Usually people will invest for cash flow when it comes to real estate. Appreciation of a house is a nice bonus. But is it OK to invest solely based on the belief that a property will appreciate? The short answer: Very rarely. That being said, there are times when it makes sense. But they are relatively few and far between and come with a lot of caveats.
When the Answer to That Question Is ‘No’
If you are a new investor just getting your feet wet, then, no, you should never buy a property based solely on its prospects for appreciation. Yes, I’m sure you can come up with a hypothetical scenario where the answer should be yes.
Say you get wind that a particular property will be bought by a giant developer hell-bent on building Burj Khalifa 2.0 and willing to pay quadruple the market value for it. OK, if you have evidence that something like that is happening, go for it.
But in almost all realistic situations, if you are a new investor looking to flip, you should only buy properties with equity in them at the current moment so you can immediately flip them and make a profit. And if you are looking to hold, you should only buy properties that 1.) have equity in them to begin with and 2.) make a positive cash flow when rented out.
Of course, a bad tenant or a bad year will cause such a rental to lose money. But the property should be projected to—and more often than not—make money on a year-over-year basis.
Margin of Error
In addition, if you have some rentals, but are cash poor and don’t have much money in reserves, investing solely on the potential of future growth is an unwise decision. This is because even if the area you buy in appreciates substantially, you are leaving yourself with a very slim margin of error.
This is a margin of error that gets even smaller as you buy a property that will be cash flow negative for the foreseeable future. (That’s until either the rents increase dramatically, or the price does so you can sell it for a big profit.)
The problem is that no one knows exactly when or even if this dramatic appreciation is going to happen. And we all tend to overestimate our ability to project such things. Take, for example, a study of 284 political and economic experts and their predictions on the future that Daniel Kahneman cites in his book “Thinking Fast and Slow.” Here’s how Kahneman describes it:
“The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of three potential outcomes.”
And if even “experts” can be wrong, you better believe that you and me can be just as wrong. And if you’re wrong, you’ll be left holding the bag. Therefore, you better be able to afford it if you’re going to take such a risk.
Investing for Cash Flow vs. Appreciation
It is sometimes falsely stated that buying for equity or cash flow is “investing” and buying in hopes of future appreciation is “speculation.” This isn’t quite right. Investopedia explains the actual difference as follows:
“Whenever a person spends money with the expectation that the endeavor will return a profit, they are investing. In this scenario, the undertaking bases the decision on a reasonable judgment made after a thorough investigation of the soundness that the endeavor has a good probability of success.
But what if the same person spends money on an undertaking that shows a high probability of failure? In this case, they are speculating. The success or failure depends primarily on chance, or on uncontrollable (external) forces or events.”
Effectively, speculation is little more than gambling.
However, when you combine that with what we know about the frailty of a human’s ability to project the future, there isn’t a huge difference. When does investing based on anticipated appreciation reach the threshold of an undertaking that “bases the decision on a reasonable judgment made after a thorough investigation of the soundness that the endeavor has a good probability of success?”
Following the ‘Path of Progress’
The first step is thorough research into an area and its potential for growth, additional jobs, and gentrification. A good book to begin with here is David Lindahl’s “Emerging Real Estate Markets.” The book deals primarily with multifamily properties, but its lessons could be applied to single-family and commercial. (Although, I should note, Lindahl recommends buying properties that cash flow in addition to having the potential of upward appreciation.) One of the key things he looks for is the “path of progress,” which he illustrates with the example of Southern California in the 1970s:
“If you had looked at a map of Southern California 40 years ago, you would have seen that Los Angeles and San Diego were the two largest cities. Between these two giants were hundreds of smaller cities and towns, and millions of acres of farms, orange groves, and undeveloped land.
The Path of Progress indicated that soon there would be little bare land between these two great cities, 120 miles apart. Los Angeles and Long Beach moved south, and San Diego moved north. Huge fortunes were made by investors who followed the path of progress.
One man, Donald Bren, became a billionaire by buying up thousands of acres of bare land in a once-sleepy agricultural county called Orange County. Orange County was smack dab in the middle of this Path of Progress equidistant between Los Angeles and San Diego.”
Donald Bren would be the perfect example of when investing for future appreciation makes sense. That being said, Donald Bren obviously had the reserves to carry that bare land for many years without it producing income. If he hadn’t, he almost certainly would have had to sell the land for a loss and then watch as someone else made that fortune instead of him.
What to Look for
David Lindahl recommends looking for several things to indicate a real estate market is emerging, which include:
- A growing number of students enrolled in K-12
- A growing number of building permits
- New jobs coming into the area, particularly high-income jobs, since each high-income job usually brings with it two to three support jobs
- Shrinking vacancy rates for industrial, commercial, and residential properties
But overall, Lindahl keeps an eye on major job announcements and the city’s economic development plan, which most places have and should give a good indicator of the path of progress in your locality. (For example, here is the plan for the metropolitan area of Kansas City). Studying this as well as looking at the indicators listed above should give you a good idea of which areas are going to experience substantial growth in the near future.
That being said, nothing is certain when you are investing, so no matter how much research you do and how good an area’s prospects are, projecting the future is always a high risk venture.
When Should You Invest Only for Appreciation?
Effectively, this type of investing (when done right) is the barbell strategy applied to real estate. This strategy “…advocates pairing two distinctly different baskets of stocks. One basket holds extremely safe investments, while the other only holds highly leveraged and speculative investments.” These investments for appreciation only are the “highly leveraged and speculative investments” that should make up, at most, a minority of your portfolio and have a high potential payout if things turn out well.
Of course, you should invest for appreciation and cash flow. Sometimes it makes sense to invest only for cash flow (if you specialize in lower-end areas); and from time to time, it may make sense to invest only for appreciation. This should be in higher-end areas that are too expensive to cash flow effectively, but have all the signs brewing of substantial appreciation.
Even still, you should do this with only a small part of your portfolio. It should be considered a high-risk/high-reward venture that you are comfortable taking a hit on if things go sideways—because you have cash flow from other rentals and cash reserves. It should not be the beginning of your portfolio, nor should it be the heart of your portfolio.
What’s your take on investing only for appreciation?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.