Great Expectations: Evaluating Cash Flow vs. Equity in 2021’s Wild Market
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Great Expectations: Evaluating Cash Flow vs. Equity in 2021’s Wild Market

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Dave Meyer Read More

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The last year has been a global lesson in adjusting expectations. Since the world learned about, and subsequently reacted to, COVID-19, we’ve all had to reset what we think we know.  Whether it’s work, parenting, school, travel, or pretty much anything else, we’ve had to adapt to a “new normal.”

The housing market is no exception. What we used to think of as “good” appreciation now looks paltry in comparison to recent data. What used to be considered “good” cash flow is now extremely difficult to find. We’re in unprecedented times.

And while it appears that things are returning to normal in most sectors of life, I am not so confident the housing market will return to pre-pandemic levels anytime soon. As such, investors will need to adjust expectations and strategies to adapt to the new reality.

Cash flow is no longer king

Even before the pandemic, cash flow was becoming more elusive. The simple fact is housing prices have been rising faster than rents since about 2011, and that degrades cash flow prospects.

When talking about cash flow at a macro level, I typically use a metric known as the rent-to-price ratio (RTP) because it requires just two readily available datapoints to calculate (median rent and median sales price) and is highly correlated with cash flow (.86). The higher the RTP, the better the cash flow potential.

Unfortunately, RTP has been declining consistently, making cash flow harder to capture. Of course, in certain markets, cash flow is still abundant, or at the very least still possible—what I am talking about here is on the national level.

Though this trend began almost a decade ago, since the recovery from the Great Recession, the pandemic has accelerated it. According to data from Zillow, since the beginning of 2020, rents have gone up an average of 5.9 percent across the 106 largest markets in the United States, while housing prices have gone up 9.8 percent.

Personally, I don’t foresee a recovery in cash flow prospects for at least another year, if not longer. Even though the rapid growth in housing prices is not ideal and will hopefully return to more normal growth levels soon, it is underpinned by strong market fundamentals. Therefore, to be an active real estate investor in 2021 you have to adjust your expectations for what a good deal looks like.

To me, a good deal in 2021 means modest cash flow and strong equity growth.

Cash flow in 2021

If you’re familiar with BiggerPockets, you’ve likely heard of the 1 percent rule, which states that in order for a deal to be considered, it must have an RTP above 1 percent. While I wish this rule was still relevant, I think it’s time to retire it. The 1 percent rule was invented in a housing market with very different dynamics than the one we’re seeing today, and it has lost much of its utility.

We need new benchmarks for measuring “good” cash flow in 2021, starting with level-setting where cash flow in the U.S. sits today. To do that, I simulated cash flow (using recent purchase and rent data, alongside tax, insurance, and repair estimates) for 556 of the biggest metros in the U.S.

What I found is that the average RTP in the U.S. is 0.51 percent—well below the 1 percent rule. Even worse, that corresponds to an average cash-on-cash-return (CoCR) of -7 percent. Of all these markets, only sixteen offer a median RTP above 1 percent, and only twenty-five offer a median CoCR above 5 percent.

Keep in mind that, in this analysis, I am talking about the average deal in the U.S. or in a given market. By rule, that means there are individual deals in each of these markets that are both higher and lower than that average. So when I say the average CoCR for Avondale, Arizona, is 1 percent, that means savvy investors can still find deals that exceed that rate of return.

For this reason, I believe that investors in 2021 need to be comfortable exploring markets that do not meet the 1 percent rule. Instead, I would argue that any market with a median RTP above .65 percent and any individual deal with an RTP above .70 percent is worthy of consideration. Likewise, it would have been unwise to accept a deal with a CoCR of only 5 percent in 2013, but today that deal might be the best thing on the market.

Let’s take Bloomington, Indiana, as an example. Bloomington has an RTP of 0.83 percent and offers an 8 percent CoCR—which puts it in the top twenty markets for average cash flow in the U.S. right now. Sure, an 8 percent CoCR was an “average” deal a few years back, but times have changed.

As investors we need to adapt with the times. Cash flow is hard to come by and, for many investors, cash flow alone is no longer high enough to justify an investment. But luckily, as cash flow prospects have dimmed, investing for equity is booming, and that means great returns can still be found.

Investing for equity

Investing for equity is not always seen as an attractive long-term investment because it is illiquid. You cannot easily pull equity out of a property and use it to support your lifestyle—or retirement.

But investing for equity is an excellent way to boost the total return you generate on your money, and it’s easier to come by than cash flow in the current market. You can also turn equity into cash flow later.

There are generally two ways to invest for equity: appreciation and amortization.

Appreciation is when the value of a property you own increases, which can happen through market appreciation or forced appreciation.

Market appreciation

Market appreciation is what most people think of when they hear the term “appreciation.” Many think you can just buy a property, and over time it magically increases in value. But that’s not always been the case. In many areas of the country, market appreciation has traditionally been inconsistent and difficult to predict. Instead, big cities like New York, Seattle, and Austin tend to appreciate while other markets keep pace with inflation but not much else.

That has changed. Between January 2020 and May 2021, the average home price has grown 9.8 percent in the United States according to Zillow data. In that time, only twenty-three of the 911 measured markets saw prices decrease.  Furthermore, a whopping 845 of the markets had appreciation that outpaced inflation. That’s a lot of market appreciation.

Again, we need to adjust our expectations. While we at BiggerPockets have been saying for years that you shouldn’t rely on market appreciation, right now market appreciation is the norm, and I believe it will continue to be the norm for at least the next year or so. The consensus among experts is that property prices nationally are likely to continue to grow at least 4 per a year through 2022, and likely much higher.

I understand that many people reading this article disagree. Many believe that we’re in a bubble and that housing prices will crash in the near term, so let me quickly address that here.

I don’t think housing prices will crash in 2021. I do believe (and hope!) that this wild market appreciation we’re seeing will level off toward the end of 2021 but not crash. Here are a few reasons why:

  1. It is estimated that the U.S. is 3.8 million homes short of what is needed to adequately house the population. When demand is higher than supply, prices go up.
  2. Inventory remains incredibly low. It is starting to recover, but it’s unlikely it will recover quickly in a way that suppresses prices. Instead, it’s more likely to happen gradually, contributing to a cooling of the market but not a crash.
  3. For those predicting a foreclosure crisis, that is still a question mark, but the data doesn’t currently support that idea. As of this writing, 85 percent of loans leaving forbearance are in good standing, and the number of loans in forbearance has dropped consistently for months. I do think foreclosures will rise starting in July but not in a way that sends shocks through the market.
  4. Interest rates remain extremely low and will probably stay that way through 2021. When the Fed raises rates, it will likely be gradual, which, again, will cool the housing market’s growth but, in my opinion, won’t cause a crash.

Of course, we’ll have to wait and see what happens, but from my interpretation of current economic data, appreciation is likely to continue for the foreseeable future, albeit more modestly than what we’ve seen over the last year.

Forced appreciation

While market appreciation is dependent on macro-economic trends, forced appreciation is more controllable by an investor.

The idea behind forced appreciation is simple. Buy a property that has potential for improvements, improve it, and increase the value of the property by more than the cost of improvements.

This is the idea behind house flipping and the BRRRR method. As an example, let’s say you buy a property for $100,000 and put in $50,000 of improvements, and then the house appraises for $175,000. You’ve now “forced” the property to appreciate by $75,000 far faster than market appreciation would have. (Note: You only would profit $25,000 in this scenario.)

Forced appreciation was a solid strategy when cash flow was great, and forced appreciation is a solid strategy now. Because each rehab job is unique, it’s difficult to measure how well forced appreciation is working nationally in any individual markets, but I don’t believe anything has fundamentally changed about forced appreciation in the past few years, except that the price of lumber and a few other building materials has jumped of late and squeezed profit margins. Nonetheless, forced appreciation remains a great strategy in my book.

Amortization

Amortization is a technical term that represents the repayment of a mortgage. Each month, when you make a mortgage payment, some of that payment is applied to interest (the bank’s profit) and some is applied to principal (your equity).

By using your rental income to pay down your principal, you’re building equity in your property each month that can add up to a meaningful return.

According to a recent analysis I ran, if you buy a rental property with a $200,000 loan and a 4 percent interest rate, you can earn a 4 to 5 percent compound annual growth rate (CAGR) by just breaking even. If you use your rental income to pay your mortgage on time and cover your expenses—even if you have nothing else left at the end of the month—you’re still going to earn a decent rate of return on your invested capital thanks to amortization.

I understand that many people aren’t excited by a 4 to 5 percent CAGR, but that is just your return from paying your mortgage when breaking even from a cash flow perspective. If you factor in even modest appreciation, you can generate an excellent return.

Putting it together

To underscore the strong returns that can be produced by market appreciation and amortization alone, I created a fake deal.

Purchase price$250,000
Annual rent income$13,600
Rent-to-price ratio0.45%
Down payment20% ($50,000)
Closing costs$40,000
Interest rate4%

This is a straight-up bad cash flow deal. In fact, for year one, I lost a whopping $6. So, you might be thinking I would get killed on this deal, but that’s not the case.

With modest increases in expenses, rent, and property value (3 percent each annually), this deal produced an average annualized ROI (AAROI) of more than 20 percent for the first five years, and a compound annual growth rate of 8.9 percent.

I know this is an extreme example, but those numbers are amazing in today’s market—and this is with just modest appreciation numbers. If you find a market with appreciation above 3 percent, or can force some appreciation, your returns would be even better.

If you could find a similar deal that, instead of offering a zero percent CoCR, offered a modest 2.3 percent return, you’d have an AAROI of 23.6 percent and a CAGR of 9.2 percent over the first five years. Those are great returns for a deal that doesn’t look great on paper but is attainable in almost any U.S. market.

Converting equity to cash flow

There are few obvious investing options right now, and we need to adjust our expectations to the current macroeconomic climate. Cash flow in real estate is hard to find. Bonds are unlikely to keep up with inflation. Stock valuations are sky high. But investing for equity in real estate is still a great option.

It’s not the sexiest choice in the world, but it is relatively low-risk, will almost certainly outpace inflation, and offers huge upsides if market appreciation continues even at half its current pace. In today’s day and age, a CAGR of 9.2 percent would exceed my expectations for return from any other asset class—stocks, bonds, gold, whatever.

I know it seems that investing for equity is counterintuitive to the passive income strategy that attracts many to real estate investing, but it’s not. It just turns it into a two-step process: build equity, then reallocate capital.

If you build up $1 million in equity over the next ten years (step one), you can liquidate your portfolio and then buy properties for cash to generate more cash flow. When buying properties for cash, cap rate equals CoCR, so if you buy a property for all cash at a 7 percent cap rate, that $1 million in equity can be turned into $70,000 in cash flow ($1M x .07). Pretty good! If you build up $2 million in equity, that’s $140,000 in cash flow, and so on.

I’m not saying you have to do this. Liquidating your entire portfolio and buying only for cash is an extreme example, but I want to show you that equity can be converted into cash flow at the right time if you have enough equity to play with.

In general, my philosophy is to take what the market is offering, and right now the market is offering equity. So rather than focus your investing on deals with weak-to-modest cash flow, I am advocating for focusing your investing on total return, which requires building equity. If you build up enough equity, you will gain the flexibility to generate cash flow later.

My expectations have changed. I am no longer focusing on cash flow, and instead I am looking to build equity and generate the highest total return. For at least the next year or so, I think other investors should do the same.