Appreciation vs. Cash Flow: What's More Important When Investing?
As rental investors, we often only focus on cash flow when discussing our returns.
It’s largely because most of us in this real estate business entered the investment because of the rental income, either to supplement or replace an existing revenue stream. It’s fair to assume that most rental investors see income as the driver of value in rental properties.
There’s nothing wrong with focusing on cash flow. But—and we say this with emphasis—there is so much more to rental investing than the rental income on the surface. Like appreciation or equity gains.
There are a lot of different definitions for “appreciation,” but we see this as distinct from equity. Equity is the amount of your down payment, mortgage payments, plus any capital improvements you’ve made to a property. Appreciation, on the other hand, is what the market does with that equity - also known as gains or “paper profits.”
Now, when you’re talking about rental properties, the type of property class you aim for should be based on how much you prioritize appreciation vs. cash flow. If you want pure equity gains, you might want to focus on Class A properties (think a Downtown Manhattan penthouse), but you’ll have lower cash flow with a rental like this. Compare that to Class C properties (like a Ring City single-family home), where you'll likely have stronger cash flow, but probably less appreciation.
With that being said, let’s discuss why you should consider equity gains and how it can change the whole game.
Your Returns on Investment (ROI)
There’s no problem with seeing real estate investing as nothing more than something you buy, hold for 30 years, pay off the mortgage, and enjoy a revenue stream to retire on. Most investors stop here. But we want to take it to the next level. Because this way of thinking provides a low ROI in terms of internal rate of return (IRR) and net present value (NPV) of your investment.
IRR: Compare the future value of your investment based on today’s dollar. By determining its future value and comparing it to the amount of your investment, you’ll have a clear view of the investment’s risk. Basically, you’ll evaluate the property’s profitability for years to come.
NPV: Determine the value of your investment and the earning income over time. NPV considers expected cash inflow, expenses, and inherent risks to compare the present value of your money and initial investment versus the value of your money in the future and projected cash flow.
Remember, you need appreciation or equity growth to drive the IRR. In a nutshell, the value of your income will erode overtime for a lot of different reasons. And the only 2 factors that can compensate for that are the growth of your income and equity—achieving a higher IRR.
This brings us to 2 important questions: How does rent increase and how does equity change?
The Reason Why Rent Amounts Increase
Rent is not a static thing and it can fluctuate a lot more than you might expect if you’re just starting out as a landlord. There are 2 reasons why the rent amount of your rental properties will grow over time:
Market Demand: Your rental properties continue to be in demand in the marketplace, often because of their location, features, amenities, or something else. As price inflation drives up operating and maintaining costs, the rent amount grows alongside it.
Market Trends: Your rental properties remain desirable in the market or submarket because they are perfectly riding on and complimenting the demographic and population trends in the area—conducive to continuous rent amount growth.
The Reason Why Investment Property Equity Changes
Now, the value of your income-producing assets is, well, income. That’s the primary purpose of investing in rental properties. But instead of stopping there, see how the location and features your asset possesses will also increase in appreciation over time.
It’s all for the same reasons. If people pay more rent to live there, investors will pay more to purchase properties there. That means property values will increase alongside potential income.
Considering that point, if you get into your rental property investment with equity growth as a priority and take a backward approach, it’s reasonable to say that potential appreciation gains will also result in strong and increasing cash flow.
In other words, you don’t have to start by focusing on short-term rental income. Instead, you can receive the returns you seek by first focusing on long-term appreciation gains—earning a two-fold investment success in equity and cash flow.
Importance of Investing in Areas with Increasing Rent
You probably think that it doesn’t matter if rent doesn’t increase. As long as you’re getting a good deal and happy with the rental income, you’ll be satisfied with that.
But you’ll have to remember that the lower your rent is in relation to the market, the fewer quality tenants you’ll be able to attract. People with good credit scores and more money will likely pay more to stay in an economically healthier location. In contrast, less financially stable people will probably choose the areas with more affordable rent (concerning the market).
In short, stagnant rent means lower quality tenants. The tenants will likely miss rent payments, do less property maintenance, and deviate from the lease agreements. You’ll end up with dead income and increasing expenses—not the best combo for the long haul.
The Sweet Spot: Equity Growth AND Strong Cash Flow
Property appreciation and rent go hand in hand. So, if you bought a property that looks good today but won't appreciate it over time, you can't expect the backend equity to offset your cash flow's increasing losses and expenses. That means your returns will slowly but surely chip away until you're left with nothing but peanuts, which cannot be farther than the whole point of investing in real estate.
At the end of the day, Class C properties are cheap and give you great cash flow, but there are lots of headaches you have to deal with to achieve that, like spending hours dealing with tenant issues and maintenance. A class A property, on the other hand, may give you negative income initially, but more equity gains.
However, property value appreciation tends to go hand in hand with rent increases, so after 2-3 years that Class A may break even, and then in another 2-3 years the rent might increase again. In time, you could have both positive cash flow and equity gains. With a Class C property, rent increases may happen, but the property’s value will increase very, very slowly over time.
The crucial thing to do is ask yourself: What do you want to do? What's important to you? If you've invested a lot, maybe you NEED positive cash flow from day 1 to replenish your capital. But for Class C, as we’ve said, you'll need to do a lot of work as a landlord. So maybe go for Class B if you want to find the sweet spot - that will give some appreciation plus some cash flow.
Best of both worlds.
Got any other questions? What are you currently prioritizing in your search for a rental property? If you need any help, my inbox is always open for you to get in touch.