High Appreciation vs. High Cash Flow... What's your pick?
Rental Property Investor · Member since 2018 · 15 posts · 28 votes
High Appreciation vs. High Cash Flow... What's your pick?
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Realtor · Los Angeles, CA · Member since 2018 · 952 posts · 1k+ votes
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- Realtor · Los Angeles, CA · Member since 2018 · 952 posts · 1k+ votes6y
Forest, FYI, I'm not sure the above is actually true.
I'm a bit of an investment property nerd, so I did a correlation analysis to understand what actually drives up building values. Specifically, I looked at what metrics actually correlate to rising rents. I used data the Census Bureau's American Community Survey, which publishes excellent data annually on every MSA in the country.
I limited the study to MSAs with populations above 100,000. I used annual data from 2005 through 2017 (I did the study in 2018), so it's a twelve-year window that includes one (Great) recession.
I calculated the correlation between how much rents grew in each market against how much other metrics grew. Do rising rents correlate with rising population? Do rising rents correlate with a declining median age? Do rising rents correlate with an increasing number of college graduates? Here's what I found:
Population growth matters, but not nearly as much as the three most correlated metrics, in order: median income growth, the population-per-unit ratio, and job creation.
The first interesting point here is that income growth is more meaningful to rent growth than job creation. The quality of the job matters, I suppose. A new Amazon warehouse in town is great, but a couple tech startups downtown is better. Job creation made the top three, though, so we shouldn't discount low-paying jobs as not important!
The second interesting point: population growth doesn't matter nearly as much as population growth relative to development of new units. If population is going up and new units are being built, you won't see much rent increase (ie, Rogers-Springdale-Fayetteville, AR). But if population is going up and unit count isn't, you get huge rental appreciation (ie, San Francisco and Manhattan).
(This, of course, is why appreciation exists in some markets and not others: constraints on growth, usually physical.)
Here's a slide I made for a presentation I gave about this:
These are the actual growth numbers and correlation coefficients for a random collection of markets. The most interesting metrics are outlined in red. As you can see, median household income growth is 4x more correlated to rent growth than population growth. And there's a strong inverse correction between rent growth and median age: rents go up as median age goes down.
Sorry for this long-winded ranted. This is what happens when I have Coke in the afternoon.
Conclusion: I guess the correct thing to say is, "The two most important metrics for a longterm successful market, according to a correlation analysis of Census data, are rising median household income and the ratio of population growth to new unit development."
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- 6yEric FernwoodBusiness MemberRealtor · Las Vegas, NV · Member since 2014 · 997 posts · 1k+ votes
Hello @Matt Camilliere,
An excellent question, one that more people should consider. Before I tell you my preference between cash flow and appreciation, I want to talk about what determines prices, and that is demand. Demand is a function of the imbalance between buyers and sellers. Where there are more buyers than sellers, prices rise until the number of buyers and sellers match. Where there are more sellers than buyers, prices fall until the number of buyers and sellers match. Demand is what makes the property on the left worth $80,000 and the property on the right $2,500,000.
I've talked about demand and prices, but what about rent? There is a relationship between prices and rents. The studies I've read state that rents lag prices by 2 to 10 years. Market conditions like you mentioned are real world examples of rents lagging prices. See the image below.
High Appreciation, Little or No Cash Flow
With rising demand, the current rents reflect property prices from 2 to 10 years ago. The result is that prices are high and there is little or no cashflow, as you are seeing in Austin. However, if you hold the property long enough, rents should rise and eventually the property generates a positive cash flow. You just have to be willing to keep losing money every month until such time as rents rise sufficiently.
When you buy an investment property in such a market, you are actually gambling that in the future, you will be able to sell the property for significantly more than you paid for it. Be certain to consider the cost to sell (7% to 8% of sales price) and long term capital gains taxes in your calculations. Also consider what you would do if it took many more years than you expected before rents rose enough to cover all your operating expenses. There is no guarantee that prices (and rents) will always rise.
High Cash Flow, Little or No Appreciation
With falling demand, the current rents also reflect prices from 2 to 10 years ago, when property prices were higher (in inflation adjusted dollars). The result is that property prices are low compared to the past so there is high cashflow. While such properties generate a high initial cash flow, if prices and rents are not rising at or above the rate of inflation, rents and prices are likely falling in inflation adjusted dollars. What does this mean to you?
Dollar bills, by themselves, are worth nothing. The value of dollar bills is what you can exchange these dollars for. What complicates things is inflation. Inflation is continuously eroding the buying power of dollars. You see the effect of inflation when you go to the grocery store. Each year, it costs more dollars to buy the same basket of goods. To highlight the impact of inflation, I created the image below. The numbers are from the CPI Inflation Calculator by Bureau of Labor Statistics.
As the chart shows, you need $103 in 2019 to buy the same basket of goods you bought for $50 in 1990. How does this apply to rent? If you rented a property in a high cash flow market (with little or no appreciation) in 2015 for $900/Mo., you would need to receive $993 in 2019 just to maintain the same buying power. If the 2019 rent is less than $993 , your rent actually declined in inflation adjusted dollars. However, by definition there is little or no appreciation in high cash flow markets (or they would not be high cash flow markets) so over time the inflation adjusted cash flow (buying power) will decline.
My Preference
There are markets where you can get a positive cash flow today and strong appreciation. This is my personal preference. I created the graphic below to illustrate the effect inflation has on (inflation adjusted) cash flow. If the appreciation rate is less than inflation, rent in buying power is declining. If appreciation is above the rate of inflation, buying power of the rent you will receive is increasing.
Even though you start with a lower cash flow in a more balanced market, it does not take many years to have a higher real cash flow (buying power) than the high cash flow property. Since your major cost is fixed, as rents increase so does your return, as illustrated below.
Matt, I hope this helps.
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