Consider two investment scenarios in which you could choose between one property with positive cash flow and a reasonable chance of some appreciation and one with negative cash flow and strong likelihood of good appreciation.
Investor has a salary of $120,000 per year with an aggressive savings rate of $30,000 per year.
Property A
3bd single family home in high priced growth market
Purchase price: $600,000
Down payment: $150,000
Monthly rent: $3,000
OPEX, capex & vacancy: ($1,000)
P&I @ 5%: ($2,415)
Cash flow: -$415 / mo, -$4,980 / yr
Property B:
Triplex in secondary cash flow market, but also modest appreciation
Purchase price: $600,000
Down payment: $150,000
Monthly rent: $5,000
OPEX, capex & vacancy: ($1,650)
P&I @ 5%: ($2,415)
Cash flow: $935 / mo, $11,220 / yr
Property A gain after 5 years: -$24,900
Property B gain after 5 years: $56,100
Delta: $81,000
Of course, the premise with appreciation is that you make it all back when you sell and realize your gain when the property appreciates. However, one inherent issue is that as we all know, we don't know exactly how and when that will happen. Of course, things can go according to plan and the property appreciates as expected. But how do you know when is the right time to sell? How do you know you're not selling too early? It's a constant guessing game and trying to time the market in order to maximize your gain, unless you have the discipline to stick to your exit strategy and predetermined hold period. Either way, the only way to profit is to sell and realize the gain, backing out closing costs and making sure you're adequately set up for an exchange unless you're okay paying capital gains tax.
However, if the market is in a contraction at the end of your predetermined hold period and the value is at or below it's original value, then you would be required to hold for longer until it recovers and rebounds, but for how long? All of course while sustaining a $5k a year loss. The 5 year hold might easily then turn into a 10 year hold. Of course it would be okay should the gains be there, but the velocity of your capital in this scenario becomes extremely low.
There are a couple of other things to consider as well. Consider a scenario with property B by comparison with the positive cash flow. With the negative cash flow of property A, it would damper your savings rate from $30k/yr down to $25,020 per year. In this case it would take you 6 years to save up the same $150k down payment for the next investment. With property B, if you were willing to save what you would be in the negative with property A ($415/mo) and you combined that with the cash flow $935, you'd be putting away $1,350/mo, or $16,200 per year. Combined with your savings rate of $30k from your job, you're collapsing the timeframe down to 3.24 years. Assuming you're able to duplicate a similar deal, now you have two properties producing $1,870/mo in just over 3 years. If you then repeat the same process again by reinvesting the cash flow combined with your savings, now you collapse the timeframe to 2.8 years and you pick up your 3rd property for a total combined cash flow of $2,805/mo, and so forth. The key concept here is that this strategy is repeatable and can be modeled and it allows the investor to build and scale a business around it, whereas with realizing gains through appreciation approach, while appreciation in and of itself IS reasonably predictable, the WHEN is most certainly not. There is a reason why the institutional and large real estate investors who operate businesses around the acquisition and operation of their assets in the hundreds of millions employ this model.
