Should You Invest for Equity or Cash Flow?

Evaluating cash flow and equity is easy!

What should be the primary goal of a buy and hold real estate investor: equity or cash flow?

“Equity” meaning built-in equity (i.e., buying properties under market value). Of course, if you buy a property under market value in Orange County or New York, it probably still isn’t going to cash flow. You’d either have to flip it or hold it at a loss with the hope that it appreciates.

As with most things in real estate, your primary focus depends on your situation and goals. But in this instance, for most people most of the time, focusing on one goal is better.

Equity vs. Cash Flow: Which is Better?

Why not both?

You should definitely aim for a real estate investment with both a significant equity margin up front and good cash flow. Additionally, seek out a property in a decent area that will be relatively easy to manage and has a good likelihood of appreciating.

But like the Rolling Stones song, you can’t always get what you want.

Choices have to be made, and you will need to consider one criterion or the other more significant. Generally speaking, the more important thing should be to go for built-in equity. But there is one noteworthy exception. This exception probably only applies to about 0.1% of investors, but it’s still worth a mention.

When Cash Flow Matters More

For institutional investors, cash flow is the number one metric. They are constantly talking about gross yield (annual rent divided by the price of the properties) and what their “buy box” is (what range they’ll accept for the gross yield of a portfolio).

These firms need to hit a certain return for their investors. For example, a fund might estimate an 8% return for its investors, or an insurance company may estimate it needs a 9% yield to cover its expected losses. For these types of Wall Street firms, built-in equity is nice, but cash flow is the name of the game.

When Equity Matters More

Buying with built-in equity allows you to buy, rehab, rent, refinance, and repeat (BRRRR) a property. Even if the “otherwise” here involved a house with better cash flow. Furthermore, it’s built-in equity that protects us from the dangers of leverage and allows us to take advantage of its upsides (which are very big).

The IDEAL acronym (I: Income, D: Depreciation, E: Equity, A: Appreciation, L: Leverage) is a great explanation for why real estate is such a good investment:

If you buy a property for $100,000, but get an 80% loan, you only put down $20,000. Now if the property goes up in value by 5%, your return is actually 25% ($5,000 / $20,000). This is a huge return.

Leverage is a two-edged sword. Real estate can go down, which would lead to a 25% loss… But if you get a good deal, that insulates you from the risk of leverage.

This doesn’t mean that cash flow doesn’t matter. You still need to buy properties that have cash flow and net income. There are a few occasions when the trends in an area are so strong it makes sense to hold a property even if it bleeds each month. But these instances are few and far between and should only be done with a small percentage of your portfolio. Going big on properties with negative cash flow is, more or less, just speculating.

However, entrepreneurial investors can pound the pavement and find the gems that slip between the bristles of the broad brush institutional investors use. This allows investors to take advantage of the inefficient real estate market by finding motivated sellers, value-add opportunities, and mislisted properties (most often by institutions). This is the advantage that entrepreneurial investors have and the No. 1 reason real estate is the best way for someone of modest means to become independently wealthy. And it’s equity that makes you wealthy. Cash flow is just the cherry on top.

The Scenario: 2 Cousins

In this scenario, we have two cousins who are going to buy a duplex. The valuation of each duplex is $250,000. Each is exactly the same, consisting of two 2-bedroom/1-bathroom units. Each cousin will live in one unit and rent out the other unit to a prospective tenant. Each cousin is employed in a salaried job and makes $75,000 per year in income and each has $50,000 in savings. Let’s also assume that each of the cousins was able to negotiate zero out of pocket closing costs.

Cousin A

Cousin A is a highly motivated individual and wants to pay off the property as soon as possible. Cousin A only knows one way to use financing: Put down as much cash as possible and finance as little as possible. Cousin A is going to put down 20% because that’s what his parents did when they bought their home, and he’s going to get a 15-year fixed, which will allow him to pay off the property in just 15 years.

Then, any cash flow that is achieved by renting out the second unit should be put toward the monthly mortgage payment, and Cousin A might be able to pay it off faster than 15 years. Cousin A wants to build as much equity as possible and as fast as possible, while at the same time paying down the mortgage as fast as possible. The duplex is kept up, and it appreciates at 3% per year.

Cousin B

Cousin B is also a highly motivated individual, but she knows less about finance. She decides to do the opposite of what Cousin A did and take as long as possible to pay off the mortgage, which means getting a 30-year amortization on her mortgage loan.

She’s going to put as little down on the property as possible, which is 3.5% with an FHA loan in this case. She’s going to save the difference in monthly mortgage payments ($302) and put that in savings. Just as in Cousin A’s duplex, Cousin B’s duplex is kept up, and it appreciates at 3% per year.

The initial numbers

Here’s what each cousin’s calculation looks like when they are purchasing the identical duplexes.

For the next five years, everything goes as planned for both Cousin A and Cousin B. The renters seem to be long term. The rent has been consistent. There have been no unexpected capital expenditures. The property is worth more five years later, so they’ve both built a little equity in the property. They still have consistent income, so nothing seems to be wrong as far as monthly payments and other expenses are concerned.

The numbers after five years

Here’s the key difference: Something happens at year seven. Cousin A loses his job, and since he put down such a large down payment on the property in order to “pay the property off faster,” he has absolutely no savings. The renter in Cousin A’s duplex decides it’s time to move out, and he no longer has income coming in from the rental.

Coincidentally, the same exact thing happens to Cousin B. She loses her job, and the renter in her duplex also decides to move out at exactly the same time as the renter with Cousin A.

The numbers after seven years

This is where the situation becomes divergent. Since Cousin A has no more income, from assets or not, because of the job loss and rental income loss, he’s forced to make a tough choice. Either he can’t make his mortgage payment or he’ll have to sell the house. Most likely, he’ll have to sell the duplex to get his equity.

Cousin B, on the other hand, feels okay with where she stands financially after the job loss and the tenant loss. She can make the mortgage payment for many years with her savings alone. She can take her time to find a tenant who fits the mold of exactly what she’s looking for.

The end.

There are several variables in this story that may or may not happen. But it illustrates a few points about residential investment real estate, rental property value, rental income, real estate finance, and money in general.

Evaluating Cash vs. Equity

Cash is liquid money and is absolutely essential when you finance real estate. Cash is much easier to use if something goes wrong, whereas equity is completely useless. You’d have to sell your asset if you ever need the money quickly, and that is not always the choice that someone needs to make if an event occurs.

The value of a residential property will go up or down regardless if you have a mortgage on the property. Value is completely out of your control in residential real estate—after all, it’s usually based on someone’s opinion, not cash flow.

Keep in mind that a key aspect of a successful investment property is knowing how to calculate cash flow. It’s important to prioritize properties that generate sufficient income to cover expenses, rather than solely focusing on “equity.” In other words, the revenue generated by the property should exceed the costs associated with it.

The most important thing a buy and hold investor should look for is built-in equity. The second is cash flow. There are other things too, of course, such as potential appreciation, neighborhood stability and safety, hassle, etc. But in real estate, first comes equity. Everything else follows from that.