{"id":102917,"date":"2018-10-14T14:30:23","date_gmt":"2018-10-14T20:30:23","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=102917"},"modified":"2024-02-19T08:00:57","modified_gmt":"2024-02-19T15:00:57","slug":"invest-hottest-markets-cash-flow","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/invest-hottest-markets-cash-flow","title":{"rendered":"How to Invest in the Hottest Real Estate Markets and Still Cash Flow"},"content":{"rendered":"

Most people think there are two options when buying rental property. Option A is to buy in a hot market with little to no cash flow and wait for appreciation. If you\u2019ve been listening to the BiggerPockets Podcast<\/a> for a while, you know this method is frowned upon by most investors here. Option B is to buy in a market with good cash flow, even if you don\u2019t see much appreciation. <\/span><\/p>\n

But what if there were a third option? What if you could combine cash flow with great appreciation? Well, you can!<\/span><\/p>\n

Before we get into that third option, let\u2019s talk for a minute about cap rates and why the first two options exist. <\/span><\/p>\n

A Primer on Cap Rates<\/h2>\n

A cap rate, short for “capitalization rate,” is the relationship between net operating income (NOI) and purchase price (purchase price divided by NOI). If you have a low cap rate, you\u2019ll pay more for the property and get less cash flow. A high cap rate means you\u2019re paying less for the property and have more cash flow. <\/span><\/p>\n

Why We Have Two Options<\/h2>\n

For this discussion, we have to assume investors are rational. We can debate that assumption in the comment section, but for the most part, large institutional investors are rational, and they\u2019re the ones setting prices.<\/span><\/p>\n

Now, why would someone be willing to pay more for a property and get less cash flow, i.e. low cap rate markets? <\/span><\/p>\n

If a market has great fundamentals, including population growth, job growth, rent growth and high occupancy, an investor is willing to pay more for income generated by a property than they would in a market that doesn\u2019t have those fundamentals. That\u2019s because there\u2019s future upside that\u2019s not being accounted for in the current income. Let me say that again: Investors are paying more because there\u2019s potential for income growth. \u00a0<\/span><\/p>\n

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\nRelated:<\/strong> Cash Flow vs. Equity: Which Pays Off for Investors in the Long Run?<\/a><\/em><\/p>\n

So, if you see a low cap rate, that means people are paying more for the same income, and it\u2019s likely that this market has good fundamentals. Markets where people are moving to in large numbers (think Phoenix, Seattle, Austin, and Charlotte) have low cap rates. Conversely, in high cap rate markets where investors are paying less for that income, the market likely doesn\u2019t have great fundamentals. Josh Dorkin would probably give an example of Detroit here. \u00a0<\/span><\/p>\n

You Can Have Both!<\/h2>\n

Now, here\u2019s where value-add comes in. What if you could buy in a low cap rate market\u2014so somewhere with strong fundamentals and a high likelihood of appreciation\u2014but still get cash flow? Ben Leybovich and I just did exactly that on a recent deal here in Phoenix. <\/a><\/span><\/p>\n

Phoenix has great fundamentals. It\u2019s number two in the country in population growth amongst large cities. Rent growth for 2018 is near 7%. Phoenix is adding jobs twice as fast as the national average. So, it should come as no surprise to you that Phoenix has cap rates under 5%. We just bought a 98-unit apartment at a 4.75% cap rate. That probably sounds crazy to some of you, but I can assure you we\u2019re excited about it! Why? Because after our $1.4 million renovation, we\u2019ll be able to increase rents by over $300. That will bring our cap rate to over 8%! What\u2019s more, we\u2019ll still get the benefit of being in Phoenix, and all of the potential upside that comes with it. As the population continues to grow, we continue to add jobs, and rents get even higher. <\/span><\/p>\n

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\nRelated:<\/strong> My Secret to Maximizing Cash Flow & Appreciation: Buying on the Fringe<\/a><\/em><\/p>\n

That delta we create in the cap rate (sub 5% to over 8%) through value-add projects is what allows us to buy in a hot market and still get cash flow. Now, as this method gets more popular, that delta will continue to shrink. Some of the big value-add investors in Phoenix last year have already moved on to places like San Antonio because of competition. It might take longer to find a property with that large of a delta in Phoenix, but if you can find it in the hottest markets, i.e. great fundamentals, the payoff can be huge. <\/span><\/p>\n

Another reason a value-add deal can be more rewarding in a hot market than a mediocre market is the amplification of your increased income. If I\u2019m in a market with a 10% cap rate and I increase income by $100,000, the value of my property increases by $1,000,000. However, If my market is at a 5% cap rate and I increase my income by the same $100,000, the value of my property has now increased by $2,000,000! The lower the cap rate, the greater the amplification of your value-add project.<\/span><\/p>\n

We\u2019ve been told for years that it\u2019s all about cash flow. Appreciation plays are too risky. Well, I\u2019m here to say it’s about <\/span>creating<\/span><\/i> cash flow in a market that will give you plenty of upside and appreciation. You can have your cake and eat it, too.<\/span><\/p>\n

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Do you invest primarily for cash flow, appreciation\u2014or some combination of both?<\/em><\/p>\n

Weigh in with a comment!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

Most people think there are two options when buying rental property. Option A is to buy in a hot market with little to no cash flow and wait for appreciation. Option B is to buy in a market with good cash flow, even without much appreciation. But what if there were a third option? <\/p>\n","protected":false},"author":240844,"featured_media":70057,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4241],"tags":[],"class_list":["post-102917","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-real-estate-business-management"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/102917","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/240844"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=102917"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/102917\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/70057"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=102917"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=102917"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=102917"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}