The choice between investing for cash flow or appreciation depends on your financial goals, risk tolerance, real estate market, and investment strategy, among other factors. Both approaches have their advantages and disadvantages, and they often complement each other in a well-diversified investment portfolio. In this post, we'll take an in-depth look at both strategies to better compare cash flow versus appreciation.
A Closer Look at Cash Flow Investments
Investing for cash flow involves strategies aimed at generating a steady stream of rental income from your real estate investments. The key to this strategy is purchasing rental properties where the net operating income is higher than the monthly expenses. To calculate cash flow, you use the DSCR ratio, which is: Monthly Rent/Monthly Operating Expenses. Typically, a DSCR ratio of 1.2 indicates adequate positive cash flow.
For example, if your property's income is $1,500 and your monthly expenses are $2,000, your DSCR would be .75%, indicating that you have negative cash flow. If we flip the numbers and your monthly income is $2,000, while your operating expenses are $1,500, your DSCR would be 1.33% indicating the rental property and gross income is cash flow positive.
Positive cash flow enables real estate investors to purchase an investment property, pay off their mortgages, and pocket some of the money from the difference. Cash flowing properties are a great way to build passive income, especially if you outsource property management.
Here are some types of buy and hold cash flow properties:
Long-Term Rental Properties
With this investment strategy, investors purchase a rent-ready rental property to lease to tenants long-term. A key to this real estate investing strategy is to find a housing market where renters are looking for stability but might still want the flexibility to move or do not have a down payment to purchase.
Vacation Rental Properties
Also known as a short-term rental property (STR), or Airbnb and VRBO, with this investing strategy, investors aim to get several short-term tenants throughout a year. The key to this strategy for real estate investor is investing in a local market with high demand for vacation stays and investor-friendly regulations.
This strategy is similar to a long-term rental property, yet at a much larger scale. You'll need substantial upfront money to get started, but ultimately you can build substantial cash flow.
A Closer Look at Real Estate Appreciation
Investing for appreciation is when you buy property that is expected to increase in value over time. Rather than look for cash flow potential, with this strategy you focus primarily on market appreciation from future real estate sales.
Here are some key considerations for real estate investors interested in the appreciation strategy:
Be aware of tax implications related to property ownership and appreciation in home prices, including capital gains tax. The capital gains tax is a tax imposed on the profit earned from the sale of a real estate investment. When you sell an asset for more than its original purchase price, the difference between the sale price (proceeds) and the original cost (basis) is considered a capital gain.
Consult with a tax professional to optimize your tax strategy.
Stay informed about market trends, economic conditions, interest rates, home values, and local developments that can impact property values. Look for areas with a history of appreciation and potential for future growth. Demographic and economic trends can be indicators of a promising location.
Consider hiring a real estate agent or real estate investment advisor who has specific expertise in the local market and can provide valuable insight.
Comparing Investing for Cash Flow to Real Estate Appreciation
The cash flow strategy and real estate appreciation are both solid strategies to build wealth overtime, and both have their benefits and drawbacks. Let's dive in.
Pros and Cons of Producing Cash Flow Strategy
Cash Flow Pros:
- Predictable Income: Cash flow provides regular and predictable rental income, making it easier to budget and plan for your financial independence.
- Hedge Against Market Volatility: Cash flow rental properties are generally less affected by current market value and fluctuations, offering stability during economic downturns.
- Debt Paydown: Rental income can help cover mortgage payments, giving real estate investors more equity over time.
- Tax Benefits: You may be able to deduct expenses related to your cash flows, reducing your taxable income.
- Diversification: Cash flowing property can provide diversification in your real estate portfolio, reducing risk.
Cash Flow Cons:
- Slower Wealth Accumulation: Cash flow real estate investors may build wealth slower compared to those investors who focus on appreciation.
- Real Estate Market Selection: Location becomes critical, and investors need to carefully choose areas with strong rental demand
Benefits and Drawbacks of the Real Estate Appreciation Approach
Advantages for Real Estate Appreciation:
- Market Risk: Appreciation depends on market conditions and home prices, which are unpredictable and can be subject to economic downturns.
- Lack of Immediate Income: Appreciation investors may not see any significant returns until they sell their properties.
Which investment approach is right for you?
In summary, investing for cash flow and appreciation are both great ways to grow a real estate business and build wealth over time. Many investors find success by striking a balance between the two, using cash flow investments to provide steady rental income and pay down debt while holding appreciating assets for long-term growth. Ultimately, thorough research, market analysis, and a well-defined investment plan will help you make the best choice for your real estate portfolio.