Balancing Cash Flow and Appreciation

[Jamie Nacht]

What's preferred: (1) High cash flow, but low chance of appreciation, OR (2) modest cash flow, but high chance of appreciation? 

I had a discussion last week with a fellow investor, and we were debating the merits of either of these situations (assuming it is an either, or situation). I'd like to throw it out to the BP community to hear your thoughts. To put a little more color to it, let's assume the following:

Situation 1: Invest in a market where it's likely to get cash on cash returns of 12%, but the market the property is located in hasn't appreciated at all over the last 5 years

-VS-

Situation 2: Invest in a market where it's likely to get a cash on cash return of 3%, but the market the property is located in has appreciated at least 6% per year, during each of the last 5 years. 

Which one do you like more? Why?

[Dan H.]

Just hoping for appreciation is for people who do not want to bother to study historical data, supply and demand, vacancy rates, income increases, cost of building new supply, population growth, etc. There are markets that in over 70 years do not have one 10 year span anywhere with a net decline. Some of these markets it costs >$100K to break ground on a new SFR. I can say with a lot of confidence that I can research a market and provide more basis for it having a higher RE value 10 years from now than a Midwest market can provide convincing evidence that their rents will not fall like Detroit did in the Great Recession. I do not consider investing in these types of markets any more speculation than investing in a Midwest cash flow market.

As for getting money out ... You certainly do not need to sell. You can try to find Equity Line of Credit but they are getting more challenging to find on rental properties. however, as long as rates continue to be low a refinance works for getting money out of a place that has appreciated (either marked appreciation or forced appreciation). Refinance is a key R in the BRRRR process.

I agree with the posters that indicated 12% COC is not enough in a 0% appreciation market. It is too close to the returns of S&P 500 to justify the effort. Because there is no compounding (i.e. the rent is unlikely to increase) my return on the S&P 500 (with compounding) will surpass the cash flow RE property given time.

One thing to note that I did not see mentioned above is the 0 appreciation market typically has 0 rent appreciation. This in effect means that the return is decreasing by the inflation rate. The high appreciation market may have 3% COC upon purchase but if the property appreciation is 6%/year you can expect that the rent will appreciate. 5 years from now when the RE has appreciated ~34%(assuming the projected appreciation actually occurs) you can bet the rent will be higher than at purchase and that the cash flow will be higher than at purchase.

I do not need cash flow from one property for my living expenses as I have my cash flow from previous RE purchases and my other investments.  I would take your scenario 2 every time.  Not only would I, I basically have.  Most of my RE investments have been in a high appreciation area that provides minimal cash flow (compared to Midwest locales) upon purchase.  I will add they cash flow outstanding today.  One purchase cash flows annually more than I invested at purchase and it was not a cheap property with a real cheap down payment; how is that for cash flow?

I will add that even historical high appreciation markets have RE declines (typically less than 5 years from peak to new peak). Anyone who invests anywhere has to be prepared for market depreciation. If you have minimal cash flow you need to be sure that you are not relying on appreciation to meet your financial commitments.  Selling when the market is depreciated is the only way for investors in some of these high appreciation markets to have lost money.  Any RE investor needs to make sure that they are not so leveraged that they may need to sell when the market is depressed.

Good luck