Why You Should ONLY Invest Based on the Cash Flow

by | BiggerPockets.com

Today I’m going to ruffle some feathers. Why? Because I’m going to talk about why you should never invest based on capital appreciation and why you should only invest based on cash flow and by looking at the numbers in the deal.

So, it’s quite simple—you should never base your decisions on the hope that a property is going to go up in value. This is a mistake that I made when I was living back in Australia. A lot of investors have made the same mistakes here in the United States on the east coast and the west coast before the global financial crisis. They were buying high, hoping that these properties were going to appreciate in value so they could sell even higher. Guys, hope is not a strategy. Hope is for those who are in the hospital right now dying from terminal cancer. You can’t use hope as an investment strategy.

Don’t Speculate—Invest Based on What You Know

Capital appreciation is a prediction; it is speculation. No one has a crystal ball. Nostradamus died a long time ago. So, if you can’t predict what’s going to happen in the next 10 minutes, how can you predict what’s going to happen in the next 10 months or 10 years? Guys, forget about it. Forget about including appreciation statistics in any of your calculations.

Now, this is how I suggest you base any type of calculation on capital appreciation. I personally bought a property next to Toledo Promedica Hospital. I knew for a fact that Toledo Promedica Hospital was buying in the area because they wanted to expand their hospital grounds. So, I was speculating that they were going to knock at my door three, five, or seven years down the road and buy the property for much more than I paid for it. Call it insider trading if you want, but that is the only way that I would speculate on capital appreciation in real estate. So, what happened?

Related: Cash Flow vs. Appreciation: What Experienced Investors Know About the Debate That You Don’t

Promedica did knock on my door, and they’re willing to pay four to five times more than what I paid for my property. Other than that, forget about capital appreciation. Forget about including any kind of capital growth in your projections. You really have to look at the numbers in the deal as they stand today. Remember to ask yourself questions like, “What is my purchase price of that particular property?” and “What are my expenses?” And include a margin of safety, meaning underestimate your income and overestimate your expenses. If the bottom line meets your end goal—if you buy the property and add to your portfolio—is it getting you a step closer to where you need to be, cash flow-wise? We live off cash flow, not capital appreciation and equity. You can’t put your hand in equity and go out and buy McDonald’s. Conversely, you can put your hands in your account every single month because you’re getting rent, which is cash flow, and use that money to go and buy a McDonald’s.

Focus on Cash Flow

So, forget about capital appreciation. Focus on cash flow. Look at the numbers in the deal. Make sure those numbers suit your end goal and that every property you buy is getting you closer to where you need to be. For all you doubters out there saying that rents can sometimes decline thus causing the numbers in the deal today not to be true, I’m not buying it. The numbers in the deal as they stand today are always true. It’s not a prediction; it’s not a speculation. You know what the numbers are, you know what the expenses are, you know what the rent is going to be.

As I just said, include a margin of safety, underestimate your income, overestimate your expenses, and then make sure those numbers work for you and what you’re looking at doing. Guys, rent is declining? I have never seen it in my five years of real estate investing, and I’ve got other entrepreneurs and business mentors on board that have been in the game 20 or 30 years, and unless something drastic happens, like a nuclear power plant blows up, rents don’t just decline. They never have; they never will. I personally have never seen it. So, it is my opinion that you guys are safe investing based on the numbers in the deal as they stand today. Just make sure that those numbers, that cash flow suits you, suits your end goals, suits where you want to be, and suits your lifestyle.

Do you agree with this assessment—or disagree?

Let us know with a comment!

About Author

Engelo Rumora

Engelo Rumora “The Real Estate Dingo" is a successful property investor, motivational speaker and serial entrepreneur that quit school at the age of 14 and played professional soccer at 18. He is also a soon to be published author along with becoming a TV personality in his very own real estate house flipping show. To find out more go to engelorumora.com . Engelo Rumora has been involved in over 400 real estate deals and founded five businesses in Ohio. The most successful is Ohio Cashflow, a company that specializes in providing turnkey properties in several Ohio markets. The newest venture is List’n Sell Realty, a real estate brokerage based in Toledo, Ohio and soon to be known as the #1 discount broker in the country.

39 Comments

  1. Douglas Skipworth

    Engelo,

    Once again, you are right on the money!

    Warren Buffett’s mentor Benjamin Graham frequently stressed the difference between investing and speculating. He said, “an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

    If you you look for cash flow and protect yourself with a margin of safety then the upside should take care of itself!

  2. Brian Larson

    “I have never seen it in my five years of real estate investing”

    Classic. BTW, I agree with your premise in the article and how you underwrite deals (be conservative on both income and expenses) but let’s be honest, the last 5 years have been very good to all of us.

    Rents could decline and although a big drop is not likely (outside of extraordinary things as you mention) it is always a possibility. Can the investor sustain a 10% drop in Rents? It’s something I look at and try to plan for. 20%? Yikes. If that happens then a lot of are in trouble.

    I liked the article and agree, do not build appreciation into your underwriting model. I haven’t in 15 years and have only been pleasantly surprised when I do sell.

      • Brian Larson

        Hey Ryan, when things got bad I only had a few rentals and all were in Phoenix. My rents did not decline BUT I thinlk part of it was that the rents hadn’t really gone up in the few years prior so they may have gone down but only to the levels I had not realized through rent increases in past years.

        One thing to add that you made me think of. A flat line in rent can possibly hurt your CF as well. Generally expenses go up every year at some % so if you increase your rents you are in theory not making as much money.

        I personally have my prop mgrs keep the rent the same for a while after the lease is up and tenants go month to month. Why would I do that if I am making less money? Easy, in my underwriting I account for both maintenance and vacancy reserves. If a tenant stays then those costs are not realized (yet). That 2% bump in overall expenses is much less than the 8%/yr for vacancy and 5%/yr maintenance I set aside.

        Now, if a tenant is there for several years and way under market rent I will adjust, but I have fouund that keeping the rent the same instead of a dmall (i.e. $25) increase helps tenants keep with you. Change in terms often means the tenant is now thinking of options. Why bother for $300 that year (which is inevitably less than the vacancy/turn reserves you stash for them moving anyhow)

    • Engelo Rumora

      Thanks Brian,

      I’m such a classic that I should be a collectible item lol

      Since I can see by some of the below comments that we have some “super experienced” investors commenting, lets some more credibility to me The Classic hehe

      My philosophy on rents not declining is not just based on my experience but that of business partners that have been pounding the pavement for 25+ years.

      Also, I have personally been involved in 400+ transactions and have invested in real estate world wide so I have seen a great variety of the good and the ugly lol

      Rents declining is not a figure I take into consideration when crunching the numbers on deals.

      Just my opinion.

      Thanks again mate 😉

  3. Lakeem Anore

    Any estimates based on price appreciation should be based on the economic factors pertaining to the asset you’re evaluating. Most investors don’t understand this and get burned because of that. If you fully understand the asset you’re looking at and all the risk involved, investing for price appreciation is actually a great idea, just because a lot of people don’t understand all the nuances doesn’t mean the Strategy is “bad”. The average Investor would be better off investing for cash flow but the enterprising investor is most certainly looking for appreciation of some kind.

    • Engelo Rumora

      Thanks Lakeem,

      Sorry, but I don’t agree.

      “Economic factors” you find online or in the news are all fluff and not even those companies know what they are doing or saying.

      It’s much easier and safer to focus on the numbers in the deal as they stand today rather than what some research company says about the market conditions.

      Much success

  4. Rita Kohms

    During the last real estate crash, rent in Las Vegas did decline. I didn’t have to lower the rent on my rental property like some did, but I couldn’t raise it either because there suddenly were many more properties available for less rent and I didn’t want to lose my tenant.

  5. Clayton Swansen

    “it is my opinion that you guys are safe investing based on the numbers in the deal as they stand today.” Not to split hairs here, but opinion = specualtion, no? I am no real estate pro, but I’ve read enough articles to know that rents certainly declined in some areas during the recession. Assuming rents won’t ever decline seems like a rather bad idea… and worse advice.

    I bought my one and only rental property/house hack in December 2016 for a decent enough price, but the real attraction to me was that the rents were still set at around a 2009 market level… way under current market value, and still covered the mortgage every month. I am in the process of renovating, and increasing rents to where they should be, now. It will cash flow about $1000 month, $500 after I put away money for cap ex. So, even if the rents were to decline precipitously in the future, I might lose my cash flow, but the mortgage, and operating costs would still be covered by the rental income…

    My point is, I have learned that I need to calculate a good enough buffer into my property to account for the unforeseen… Cap expenditures are a bummer, and can set you back, but presuming that rents will always rise, buying with that presumption in mind, and then finding out you were wrong could be catastrophic.

    • Engelo Rumora

      Thanks Clayton,

      I refuse to get into an English grammar contest

      What’s really funny to me tho is that you’re basing your opinion on “reading articles” and 1 deal.

      I’m basing my opinion on doing 400+ deals, investing world wide for 5+ years and working with partners that have been investors for 20+ years doing hundreds of millions in transactions.

      Much success with getting a few more deals under your belt ?

      ps. My hair is firm and beautiful so it’s hard to split haha

  6. Colin Reid

    I can’t totally agree on “rents never decline.” It depends on your market. As an Active Duty military member, I have a significant portion of my portfolio in military towns. Some I’ve lived in and rented when I got orders. My first home, and a solid performer, that I rented for a fair rate 4 years ago is now top of the market for rent. If I hadn’t refinanced, I’d be negative on that one. But I bought it as a home and got lucky with renting it. How about my pure-investment at my current duty station? The base is growing, which sounds good, right? But they’re also expanding the housing on base. Inexplicably, that expensive, low quality housing is negatively impacting sales prices and rents”downtown,” or off base.
    The point is, markets determine rent fluctuations, not history or rules of thumb.

    • Engelo Rumora

      Thanks Colin,

      I’d personally never invest in a market that can make the rents fluctuate so much.

      I’ve only seen this in mining towns in Australia and investing in such areas is like to the casino.

      I wouldn’t touch it.

      In any “normal” market, rents don’t decline.

      Thanks again

  7. jeff pollack

    I used to think buying single family homes was all about cash flow, too. I remember years ago when a far more seasoned investor than I tried to convince me otherwise. He insisted single family homes don’t cash flow. Said they are a long term appreciation play and advised me as to where one should and should not buy single family. But I’d have none of it and thought he was nuts. A few years later after my buddy and I had annually compared notes on our 30 or so properties in two states I concluded the guy was right.

    Investing for cash flow is great, but buying single family homes is not the way to do it. If somebody wants cash flow they should buy multifamily. If buying single family homes with traditional financing (e.g. 20% – 25% down) all or most of your cash flow over time will be eaten by debt service, turnover, maintenance, CapEx, and management fees. Sure, you could have a good couple years with no turnover, no CapEx, no maintenance, etc, and make $100-$200/mo, but it will all even out in the end. And if you had several years of $100-$200/mo cash flow from each SFH how many of those do you need to gain significant cash flow? 50? 100? They won’t cash flow significantly until the mortgage is paid off.

    Buy and hold single family is best suited for long term wealth generation. Its about the ‘hockey stick’ (the exponential equity growth that comes years down the road via principle pay down on the mortgage and compounded, leveraged, appreciation). Any cash flow that may exist is peanuts by comparison. Granted, if you’re buying SFH in flyover country where there is nothing but land, no diversity in the economy, no history of appreciation, and nothing on the horizon that would lead one to believe there will be future appreciation then yes, you are “hoping” for appreciation that will likely never materialize. Your $75,000 SFH that may cash flow $100/mo if you’re lucky will be worth $85,000 in 30 years. But if you buy where the land is limited or in demand, where the economy is strong, immigration projections are high, solid schools, path of progress, etc, that $75,000 property will be worth $200k+ in 30 years with even a modest annual appreciation of 3.5%.

    Cash flow from single family homes is icing on the cake. Investing in single family homes is inherently an appreciation play, but you’ll get none if you buy in the wrong parts of the country/city/town.

    • Brian Larson

      Jeff, great post and something I have certainly been thinking about over the past few months as I have been adding SFR.

      One caveat about the Midwest/flyover states is that you could BRRR the props which would get you the immediate equity/forced appreciation.

      When I began aggressively using BRRR 18+ months ago the strategy was used so I could add lots of SFR doors and stack that cashflow. Can I retire on SFR @ $100/door comfortably? sure, but it is a lot of units. What I have realized in the past few months is that another option (better option) is to leverage that forced appreciation and 1031 into MFR. Essentially I am using that forced appreciation as the down payment into larger MFR.

      I am going to reread your comment again as I think there is a lot to be said/learned there. thanks for posting

      • jeff pollack

        Thanks Brian. Doing BRRR (am I missing an R?) with single family homes is great. I bought most of my SFH, duplexes and triplex with that method and paid little or nothing out of pocket other than debt service on my original private money loan. Of course, the refi also increases leverage up to 75%-80% of appraised value, which further reduces cash flow but I’d rather have the $20k-$25k in my pocket today than a few extra dollars per month in cash flow.

        I sold 3 SFH in TX last year and one of my properties in the Atlanta area (I’m keeping my other Atlanta Metro properties for the time being). Total cash flow over 5 years for these 4 properties was about………….$14,000. But after fees and closing costs I netted over $200k from appreciation.

        Doing the 1031 to MF is a good idea, though timing the sale of numerous single family homes to work within the confines of a 1031 will be difficult.

    • John Murray

      Jeff you are correct I have 8 SFH rentals and generate about $60K per year profit from rent. The flip side of appreciation is about leverage of $3M and appreciation of just north of $200K. The total is just north of $260K per year through BRRR. I live in one of the most moved in destination cities in the US. So I do get to get my cake and eat too.

    • Engelo Rumora

      Thanks Jeff,

      A few things.

      I don’t believe in leverage and your comment is based on predictions of appreciation.

      What if someone follow this strategy and buys in CA or NYC and the market stays stagnant for next 30 years and they loose money every month on mortgage repayments?

      Different strokes for different folks.

      I currently own 25 SFH and am looking forward to owning 200+ along with multifamily and commercial.

      I might even speculate one day for fun and buy in a market that has growth potential

      Thanks again

      • Dan Heuschele

        So Cal has never been stagnant for anywhere close to 30 years. You might as well state what if an earthquake happens and it falls into the Pacific as both have never happened and are not likely to happen in my life time.

        As for you not believing in leverage this is very small time and will limit your successs (not implying you cannot have success but on a smaller scale than otherwise).

        Look at all the wealthiest people who have made a significant amount on investments and you will see leverag at use. Do you think trump or Buffett limit their assets to their net worth?

        I think the comment alone speaks volumes.

        • Engelo Rumora

          You reference Buffet.

          If you followed Buffet more closely and investing based on value you would know that speculating on the future id a risky game.

          You would also know that past performance doesn’t indicate future performance.

          So your awesome So Cal market could actually experience an earth quake or Trump (Since you mention him) might start WW3 and the market could decline lol

          I think your lack of facts speak volume

          Let’s agree to disagree or we can continue being keyboard cowboys

          It’s up to you

        • Dan Heuschele

          I know Buffett uses leverage to make smart investments whether they are value or appreciation plays.

          I also know that past performance does not necessarily predict future performance and yet without any change of events I cannot think of anything that I would think is a better predictor of future performance than over 50 years of long term appreciation.

          I agree that Ca can fall into the ocean or WW III can start but I can also die tomorrow. Note WW3 likely will impact all RE values including cash flow locals and not just Ca. If Ca falls into the ocean I have bigger concerns and seems so unlikely that I will take that risk.

          >I think your lack of facts speak volume

          Funny because I referenced facts. Fact is appreciation markets have produced better returns for financed buy n hold historically than locales that only have provided cash flow. I provided you information that would allow you to verify this fact. I think you provide opinions that the facts do not support that one should not invest for appreciation (at least historically you would be incorrect but we will not know going forward until some point in the future that may show the returns are great for each).

          Seeing that I clearly provide a critical fact (i.e. that historically appreciation markets have produced better ROI for financed buy n hold than pure cash flow markets) I question what fact did you provide?

      • jeff pollack

        Hi Engelo,

        I didn’t realize you were talking about buying SFH for cash. I stand corrected. Any property bought for cash will cash flow. But what is your cash on cash return?

        Let’s take, for example, a $70k property in Ohio that rents for $850, has taxes of $1600, $600 for insurance, $900 for property management. The net is $7100/year. But this is not reality. It assumes 100% occupancy, no maintenance, no CapEx, and no lease-up fees. Let’s account for vacancy, maintenance, and CapEx combined at 20% annually. This is a realistic number over several years. Your net drops to $5060/year and you’ve got a 7% CCR. There are some tax benefits baked into buy and hold, so over time you may get a better return than the S&P500. But without the benefit of appreciation, real estate becomes a diversification play (as opposed to just sticking money into in index fund). One could get 8% investing with a hard money broker and have a fraction of the drama of owning SFH. Or get double the return on a decent syndication deal, also with virtually no drama.

        And yes, my position on appreciation is predicated upon the belief that long standing real estate trends are very likely to continue over long periods of time. It is possible that people will stop wanting their kids in good schools, will no longer want to live where there are jobs, and will cease to value good weather. Scarce land in desirable areas could suddenly depreciate over time. Properties in California and NYC could buck trends that are several decades+ long and stagnate for the next 30 years. Any or all of these things are possible, I guess. But very unlikely and I think it is unwise to make investment choices (i.e. discount the benefit of appreciation) based upon an unprecedented occurrence becoming common place.

        But hey, to each his or her own. One of the best things about real estate is there are a MILLION ways to make money. There is a strategy that fits with anybody’s personality, risk tolerance, money or time limitations, etc, and I have found that for every strategy there is one person who swears by it and another who says it will never work.

        Happy hunting!

        • Engelo Rumora

          Thanks Jeff,

          I personally see nothing wrong with a consistent 7-8% hands off net ROI. No need for any appreciation in my eyes.

          We can use cashflow to live of while equity is just a way of building wealth.

          You don’t want to know my cash on cash returns as it will make you jealous haha

          I live in a “boring” market called Toledo, OH and when I invest for myself I wouldn’t get out of bed for less than a 20% net cashflow return.

          And we aren’t talking about D class ghetto property either.

          Solid blue collar working class areas.

          It’s a great topic where every comment is biased due to someone investing in one or the other or plugging one or the other through their business model lol

          It’s always fun reading between the lines in such instances.

          Thanks again for your comment and much success

  8. Dan Heuschele

    I think a lot of people who have invested 10 years or less are into cash flow while those who have invested longer are into appreciation plays. My family and I have been doing REI since the 1970s. We skip the out of state cash flow deals (been there, done that) for an appreciation play that has over 50+ year track record.

    Rents do decline but typically it is in declining areas. My rents did not decline in my market at the housing recession. However, my wife’s family is from North Dakota and prior to the oil jobs you could not rent a home to anyone where her family is from. Why? Because the banks were basically giving away abandoned homes.

    You can make money using both methods (cash flow and appreciation) if you invest in the right properties but there is no solely cash flow locale that has produced the returns of the best appreciation markets for financed buy n hold properties. It is a fact: look up annual appreciation rate of San Francisco since 1970 and realize the annual return if financed at 80% LTV. Markets goes in cycles so you have to be able to withstand a down cycle but the top appreciating markets have been appreciating for 50+ years. That seems like a speculation with a lot of history behind it.

    • Engelo Rumora

      Thanks Dan,

      It’s quite simple in my eyes.

      I can live of the cashflow and not the growth so I would never invest for growth.

      I want the cashflow supporting my lifestyle and not to build wealth over 50 years.

      I won’t be alive to enjoy in all that “equity” then lol

      Much success

      • Dan Heuschele

        I do not understand the view you cannot live off of appreciation. My investment accounts are full of money from RE appreciation. The appreciation can be accessed via refi or equity line (harder to find than a refi).

        So how can I not live off this money?

        Your reference to waiting 50 years is funny considering the ROI in appreciation markets has historically been better than cash flow locales. So historically the wealth build up is greater at 10 years than the better cash flow locales. If you purchased in So Cal 5 years ago you would have plenty of money to live off of today.

        • Engelo Rumora

          i don’t agree with you.

          It’s a risky game living of equity.

          if the market pulls back and you’re caught under water, then what?

          To many folks did that before the GFC and that is how they went bankrupt.

          History is different to the future.

          And the “If” that you mention is a big question.

          What “If” you bought in So Cal at the market peak?

          Thanks

        • Dan Heuschele

          I purchased twice in So Cal at market peaks. In 1992 I purchased a unit for $167K. It lost around 20%. Today it is worth ~$560K. In 2003 I purchased a unit at $741K. It lost around 20%. It was recently refinanced at a value of $950K.

          In the short term San Diego RE may depreciate because the market has gone in cycles. I have purchased near the bottom of cycles and near the top of the cycles but in the long term San Diego appreciates. it always has and I see nothing that convinces me that 10 years from now the price will not be higher than it is today. Note I do not make the same claim for 3 years from today as I do not try to time the market.

          As for leverage there is a difference between leveraging your money and over leveraging your money. In San Diego the only people to have lost money on buy n hold at the GFC (what I call the housing crisis) are those that were so leveraged that they were forced to sell. Anyone who did not sell and still owns the buy n hold has experienced appreciation.

          If you finance your buy n hold you are using leverage. If you pay cash without any financing your ROI potential is significantly reduced. So I use leverage but do not over leverage. I do not even know how to respond if you are not using financing to leverage your money to maximize yours ROI except I suspect your opinion will change when you have done this for a couple of decades.

          Good luck

        • Engelo Rumora

          Thanks for your detailed comments Dan,

          I appreciate and respect the exchange we had.

          I wish you continued success with your real estate endeavors and let’s catch up on one of my other blog articles.

          The back and forth banter gives my blogs a higher rating and more folks see my name and get to know who I am lol

          Speak soon

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