Cash Flow Versus Equity Growth (Which One Wins)
A typical phone call comes in where the investor on the other end wants to inquire about investment properties. Any guess as to what is the first question I ask them? “What is most important to you Cashflow or Equity Growth”? The typical response of course is both! I understand that we want to have it all, but the question is designed to help identify what is most important to you within an investment. Having a mix of cash flow and equity growth (appreciation) is important to most investors and identifying which is most important will help with your investments performing the way you wish them to perform.
Don’t Buy a Sports Car if You Need a Pickup Truck
The metaphor suggests you want to buy the type of property that is best suited to accomplish your long term objectives. I always like to discuss this topic of cash flow versus equity growth with my investors before looking into property. Interestingly enough, what they say they want to purchase often does not coincide with the properties or locations they are looking for.
Often people will say they want to provide a long term retirement plan by purchasing real estate that will increase in value. They then say they are looking for cheap property that has huge cash flow. This is very incongruent as the cheap property will not be a suitable investment for the sustainability of a long term hold.
Cheap property is cheap for a reason and often requires more repairs and updates during the hold time. Meanwhile the property value on cheaper property does not appreciate very fast, if at all. This is why knowing your long term objective before shopping for property is so important.
Strong Cash Flow Versus Long Term Hold for Equity Growth
The main distinction between the two is those buy and hold properties tend to be more expensive on the purchase with a smaller monthly cash flow but with a larger gain on the sale price. The large cash flow properties tend to be cheaper on the purchase with larger cash flow. The sale on the other hand will generate smaller and often much smaller gain on the sale price.
To be an effective real estate investor, it is imperative to know what exactly you want to invest in and why. Knowing the attributes of each investment type may be beneficial to identifying your desired investment.
Attributes of Long Term Hold Properties
With 382 statistical markets (MSA) in the U.S. you can rest assured knowing that there are markets which are better poised and positioned to give you better, longer lasting more sustainable returns than others. Investors looking for long term are always looking to invest in sustainable emerging markets.
Once you have identified the best market for sustainability, it is imperative to find the properties that will be the most sustainable.
There are a number of things to look for that make up these properties.
I have found great success in the 2-3 year leases. To maintain long term sustainability having long term tenants is paramount. Having a 2 or 3 year lease on a house will help you find tenants who essentially are telling you they too want a rental property for a longer duration. You tend to find tenants who are not interested in moving every year, but instead want the security of knowing they have a place to live for the duration. (Note: you will want to follow lease laws and do contracts that are legal where your property is)
The multi year lease removes the mystery to the landlord (Will my tenant renew their lease or will I be stuck with another vacancy to fill next year?) and the mystery to the tenant of course is (How much will rent be next year, or will I be asked to leave because the landlord wants to sell the house?) The transparency that comes with 2- 3 year leases helps both landlord and tenant.
I believe long term hold properties represent the Number 1 investment objective today. The key to the long term hold is finding the sustainability of all aspects of the investment from location to property to tenant and even property management for us passive investors. If you will be hiring property managers, you will want sustainability there as well and you want to hire the right property manager.
Attributes of Cash Flow Properties
Age of properties:
It is rare to nonexistent to find a new property that is strong in the cash flow arena. Typically your strong cash flow comes from homes in the older areas and these homes tend to be aged and more tired out. Things you want to watch for are deferred maintenance and outdated features and benefits. What I mean by that is today people want homes that are at least 3 bedrooms and 2 baths. When buying cash flow properties, always try to find structurally sound and well maintained (or updated) property with at least 3 bedrooms and 2 baths.
Sellers tend to make a pro-forma appear to be stronger than the reality of them. Perhaps you are buying a property that is not turnkey and you must hypothesize a pro-forma. Either way, you want to make all considerations for the age of the property and possible maintenance or deferred maintenance. These older properties can still be great investments and provide incredible cash flow. However, without proper due diligence, they are more susceptible to providing a much smaller producing cash flow than anticipated.
As any seasoned investor will tell you, you want to know your exit strategy going into the sale. Do you want a property that you can sell to the retail buyer who will pay retail prices for the property or will you settle for the discount buyer who will want to make an ROI on the property as they purchase it.
Exiting a cash flow property
Strong cash flow rental properties tend to be more of a rental style property versus an owner occupied property. They tend to be in highly populated rental areas and as a result the most prominent exit strategy is to sell to another investor. Investors of course limit your buying audience and they will want a good deal on the purchase. Buyers of cash flow property tend to be other investors who will be looking for a good ROI, this may limit your resale and its value. The strategy for the cash flow buyer will want to take this into consideration when purchasing.
Exiting an equity growth investment property
This is the strategy that assisted 90 percent of millionaires in America today to create wealth. The equity gained on the sale of a strong equity growth property is paramount to creating wealth. There are things an investor can do to create equity over and above buying it right. After you hold a property for a number of years and the appreciation organically grows your equity position you can also manufacture some equity.
Before you sell you can update the property to be the shining star on your block. Simple upgrades will go a long way to getting top dollar. You may also opt to do some capital improvements to grow the value. My favorite is converting 2 bedroom homes into 3 bedroom homes for a quick value increase. This of course requires buying a property that has a floorplan conducive to easily and inexpensively doing so.
As you sell this equity growth property you will be able to attract the retail buyer who buys the home to move their family into it.