What Does It REALLY Take to Build Wealth in Real Estate? The Answer May Surprise You…

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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.

Related: Cash Flow vs. Equity: Which Pays Off for Investors in the Long Run?

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:

Principal Pay-Down

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.

Value Add

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…

Organic Appreciation

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.

Related: Should I Invest for Cash Flow or Growth? An Investor’s Analysis

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.

Conclusion

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!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

31 Comments

  1. karen rittenhouse

    Hi Ben:
    I agree. Cash flow is not for income. Cash flow is to, hopefully, make enough money to allow you to maintain the properties you own. I can’t imagine making enough cash flow to live on (until the properties are paid off).

    Equity is a beautiful thing but you can’t eat it. We, too, continued for a time to borrow our equity to buy more assets.

    What happens long term with holds is that someone else pays down your equity (tenants) while the investor uses excess cash flow to handle repairs (rarely enough), and there are tremendous tax write offs to offset any profits you can generate through flips and wholesales.

    Real estate is a long term investment strategy. We work full time to protect our investments and our equity so that our retirement will be sweet as mortgages will be paid off and income from the properties we’re holding will be high. All of it flows on to our kids and grand kids to do with as they please.

    This is a big business with a lot of moving parts.

    What does it really take to build wealth in real estate? Time. This business is not for the faint of heart!

    Thanks for your post.

    • Ben Leybovich

      Because if you have to manage tenants, cash flow is more passive than W2, but not completely passive. And if you hire management company to off-set your managerial involvement, then you won’t have any cash flow…

      You pick 🙂

      • Luis Melendez

        What do you mean you won’t have cash flow if you hire a management company???? all that means is you didn’t properly do your financial due diligence on the property. You factor in management when figuring out what price point works for you when buying the property!!!! Simple as that. I think you are very very smart when it comes to analyzing real estate deals BUT you are very pessimistic in your articles. Your strength in analyzing is also your weakness. there will be unexpected expenses and repairs I get that fully, but you can’t go into every deal thinking you will incur every last possible expense or repair. its called paralysis of analysis and every article you hit it on the head, scaring investors or potential investors away. If it’s a reverse psychology strategy then it can work in your favor but I don’t think that’s your goal. Every investment is a risk and the bigger the risk the bigger the reward as they say. I’ll continue to read your articles cause I can still learn from you, but please pipe down on the negativity. No deal is 100% perfect and will never be!!

    • Ben Leybovich

      What hasn’t been? Purchasing quality in location which exhibit stability and growth? haha Jeff – I think this is exactly what you do.

      Now – you tell your clients to put much more cash down (in order to buy cash flow spread) than what I think is either necessary or prudent relative to IRR. But, in general you are very much a quality guy as it relates to RE – note component aside…

      What hasn’t been you experience? Am I not understanding something?

  2. serge s.

    Well Leybovich …. another well written article. How do you account for the people that do in fact live off their cash flow reliably, me included? It can and does happen and I’m not sure I agree with your blanket statement. The answer is that you can live reliably off your cash flow, just not by purchasing RE during the wrong time in a cycle and/or with 80-100% debt and property management. Unfortunately, if you want to live off cash flow you need cash first (a lot of cash). Isn’t that the definition of investing? This is why I never understood the value of no money down investing. There is simply no cash flow left and if your combining that strategy and buying the wrong assets in the wrong market then you are in for a rude awakening. In that scenario you are trading your time for very little to no cash while your tenant is “paying down” your depreciating “asset.” Unfortunately, once its paid down its worth just about nothing. Unless of course you are buying quality location and assets where you will still have no cash flow but some hope for the holy grail which is appreciation. This is the real point of your article.

    • Ben Leybovich

      First – that’s Mr. Leybovich to you haha

      Second – what I’d say is that the critical mass barrier is so high that it is impossible to achieve with something I refer to as “leveraging of appreciating assets”. You bought at the right time. You went all in and borrowed to the hilt. And now your income statement is tied to your balance sheet…

      You did it right. Now you just need a schticle to keep you from being bored. Use me as an example 🙂

  3. Edward Synicky

    I have been living off of my passive income for 15 years, and it is a lot easier than going to a day job. Sure it took time but that’s part of the investment. You can’t have copious amounts of cash flow without copious amounts of equity. So when I pass my heirs will be receiving both cash flow and equity. This is not brain surgery.

    • Ben Leybovich

      Exactly, Edward! However, if it were so simple, how come I see CA money coming to Ohio to buy turn-key pigs that will have to be sold for less than they paid, only because the proforma looks like $350/month of CF – with no debt?! Why are people being hoodwinked like this?

      You are right – real, stable, reliable CF comes with equity appreciation. It has to, by definition. But, this is not as simple of a concept as you think on BiggerPockets today 🙂

      • Edward Synicky

        The answer to your Ohio example is due diligence. I actually have an older home in Toledo that I purchased 6 years ago for 32K cash. It rents for $625 monthly and it had been rehabbed by a local broker/investor that passed my due diligent test. I have only had one repair and no vacancy. Sure that is probably not a “normal” experience but it is a real one. The house has returned enough cash so that it is now mine for free. There are gems in the rough in any market. Obviously I did not buy this home for appreciation, just part of my diversified portfolio of real estate, some free and clear for cash flow (Toledo), some leveraged for both appreciation and cash flow (Nashville) and some free and clear that also have appreciation and cash flow (Phoenix). I like @Jeff Brown have been in the business for decades.

  4. Justin B.

    Ben,

    I like the article but in reading it I found that it lacks a little clarity. Cash flow is obviously needed to grow your business and pay your bills, but it all boils down to what your goals are. The idea is to have more coming in than out of course. If you only need $5k/month to live comfortably and your cash flow is $5k/month, a major expense could wipe out cash flow for a month or two and what you said is very valid. Cash flow fluctuates and that situation is very risky. But if your cash flow fluctuates between $10k-$15k each month and you only need $5k your golden. The question is just how much does it fluctuate and how comfortable are you with risk based on that amount and what you need.

    Also, equity and mortgage pay down can be a means to increase cash flow (if you want). For example, if your mortgage payment on a $100k property is $1,000/month (just using round numbers here), 10 years goes by and you owe $50k. You could do 2 things: re-finance for the full term on the $50k and your payment becomes $500/month (instant cash flow created by mortgage paydown) or you could re-finance back to $100k/full term and still pay $1000/month and pocket $50k in cash that you could do whatever you wanted with (including buying more properties that could increase your cash flow).

    In the end, the goal of any business is to make money. In my situation, I’m investing 100% for cash flow and building a “business”. I’d rather leave cash flow (a business) than equity to my kids. I’m creating a “business”, not a collection of properties. But that’s my goal, everyone is different 🙂

    • Ben Leybovich

      Justin – you are reading between the lines a bit 🙂

      CF is not all created equal. Some CF is a function of the balance sheet, while other CF is just that – CF. Wealth does not happen on the income statement; it happens on the balance sheet. But, bread is bought with cash. Meaning – we need both…

      We need wealth. Equity is what we need today, but wealth is what you’ll need tomorrow. If all you can do is put CF in the bank, real wealth will never happen. Appreciating assets are key!

      • Justin B.

        I fully agree and I may be reading between the lines too much but I see wealth as a means to create cash flow. My main goal is to own property to produce cash flow. In my opinion cash flow doesn’t come without wealth. My brain won’t allow me to separate the 2 🙂

  5. Edward Synicky

    Ben, you have hit the nail on the head as they say.
    But consider, when you are in the advanced stage of your career cash flow becomes the most important item between it and appreciation. I live on the cash flow and it allows me to live well. If we get another 40% drop here again in Ca. my rents drop maybe 10%. So at this stage of my investing career I really only have an esoteric interest in appreciation. Yes it is there but it is not want counts. I suppose my heirs will appreciate my wealth but my guess is they will appreciate more what the cash flow buys as that is what we use daily. Wealth is the scorecard and I like to see it grow, but as you said in a previous post you can’t use appreciation to buy bread.
    PS I manage my Ca properties but use a property manager on all out of state properties and they still cash flow nicely. I pass on the dogs and only buy if there is cash flow after all expenses including property management, vacancies and repairs. This requires a 25% down payment and 30 year conventional financing, so you are limited to 10 mortgaged properties, but they all cash flow.

  6. Aleksandar P.

    Great post Ben. Cash Flow is everything but a passive income. There is noting passive there.
    If you really want passive income from Real Estate buy a REIT that will yield 5%-6% per year and appreciate in that range as well.

  7. Dan Mortimer

    Definitely a solid piece Ben. I agree that cash flow should not be the end goal, but a means to create more. That could be other properties, increasing value in the current property, or other investments. I think there is definitely an evolution that occurs when you invest in real estate. As a newbie, I am focusing on cash flow and considering appreciation to be a bonus while I get my feet wet. Since you’re much further along, your goals for your properties are different, but that doesn’t mean that your opinion is wrong at all. Every investment, no matter how safe it can seem, has some risk and we have to be prepared for that. If cash flow is the end goal for anybody, they need to start thinking further down the road.

    • Ben Leybovich

      Dan – nothing wrong with CF being the end goal, so long as it’s the right type of cash flow; the type that is tied to equity. Equity is a function of desirability in so many ways I don’t dare to open that can here, but the bottom line is that desirability = stability. This is why if the CF is tied to equity, then it’s also tied to desirability, which makes it stable. If that’s your end goal – we are good. But, if you are buying cheap pigs because pro forma looks better on CF – wrong!

      Makes sense?

      • Jeff Formeller

        Ben, could you explain a bit more about “the right type of cash flow” and it being tied to equity? I think I’m confusing myself on the overall concept, to me and I’m sure to many others, all cash flow may see the same, when in reality it appears that it is not. Any additional comment would be helpful.

  8. Ed Gray

    I do appreciate the different perspectives. I used to be in the pay down your mortgage crowd. But I would argue that equity in your house earns you a rate of return of 0% until you actually use it to do something that gives you a better return then the money your borrowing from the bank. I personally would rather have 50K of cash flow over 500K of equity earning 0%. Because 500K at a rate of return of 10% is 50K and easily achievable investing in mortgage notes. @ Jeff Brown can atest to that.

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