Residents
Owners
Making money is the very purpose of investing in real estate, and there are two ways to achieve this goal: through cash flow or appreciation. Many newbies in the business ask which to prioritize between the two when buying an investment property.
This question can be answered depending on the investor’s financial strategies and goals, as there are different considerations when choosing your priorities. Deciding which strategy suits your financial circumstances can be a big help. This blog post will talk about the difference between cash flow and appreciation.
Rental Property Cash Flow
The remaining money at the end of each period after the collection of rental income and deduction of all the expenses is called the cash flow. Every property investor should make it his goal to generate positive cash flow, which means that expenses should not exceed the profit from the rental property.
Sometimes, you cannot avoid generating negative cash flow. For instance, there may be unexpected repairs that cost more than the income in a particular period. Of course, the result is a negative cash flow.
Benefits of Prioritizing Cash Flow
There are various advantages you can gain if you focus more on generating positive cash flow than appreciation.
- Rent payments cover the mortgage and property operating expenses. As a property investor, there are expenses related to owning the property and running it. You can also put the rental income into a capital expenses account if the profit collected exceeds the total expenses in a given period.
- Build wealth faster by reinvesting rental income. Use your rental profit to make extra mortgage payments to raise home equity faster and increase the money for the down payment on another investment property. You can also use the positive cash flow to improve the property and raise the rent.
- Improve financial freedom. If your investment property generates positive cash flow, it is an opportunity to make additional income streams. This, in turn, allows you to retire early and achieve financial freedom.
- Cash flow opens the door to favorable financing options. Lenders check your rental property’s cash flow to decide the loan terms and interest rate and whether to approve your loan application. One of the metrics lenders use in determining a rental property’s cash flow is dividing the rental income by the annual debt service. The result of this calculation informs the lender whether you can cover debt payments.
Real Estate Property Appreciation
Real estate appreciation refers to the increase in home values. Along with the increase in home values, the home equity also rises, creating a gap between the original purchase price and its current value.
If a property investor buys a $200,000 single-family house and makes a $40,000 (20%) down payment, the mortgage balance is $160,000 and the equity is $40,000. Then, say the home values have increased by 30% five years later. It means that the property will be worth $260,000 by then.
Statistics on Increase in Home Values
Home values have increased quite significantly in the past decades. The Federal Reserve statistics show that median sales prices of properties have grown by 31%. Meanwhile, the value of middle-priced homes in the country has increased by 56% in the last five years.
It is crucial to remind ourselves that different numbers may result from different data sources. Moreover, home values may increase or decrease based on various factors. For instance, from the year 2007 to 2009, the Federal Reserve reported that median property sales prices had decreased by about 20%.
Advantages of Prioritizing Appreciation
Of course, you can also gain some advantages when you focus on real estate appreciation instead of cash flow.
- Buy-and-hold strategy. The long-term gain when you purchase and hold a property for years can be significant. The increase in home values since 1990 is a solid basis for this investing strategy.
- Cash-out refinance. You can pull the equity out of your investment property through a cash-out refinance. You can convert this equity into cash and use the money to purchase another investment property while continuing to hold the first home.
- Use the property as a short-term rental. If the rental home does not produce positive cash flow as a long-term rental, you can convert it into a short-term rental. STRs can generate higher profits than LTRs, but you must consider that STRs also incur higher operating expenses. You may be on the losing side if you fail to consider factors such as demographics and economic viability of the area.
Endnote
So, there you have the difference between cash flow and appreciation and the reasons why you must prioritize one over the other or vice versa when buying an investment property. Keep in mind the advantages and disadvantages of both and decide wisely.
