Investing for Equity vs. Cash Flow: Which Is More Important?
And by “equity,” I primarily mean built-in equity (i.e., buying properties under market value). Of course, if you buy a property under market value in Orange County or New York, it probably still isn’t going to cash flow. You’d either have to flip it or hold it at a loss with the hope that it appreciates.
As with most things in real estate, your primary focus depends on your situation and goals. But in this instance, for most people, most of the time, focusing on one goal is better.
Is It Better To Have Equity or Cash?
First and foremost (and something you might be wondering), why not both?
You should definitely aim for a property that has both a significant equity margin up front and good cash flow. Additionally, seek out a property in a decent area that will be relatively easy to manage and has a good likelihood of appreciating.
But like the Rolling Stones song says, “You can’t always get what you want.”
Choices have to be made, and you will need to consider one criterion or the other more significant. Generally speaking, the more important thing should be to go for built-in equity. But there is one noteworthy exception. This exception probably only applies to about 0.1% of investors, but it’s still worth a mention.
When Cash Flow Matters More
Most years, I attend an event called the IMN Single Family Forum (I wrote about one such experience here). A bunch of mid-sized investors like myself attend, but the events are dominated by large, institutional firms that buy 100-unit portfolios on a routine basis (or lend to them or provide services for such companies).
And for institutional investors, cash flow is the name of the game. They are constantly talking about gross yield (annual rent divided by the price of the properties) and what their “buy box” is (what range they’ll accept for the gross yield of a portfolio).
These firms need to hit a certain return for their investors. For example, a fund might estimate an 8% return for its investors or an insurance company may estimate it needs a 9% yield to cover their expected losses. For these types of Wall Street firms, built-in equity is nice, but cash flow is the name of the game.
When Equity Matters More
Most of us on BiggerPockets (and in real estate in general) are entrepreneurial investors, though. I certainly am (or would at least like to think of myself as such). We don’t have to hit a specific percent return for our clients since we don’t have any. Thereby, we can focus more on getting a deal with a large chunk of equity up front than on satisfying a client’s yield requirements.
Buying with built-in equity allows us to BRRRR a property, get all (or most) of our money out, and repeat the process more quickly than we would have otherwise. Even if the "otherwise" here involved a house with better cash flow. Furthermore, it's built-in equity that protects us from the dangers of leverage and allows us to take advantage of its upsides (which are very big).
As I mention frequently, the IDEAL acronym (I: Income, D: Depreciation, E: Equity, A: Appreciation, L: Leverage) is a great explanation for why real estate is such a good investment:
If you buy a property for $100,000, but get an 80% loan, you only put down $20,000. Now if the property goes up in value by 5%, your return is actually 25% ($5,000 / $20,000). Which is a huge return.
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Now yes, leverage is a two-edged sword. Real estate can go down, which would lead to a 25% loss… But if you get a good deal, that insulates you from the risk of leverage.
For example, if you buy that hypothetical deal above for $100,000, but the property is worth $120,000, you have a $20,000 cushion right off the bat. If the property goes up in value by $5,000, you made 25% (assuming you got an 80% loan). But if it goes down in value by $5,000, you still have $15,000 of built-in equity and haven’t lost anything.
This doesn’t mean that cash flow doesn’t matter. You still need to buy properties that cash flow. There are a few occasions when the trends in an area are so strong it makes sense to hold a property even if it bleeds each month. But these instances are few and far between and should only be done with a small percentage of your portfolio. Going big on properties with negative cash flow is, more or less, just speculating.
However, entrepreneurial investors can pound the pavement and find the gems that slip between the bristles of the broad brush institutional investors use. This allows us to take advantage of the inefficient real estate market by finding motivated sellers, value-add opportunities, and mislisted properties (most often by institutions). This is the big advantage that entrepreneurial investors have and the biggest reason real estate is, in my judgment, the best way for someone of modest means to become independently wealthy.
And it’s equity that makes you wealthy. Cash flow is just the cherry on top.
A Note on Syndications
In between the world of institutional investors and entrepreneurial investors are syndicators (like Ben Leybovich, Matt and Liz Faircloth, and several others on BiggerPockets). Now, don’t get me wrong, these guys are plenty entrepreneurial. But syndications—which are usually for apartments or commercial properties—have passive investors who are not so entrepreneurial. These passive investors will be much more interested in a consistent return on their money than on promises that the deal was bought with equity or that it can cash out in five years (or however much time).
In the world of syndications, both cash flow and equity are important—and perhaps equally so. But I’m not much of a syndicator so I’ll let the experts hash that one out.
The Bottom Line
Syndicators and institutional investors aside, the most important thing a buy and hold investor should look for is built-in equity. The second is cash flow. There are other things too, of course, such as potential appreciation, neighborhood stability and safety, hassle, etc. But in real estate, first comes equity. Everything else follows from that.
Do you look at cash flow or equity first when you’re looking for a deal?
Share your preference in the comments.