Should I Invest for Cash Flow or Growth? An Investor’s Analysis
The new year is upon us, so if you haven’t taken the first steps to start investing, you should — and now is the time. I do understand that for a new investor, so many questions come to mind and getting answers that make sense can be a struggle. Here on BiggerPockets, the Forums, blogs and podcasts are all available to satisfy the never ending thirst for knowledge and feedback.
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With this blog, I thought I’d answer a question I get asked repeatedly from people all over the world, it also just happens to be my favorite.
Q. Should I invest for cash flow or growth — and why?
While this is as simple and straightforward as a question can get, it has quite a complex answer. I will try to keep my opinion clear and concise.
A. Cash flow! Always cash flow.
Always, always, always base your investment decisions on the numbers in the deal. The real numbers, the numbers as they stand TODAY. Never base your return on a prediction and hope that a property will rise in value. Hoping is not a strategy. Many other investments work completely off of predictions of growth, and that is fine. There is nothing wrong with that, but in real estate you have the option to look at only the true, in-your-face return. That is what I go with every time.
When I purchase a property, I only have two major concerns: what is my return based on the cap rate (click here for simple rule I use to crunch numbers) and is it in a solid B class area should I need to exit the investment quickly? (Meaning, can I sell it to another investor or owner occupier?) If you get growth or see a realization of appreciation, then that is just a bonus and the cherry on top. 🙂
When I say base your decision on the numbers in the deal, this is what I mean…
Basing Your Investment Decisions on the Numbers
You purchase a property in Toledo, Ohio for $50,000 cash, no financing, completely renovated. It’s a nice 3 bed, 1.5 bath, 1,400 sqft 2-story single family home built in 1935. It is currently renting for $1,000 per month and is in a solid B class area. Total gross annual return is $12,000 — deduct 40% for taxes, insurance and property management, leaving you with $7,200 in net annual return (feel free to discount further for maintenance/vacancy).
This is what you’re actually cash flowing. A rate of return at 14.4%! Those are real numbers, not predictions.
You purchase a property in Mesa, Arizona for $200,000 with financing involved at a low rate of 4%, hoping the value would increase to $300,000 in the next 5 years. It's a nice 3 bed, 1.5 bath, 1,400 sqft 2-story single family home built in 1992. So far the property has not been completely renovated, but it's all up to date. It is currently renting for $1,500 per month and is in a solid B class area. Total gross annual return is $18,000 — deduct 40% for taxes, insurance and property management, leaving you with $10,800 in net annual return. A cap rate of 5.4%.
Now, you still have to service your debt at 4% so your true return is only 1.4%, and you haven’t even added any calculations for maintenance/vacancy. (Note: I am not bagging Arizona as only a “growth” market; it was just a recent deal that came across my desk so I decided to mention its numbers in this blog.)
In my experience, predicting that a property will appreciate a third of its value in the next 5 years is unrealistic. Even a prediction of $50,000 cannot be justified.
I do understand the disbelief if you’re looking at a 14% return and thinking I must be crazy, but here in Ohio, Michigan and other parts of the Midwest, this can be a real expectation for that type of cash flow. I would much rather collect a 14% return year after year with no debt service because of a low entry price than wait and hope for appreciation to make up my return when I sell. Most of the folks renting these cash cows were once homeowners in the same area so it’s also only a matter of time before they jump back into the market looking to buy again.
Just think about this for a moment: the average turnkey B class property in Toledo generates a 12-14% return. So just taking those numbers, you could purchase 10 properties for $500,000 through a self-directed IRA or tap into existing equity, for example, and generate a gross annual return of $70,000 and have the ability to think about more important ventures like where to take your next vacation or how much sooner could your retire. These amazing numbers are one of the main reasons why I am not on the beach in Sydney, Australia right now, but rather freezing my, well, you-know-what here in Ohio. 🙂
I have always been a numbers person. I love working out the details of a property in my head. It is always necessary to have competent, trustworthy people on the ground to provide input, though. So if you’re a new investor or maybe just want to change course and rethink your methods, broaden your dreams and goals, and find good people AND good numbers.
I’d love to hear your plans for 2015 and your experiences in the different markets.
Please leave your comments below.