Eric is a real estate investor and founder of MartelTurnkey. MartelTurnkey sells rental properties to investors looking for passive income.
When putting together an investment strategy, real estate investors often debate whether it's more beneficial to focus on cash flow or appreciation. Obviously, the goal of investing is to make money, but how you make money matters. While there are benefits to each, in my opinion, new investors should focus on cash flow opportunities first. That's because I strongly believe it can help meet your number one goal — whether it's financial freedom or something else. When you invest for cash flow, such as turnkey rental properties, you'll be one step closer to reaching that goal. Despite my preference, both methods are valid investment strategies and each have their own set of compromises. What I mean is that the more you focus on appreciation, the less cash flow you can expect. The reverse is also true. There are several distinct ways that each strategy will help you achieve your financial goals.
When you invest for appreciation in real estate, you are buying and holding a property that you think will increase in value over time. This appreciation strategy is often found in high-demand markets, such as San Francisco or New York. Most of the time, investors would buy a property, renovate, refinance it and then rent it out. These investments typically produce low to negative cash flow. Negative cash flow means that an investor must be willing to put in additional cash every month to stay afloat. To avoid negative cash flow, investors can increase their down payment to reduce mortgage payments. The return is typically low because of the amount of initial investment required to acquire, renovate and bring the property into positive cash flow. When it comes to an appreciation strategy, the hope is that the value of the investment property will continue to increase over time, but this appreciation is not realized until you extract it through selling or refinancing. A market crash, a pandemic or other economic forces could take away the unrealized appreciation. How do you convert that additional equity into a stream of income? If you continue to hold the property, the cash flow should improve, but the return on equity will decrease. This means as you continue to own the property, the rent will increase but the mortgage will remain the same — which will improve your net cash flow. During that time your equity is also increasing due to principal paydown and appreciation, which in turn will reduce your return on equity. Refinancing will negatively impact the cash flow. The other option is to sell and purchase a property with cash flow.
A cash flowing investment is an investment where the revenues cover all expenses — mortgage, insurance, property management and more. The revenues also typically provide leftover money at the end of each month. These opportunities are typically found in markets with sustainable growth where the demand for real estate is balanced. Some examples include the midwestern and southern regions of the U.S.
When you invest in a cash flowing property, you are sacrificing some of the appreciation in exchange for net cash flow. These properties still appreciate over time but typically not as fast as properties in an appreciation market. The returns vary, but I've seen investors I work with receiving around 15% in cash returns — after financing. After a few years, the property still has positive cash flow and has accumulated some equity due to mortgage pay down and appreciation. At this point, you can extract the equity and add to your portfolio or simply continue to hold. A cash flowing strategy is great for those who want to focus on achieving specific financial goals. If you're looking to cut back on your work hours or retire altogether, a cash flow strategy can be a beneficial one. You'll be receiving cash every month, which allows you to easily measure how close you are to your goal.
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When deciding which strategy is right for you, it's important to note the major differences between rentals with cash flow and appreciating properties. Appreciation is more speculative since the value is completely dependent on the market whereas rentals can be more stable because tenants tend to stay in your unit and pay rent. I often compare investing for the appreciation to investing in the stock market. If you bought a stock today, you hope that by the time you need the invested money and returns — retirement age, large purchase, etc. — the stock will be worth more than what you paid for it. While there are certain factors you can evaluate before you invest in a specific stock, there's no way to guarantee that the value of the said stock will be higher 10 years from now.
Why would someone invest for appreciation, then? This is a great strategy for building multigenerational wealth after you have reached financial independence. Another reason is the tax advantages. For instance, if someone has a significant amount of money saved and doesn't want to keep it in their savings account or invest in the stock market, he or she may take that money and invest it in real estate. This way the gains from appreciation are not taxable. With 1031 exchanges, you can use the appreciation to buy another property and defer capital gains tax indefinitely. That being said, appreciation is not a guarantee, and in order to enjoy the benefits of appreciation, you will need to either sell your property or refinance it at some point.
Investing for cash flow is ideal for those who need a stream of income to retire and be financially independent. Additionally, cash flowing investments make it easier for you to plan your future, as you'll be able to track your progress based on the passive income you are receiving every month. Cashflow investments enjoy the same tax benefits that appreciation investments do, but cash-flowing properties help pay for themselves during ownership and can have higher returns.
The decision of whether to invest for appreciation or for cash flow is one that will forever be debated by investors of all kinds. However, before you decide which strategy to implement, it's important to evaluate your personal goals. As mentioned above, focusing on a cash flowing strategy is often the ideal way to achieve your goals — including financial freedom.