rental property, you’re first thought should be- “how am I going to make money with this property?” You can make money in a few ways with rental properties: cash flow, appreciation, equity build, tax benefits… But let’s just focus on the first two since those are the big ones and those are the two that will (should) drive your decision of what property to buy.
1. Cash Flow
The most popular way to earn money on a rental property is with cash flow.
Cash flow refers to the profits you collect each month from the property. The way it works is you collect the rent from the tenant (a.k.a. gross income) and subtract your expenses (mortgage, taxes, insurance, repairs, management fees, vacancies, etc.) and that leaves you with your cash flow (a.k.a. net income).
Cash flow is exciting because it’s money in your pocket but also your financing and expenses are covered by your tenants’ rent rather than out of your own pocket.
The trick to buying for cash flow is to know how to properly calculate the returns that you should expect on a property. For details on calculating these returns, check out Rental Property Numbers So Easy You Can Calculate Them on a Napkin. But more generally, you need to understand price-to-rent ratios, as they pertain to rental properties.
The price-to-rent ratio will give you an idea, first and foremost, as to whether or not you can even get cash flow from a property. When could you not get cash flow from a property?
When the rent you can collect on a property is not high enough to cover the cost of buying the property. Higher purchase price + lower rent collected = bad price-to-rent ratio. There are few better examples than Los Angeles to demonstrate bad price-to-rent ratios. I used to rent a townhouse in Los Angeles for $2,250/month.
I know that the owner bought the townhouse for $460,000. Calculating the mortgage payment on that house, plus taxes, insurance and condo fees brings the monthly expenses to $2,525.50. See any problems there? The cost of owning that house, per month, isn’t covered fully by what I was paying in rent.
And that doesn’t even include expenses like maintenance and repairs; I only included the fixed expenses that can’t be avoided. Why not raise the rent, you ask? You can’t just raise rents to whatever you want them to be.
What you ask has to match market rents or you’ll never get it rented. So the price-to-rent ratio on that townhouse is bad for investment purposes because the owner is losing money every month.
If you are wondering, yes there are plenty of properties that have great price-to-rent ratios. The first investment property I bought in Atlanta had a great one. I bought the house for $55,000 and it rents for $975/month.
All of the expenses combined only total $650/month, so I’m profiting $325/month. See how much nicer that works out than the Los Angeles townhouse? It’s all because of the difference in the price-to-rent ratios.
Well why would anyone in the world ever buy a house with such a bad price-to-rent ratio that they lose money every month? Oh, it happens more than you think.
The majority of people who do that are those who just don’t know any better (good thing you have BiggerPockets, so you can know better!). There is another group of people though who happily take the monthly loss; those who are investing solely for appreciation.
Speaking of Los Angeles… where better to buy a rental property than if you are just hoping for appreciation?
California in general is huge for the appreciation play, and southern California especially ranks up there for one of the most popular areas for this game.
California has been one of the most widely-known states, if not the most widely-known, to experience drastic increases in real estate prices and a lot of investors have made a fortune from this. So are investors more likely to be totally fine with losing money every month on Los Angeles properties? Absolutely.
Why? They assume their returns will come later once the property appreciates significantly and they collect on that appreciation.
Appreciation plays can award insanely high returns if done right. But what comes with higher returns, almost always? Higher risk. The problem with the appreciation play is appreciation isn’t guaranteed. Appreciation is based off of speculation.
There are smart ways to speculate of course, but none of it is guaranteed. If you don’t believe me, just ask any speculator in 2009 when the market crashed.
Of course, if your property doesn’t appreciate like you hoped you can keep hanging onto it and wait it out longer, but if all the while you are losing money each month, you could be hurting after not very long.
Which One to Choose?
It all depends on your goals.
Some people would never play the appreciation game because they say it is too risky. Some people say cash flow is stupid because you only get a couple hundred bucks a month which is next to nothing compared to what you can make from appreciation. You can be either one of those people and choose which one you like or feel more comfortable with.
Just realize, they are completely different plays. Investing for cash flow is less risky and built more on solid (known) fundamentals but it will give you your return in small amounts over a long period of time. Investing for appreciation is much more risky because appreciation isn’t guaranteed but if you play it right, you can end up with a fat wad of cash in your pocket later on.
There is a third option. This option falls more closely towards the cash flow end of the spectrum, but it still considers the appreciation play. That option is- invest for cash flow in markets that look promising for growth. Los Angeles won’t be one of them because it’s almost impossible to get cash flow.
It’s appreciation-only. Cleveland won’t be one of them because it’s not looking promising for appreciation anytime soon. It is a cash-flow market. But what about cities like Houston, Dallas, Atlanta, Chicago- all of which are seeing substantial growth booms right now?
If you buy a rental property in those markets, you won’t get as high of cash flow as you would in places like Cleveland or Detroit, but you also stand a much better chance of seeing some appreciation in the very near future and potentially a good bit of appreciation over the farther out future. You will never get as much appreciation in those cities as you would in say Los Angeles, but you stand room to get some.
So there is a spectrum of investing for cash flow or appreciation. You can invest for cash flow only, appreciation only or somewhere in the middle. The major difference you need to understand is the difference between the appreciation-only option and the other options.
The other options (cash flow only or in the middle) are giving you positive cash flow each month which is very important in the case that appreciation on the property doesn’t happen. If there is no appreciation, it’s okay because you are still profiting. The appreciation-only play is 100% dependent on the property seeing appreciation.
That is where the risk comes in and differentiates it from the other options. The appreciation-only play is that house that is losing money every month, like the Los Angeles townhouse. You have to lose money every month in hopes that the appreciation happens.
A lot of people do this and would invest no other way, but a lot of people out there have lost a lot of money doing this too so be very careful getting into it. If you do invest for appreciation though, and it has worked for you, consider me jealous and I’ll give you a high-5 next time I see you!
Where do you fall in the cash flow versus appreciation spectrum?
Be sure to leave your comments below!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.