There seems to be a lot of disagreement nowadays about what’s more important in an income-producing property: cash flow or equity. In this short article, I’ll try to help you gain perspective on this issue. I am going to do this by asking you a question, for which I’ll provide the answer that I see as most common. Then, I’ll offer a commentary on this answer.
See if following this logic illuminates some wisdom to you. Here we go.
Question: Why do you want to buy property?
Answer: Because I want the cash flow so I can quit my job and tell my boss to kiss off!
Commentary: Cash flow in most cases is not real — because in most cases, it’s not stable enough to accomplish your goals. In other words, you can’t plan on it to replace your W2 income unless you have a very significant amount of cash flow that is stable and doesn’t fluctuate wildly from one month to the next.
Understand, stability of cash flow is a function of desirability of the asset as it relates to both the tenants and the owner, and 99% of the assets you could buy lack important features of desirability that would provide for stability of cash flow in the long-term.
And then there is this thing we call cap ex, and instead of talking about it, I’ll just let you read this amazing thread from the Forums – think that won’t happen to you?
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So, if Not the Cash Flow, Why Do We Buy Property?
Here’s the thing: Cash flow is there to hopefully allow you to be around long enough to do what? To build wealth. How? Principal pay-down, forced appreciation, organic appreciation.
Let’s talk about these:
This is seemingly an automated process in that, so long as you make the mortgage payment, the owed amount goes down every month.
While this process is not exactly rocket science, it is not exactly as simple as that. If it were simple, we’d never have any foreclosures in any rental property. (Ha, ha — I can just see steam coming out of your ears.)
Indeed, sorry to bust your bubble, but it’s anything but common to buy an asset that is capable of attracting the type of tenant who’ll pay on time and facilitate steady principal pay-down.
Let’s face it, real value add is more difficult to find than water in a desert. And if that’s not present, all you’ve got left is…
This, in an income-producing asset, is a function of many macro and micro economic elements. But the important thing to understand is that if you’ve bought the wrong kind of asset, no amount of economic growth will facilitate your equity. And what’s the right kind of asset to buy? One that has a proven track record of all of the features of desirability. Most of you are not buying the right kind of assets… 🙂
Why Do You Want Equity?
When I was younger, I could only think of one answer: because appreciating equity will allow me to bridge into acquisition of more assets, which will diversify my equity, which will help me hang on to my appreciating assets, which I can then bridge into more appreciating assets, etc.
All of this is still very true, and it works very well.
However, at 40 years old, I am suddenly cognizant of the reality that cash flow may not be the thing I want to leave to my kids. Why? Because there’s very little that’s passive about passive cash flow. Indeed, I’m starting to think that I might do better leaving equity to my kids; they’ll do with it as they please.
Cash flow is a necessary component of what we do, but it may not be the end goal. Wealth, as represented by your balance sheet, may be the goal, as long as your balance sheet is a function of your income statement.
Thoughts? Do you agree or disagree?
Let me know with a comment!