How do you consider equity build up when analyzing a property?

Question

So many calculators I've seen ignore equity build up. Why is that? Is it because that equity is locked in the property and not available to you?

I just think it's crazy to ignore the fact that somebody else's money is paying down your mortgage (interest AND principal). When you sell the property those principal payments become money in your pocket. Why wouldn't you factor that in? Most people use pure cash flow analysis for calculating after-tax returns, but in my opinion it ignores a huge part of the value of leveraged real estate investing.

What am I missing? The practical implication for me is that I will look not only at traditional cash flow numbers (cash-on-cash, before tax, after tax) but I will also then factor in equity build up when generating a "complete" or "comprehensive" return. Maybe there's an actual word for that.

Joseph Cacciapaglia · Answer

A lot of my clients are total return investors. They look at cash flow, appreciation, equity pay down, and tax savings. They also pay a lot of attention to rent growth. Most of the data driven investors that I know actually focus on rent growth and appreciation more than anything else when selecting a market and property. I realize that the majority of people on BiggerPockets skew much more towards being cash flow investors, but I don't believe that's representative of professional investors in general.

When I worked for commercial REITs and other institutional investors, we always looked at IRR first, and cash flow was always a secondary test. We wanted to be sure we had enough cash flow to get us to the finish line, which was a future liquidity event where we unlocked the equity pay down and appreciation (both forced and market). The upside to this strategy is that it leads you to invest in better areas than a cash flow focused strategy would take you.

Joseph Cacciapaglia · Answer

My number 1 source is our in-house property management team. They always have the most up to date information about which areas are getting the most rental apps/activity, which allows us to push rents. These trends are easier for them to spot, because they're living in it day in and out. I'm lucky, because we tend to manage nicer properties to begin with, so our portfolio already skews to the areas that work best for this strategy.

Beyond that, for 1-4 unit family properties, we use MLS data. We have very robust MLS use for rentals in San Antonio. This provides a ton of data. For 5+ unit properties CoStar is the go to source. It's not always reliable for the smaller end of the market, but it's the best option at the moment. I also have a couple of sophisticated clients that have proprietary data sources. Unfortunately, they don't share, but just working with them helps me find new areas that I may have missed otherwise.

Roochita P. · Answer

@Joseph Cacciapaglia - That's really reassuring to hear. I generally do the same - IRR and total return. It just seems like everyone and their mother (90% of blogs, friends, etc.) are all seeking only strong cash flow. You're exactly right when you say that approach generally leads you to tertiary markets (with pretty much zero appreciation).  This strategy makes complete sense for folks just starting out with limited capital and looking to replace W2 income with rental income (but it will take a lot of properties to get there).

We end up more willing to purchase buy-and-hold properties that have low cash return but where we believe strongly in appreciation - great school districts, close to hospitals, etc. I know there's much more risk with this approach, but it just seems like such a huge lever that you can't ignore. Also, the nice thing is that there tends to be less competition for this class of property.

Of course, in a perfect world you'd get high cash-flow and high appreciation, but that's just not reasonable to expect. In reality, we're looking to construct a portfolio that's a blend of high cash-on-cash + low appreciation potential and low cash-on-cash + high appreciation potential.

Out of curiosity, what sites/resources do your clients use to monitor rent trends?