This post is for those who like digging into the details of how their investments work and optimizing their portfolios through math. TLDR: Your net worth will grow around twice as fast by passively investing in unsexy, low-appreciation markets in the South and Midwest than glitzy, high-appreciation ones in the Sun Belt or on the coasts.

The title might seem counterintuitive, but there's a firm basis for this claim. That's right--high-appreciation markets are not the ones to invest in if you want your net worth to grow passively. Your total return, specifically return on equity, is always lower in these markets, and therefore, your net worth grows more slowly. This is true even if the appreciation is eye-popping.

First, high-appreciation markets generally have low cap rates, meaning low cashflow. These are markets like Austin, Phoenix, Nashville. In Austin, for instance, a home purchased for $400k might rent for $2,200 a month. With a 30-year loan at 7%, a typical interest rate today, you'd have to put down around $255k, nearly 65% of the purchase price, to hit roughly $0 cashflow (at these round numbers, it comes out to around -$328). The upside is that if Austin continues appreciating at the same rate as the last decade, around 7% annually, you'll make $28,000 in appreciation and the principal paydown in the first year will be $1,473. That's a total gain of $29,145 on your equity of $255,000 or a total return on equity of 11.4%. Yes, in spite of the seemingly great appreciation rate of 7%, this return doesn't beat stocks by much, if at all. Again, 7% appreciation, total return of 11.4%.

Now, say you're in an unsexy market that lacks this eye-popping appreciation, but offers higher cap rates, meaning higher cashflow. We're talking places like Cleveland and Memphis. In Memphis, a single family home might sell for $150k and rent for $1500 a month. With a 30-year loan at 7%, you would have to pay the loan down to $115k (a down payment of $35k or around 23%) to keep the cashflow positive (it should end up at about $185). Memphis definitely appreciates, too--over the last decade, it actually appreciated as well as Austin, but since it has recently slowed, we'll use a more conservative rate of 4.5%. That makes for $6,750 in appreciation (4.5% of $150,000), principal paydown is $1,168, and the total gain here is $8,103 on equity of $35,000, or 23.2%. Yes, around 23% is a reasonable rate that you can expect your money to grow at in a place like Memphis--even with modest appreciation of 4.5%.

Though the specific figures will change, this pattern will hold true across any combination of high cashflow/low appreciation and low cashflow/high-appreciation markets. There are various things to be said about the merits of both, but for a passive investor interested in growth, the cashflow-intensive markets that don't appreciate as much are better.

I have assumed in these examples that you are not willing to take on negative cashflow. If you have very high income from other sources or very large reserves, you may be able to leverage yourself to the hilt and take on insane negative cashflow to profit from high appreciation. Also, if your goals are not maximum growth, you could think about parking your money in coastal or Sun Belt markets. I have not taken taxes into account--appreciation gains are not taxed until sale--nor volatility, which is greater for appreciation than cashflow. Also, to get the higher returns I've mentioned, you must be invested in more properties total, meaning more work for you or, preferably, your manager--that's what it takes to get this return. I'm sure that there will be quibbles with these numbers--I don't invest in either of these places and am interested in hearing from those who do if there are any small corrections. The point remains: for people looking for maximum passive growth, the less glamorous, low-appreciation, high-cashflow markets are the place to be.

Oh, to show the work:

Austin

Revenue

Annual revenue $26,400 ($2,200 x 12) less 7% vacancy ($1,848) = $24,552

Expenses

Property tax: $7,000 (1.75% of property value--Austin is high!)

Insurance: $2,300

Turns and maintenance: $4,000

Principal and interest on $145,000 (30 year loan at 7%) = $965 monthly/$11,580 annually

Cashflow: -$328

Principal paydown: $1,473

Appreciation (7% of $400,000): $28,000

Return on equity ($29,145/$255,000): 11.4%

Memphis

Revenue

Annual revenue $18,000 ($1,500 x 12) less 7% vacancy ($1,260) = $16,740

Expenses

Property tax: $1,275

Insurance: $1,100

Turns and maintenance: $5,000 (a little higher in Memphis due to rougher tenant base)

Principal and interest on $115,000 (30 year loan at 7%) = $765 monthly/$9,180 annually

Cashflow: $185

Principal paydown: $1,168

Appreciation (4.5% of $150,000): $6,750

Return on equity ($8,103/$35,000): 23.2%