I am once more sitting on a raised deck in a rental home in Sandusky, OH on Lake Erie. I wrote about this place a month ago or so. At that time, Patrisha surprised me with a 2-day getaway (read about it here), and I liked it here so much that we have come back – this time with the twins. I just completed a remodel of our house, which I wrote about here, and it is time to decompress once again.
I am, after all, of a ripe old age of 40, and I do need to take more breaks than I used to. This place, Sandusky bay, just does it for me. Here we are on a ferry crossing the bay to Kelly Island, and my kids decided it’d be good to stick their heads out the window and serenade everyone with a rendition of Steve Miller Band’s Abra Ka Dabra.
I have to say, there are very few things in life that put the meaning of the word “perspective” front and center. Few people who make me think. My wife is at the top of that list, and my children are in close second. When it comes to real estate, my friend Brian Burke stimulates me in ways no other person can.
Hear that, Burke? You stimulate me, man. If I were you, I’d be concerned! Run with that. (But not too fast, ’cause just like me, you’re not the freshest chicken in the cook no more.)
I was not planning on writing an article today, but I am inspired to teach this morning. Thank my children; they bring it out of me. So, while they are busy doing their Kumon math and reading with mom, here we go.
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What’s More Important: Cash Flow or Appreciation?
Serge Shukhat is reading this right now, and I bet he’s thinking — Leybovich, what a schmuck; there he goes again!
Whatever, dude. You know I’m right. 🙂
The answer requires quite a bit of perspective, which we develop after years in the game and which cannot be expected to be easily accessible for new investors. Let’s put this in perspective for you – this will be shorter than you’d think; I ain’t got time to mess around, considering my agenda today includes the beach, racing carts, and the water park. Here we go.
Why Do We Need Appreciation?
We need assets to appreciate because equity is the primary driver of wealth. While it’s true that cash flow pays the bills today, equity appreciation makes us rich and allows options. What options…?
- To re-leverage the asset and use the cash out to bridge into a larger asset base.
- To sell the asset and exchange the equity for a larger asset base.
- To sell the asset and ride into the sunset, leaving your kids something to remember you by aside for your shiny personality.
Those are the 3 basic options that we have when we have equity – nice place to be, indeed.
Why Do We Need Cash Flow?
Simple. Cash flow allows us to hold onto the asset long enough so that it can appreciate and allow for the three options we discussed above. We can help speed things along through value-add strategies, but those also take time. While it’s true that once you reach a critical mass, you can indeed reverse the time paradigm and arrive at a place where time is helping you instead of hindering you.
Once there, the cash flow has value that stands alone, disengaged from equity – you don’t necessarily need any more appreciation once there. But until you get there, which is the place where most of you live today, the only function of cash flow is to hold you afloat. To buy time, so to say.
Why Do Sophisticated Investors Underwrite to the IRR?
I’ve written about the IRR a lot; please look up the other articles. Having said this, have you ever wondered why big time investors never give a hoot about things like cash on cash (CCR) and capitalization rate (Cap Rate), and all they want to know is the IRR? Why is this?
There are many reasons, but the basic logic is that they don’t care about stand-alone income. These people have plenty of money to live on. These people are accomplished professionals and investors. What they are concerned with is wealth, not income for its own sake! The IRR tells them how much real wealth they will create with the investment, and here’s why:
The IRR tracks all of the cash flows, right? Say, yes sir, Mr. Leybovich. Well, if you’re going to track ALL of the cash flows, then you must project the final and all intermediary exits of capital since the sale or refinance of the asset represents the largest positive cash flow event in the life cycle of an investment.
While amateurs perceive long-term hold as just the long term hold for cash flow, the sophisticated investors know better. They know that those hundreds of thousands and millions of dollars of their wealth will be created not through cash flow, but by liquefying equity.
They want to know what the exit of capital will look like before they put capital in! They want to know how much and how soon. They want to run a Net Present Value of these events to compare them to other available to them opportunities.
The side benefit of this, of course, is that this line of thought requires us to underwrite the entire lifespan of the investment beginning to end. It requires us to make our best assumptions and projections of EVERYTHING.
So, They Don’t Look at Cash Flow at All?
Be honest – this is indeed what you are thinking now, isn’t it? I did sorta make it sound like cash flow ain’t important…
Not at all. In the world of income-producing property, income drives the setting of value — NOI to be specific. This means that in order to sell for more than we paid or to be able to refinance, the NOI has to increase.
Cash flow pays for the life of the investment until wealth can be taken off the table. We know this, and that’s why we don’t care about appreciation – only the cash flow. We know that if we take care of the cash flow, which requires buying a very specific kind of asset, the mechanics of property valuation will automatically create equity and wealth, no question.
You see, a different perspective. Some guys worry about cash flow because that’s all they care about and can see. At best, those guys are buying themselves a job — forever. Others, who are in the minority, realize that cash flow does not build wealth, but it backs into wealth if you’ve bought the right kind of an asset, in which case we work very hard for a while, but eventually equity starts to work for us.
As such, there should never be a question of equity or cash flow. There is cash flow for the sake of cash flow, and there is cash flow for the sake of wealth represented by equity.
Where do you stand?
Be sure to weigh in with a comment below.