Real Estate Strategies :: Cashflow vs. Appreciation

The two most basic real estate strategies are:

1. Appreciation - Buying property you think will appreciate in value in order to sell it for a profit.

2. Cashflow - Buying property that will rent for more than the cost of holding the property.

Appreciation Strategies

Appreciation strategies are the more glamorous of the two, and the only thing anyone seems to talk about when real estate comes up around the water cooler. The idea of making 10, 25, 50, or even $100,000 in a year just by owning a piece of property is very appealing to most people.

Here’s how a typical appreciation strategy works:

Purchase price: $300,000
20% appreciation: +$60,000
Sales Price: =$360,000
Gross Profit: $60,000
Expenses: -$30,000

Net Profit: $30,000

These were the types of deals we often saw during the real estate boom of the early 2000’s. People were making money hand over fist by simply owning property. With the stock market in a slump, people thought that real estate was the next great money-making opportunity.

Appreciation strategies are typically short-term in focus, with investors holding the property anywhere from a few days to a few years before they cash out. Short-term holds are known as “flips,” where the investor only holds the property long enough to fix it up and sell it again. A slightly longer-term strategy is to find a tenant for a year and then sell it. Transactions tend to be larger in size, where bigger margins mean bigger profits to cover transaction expenses.

Supply and Demand

Appreciating properties tend to be closer to the center of a metro area. As more and more people move to a city, competition for limited urban property intensifies, and prices go up.

The ultimate example is New York City, which is a city on an island. Since the supply of land is limited by water on all sides, and demand is extremely high, the resulting property values are astronomical.

In more rural areas, like the midwest; the supply of land is much greater. As demand increases, cities spread out to absorb it, and prices remain more reasonable.

Speculation

Financing for appreciation-focused investors has been increasingly creative in the last few years, with investors taking on riskier mortgages such as variable interest and even interest-only loans. Since short-term home buyers plan to get rid of their property quickly, they tend to choose the loan that allows them the greatest purchasing power with the lowest holding costs.

The national average for annual real estate appreciation over the last 100 years is somewhere around 5%, so the 20, 30, and even 50% gains that we saw in the early 2000’s were somewhat of an anomaly. Speculators with short-term mindsets and highly-leveraged financing were a major driving force behind the bubble that has now burst.

If you were an unlucky appreciation-minded investor who bought at the height of the bubble, your investment might have looked something like this:

Purchase price: $300,000
10% depreciation: -$30,000
Expenses: -$30,000

Net Loss: -$60,000 & $2,000 per month until it sells

Appreciation strategies carry enormous risk for those who can’t afford to hold a property if it doesn’t sell for what you need to make a profit. If a market turns upside down (like it has in many areas of the country), you might have to wait 5-10 years to make your initial money back. Unfortunately, the cost of holding onto a property that long can be immense.

Cashflow Strategies

Cashflow strategies are the less talked-about sister of the two; but tend to represent a more stable, long-term strategy. A typical cashflow strategy looks something like this:

Purchase price: $100,000
Monthly Expenses: $900
Monthly Rent: $1000

Monthly Profit: $100

$100 a month is a lot less sexy than $100,000 profit, but here’s where it gets more attractive:

1. The cashflow lasts as long as you can keep the property rented, which could be the rest of your life.

2. Rents tend to go up over time, increasing your cashflow.

3. If you get a 15 year fixed mortgage, your mortgage payment will drop out after 15 years, increasing your cashflow by around $600.

4. You could realistically end up turning a $100-a-month cashflow property into a $1000-a-month property over the course of 15 years.

5. As long as your rents cover your expenses, you don’t have to worry about property value, even if it goes down.

6. Any appreciation you get along the way is icing on the cake.

Cashflow investors tend to be long-term oriented, intending to hold their properties for 10, 15, 20 years; or even forever. The transaction sizes tend to be smaller, where rent levels can match expenses.

Casflow-type properties tend to be located on the outskirts of a metro area; where prices are lower, but rents are still strong. These areas tend to have more families and people with more consistent lifestyles; both desirable qualities in a tenant.

Downside

A sure-fire way to become a millionaire is to buy a cashflowing property every year for fifteen years. The accumulation of increasing cashflow, mortgage reduction, and capital appreciation will provide enough money to get most people out of the rat-race.

The problem with this strategy is that it’s expensive. An investor usually needs a 10% down payment in order to buy a property. If each house is 100 to $200,000, you’ll need 10 - $20,000 a year for down payments. In addition to that, you’ll need another 2-$5,000 for repairs and holding costs.

The average Joe doesn’t have this kind of money laying around each year. That’s when he starts thinking about flipping.

Hybrid Strategies

If you’re looking for long-term wealth, but need short-term cash to get the ball rolling; a hybrid strategy might be a smart way to go. Combining short-term and long-term property acquisitions is a way to benefit from both strategies while minimizing risk.

Here’s one example:

1. Starting Cash: $15,000

2. Flip a $150,000 property, making a 10% return on the purchase price after expenses: $15,000 profit

3. Take your $15,000 profit, plus the $15,000 initial investment and buy two $150,000 properties.

4. Put a tenant in one property, and flip the other.

5. Continue the process of buying two properties and flipping one until you have as many properties as you want.

The advantage of the strategy described above is that you don’t need to add any more capital than your starting amount. This, of course, is in a perfect world where every one of your deals goes as planned. It rarely works this way, but here are a few ways to limit your risk:

Never Lose

One-time richest man in the world and fellow Nebraskan Warren Buffet knows how to make money. He famously champions value investing, which goes in and out of fashion depending on whether it’s a bull or bear market. In great bull markets (like the tech boom of the late 1990’s), so-called experts tend to discount Buffet’s strategy as old-fasihioned; but he always gets the last laugh.

His most famous advice to investors is “never lose,” meaning to protect your downside at all costs. Using this strategy in the stock market, you would never risk your money on an overpriced stock (with a high P/E ratio). The idea is that underpriced stocks have much of the risk already taken out of them.

Buffet looks at a company and figures out what it would be worth in a worst-case scenario. If it went out of business and stopped making money, what would the assets themselves be worth if sold on free market?

This price represents a theoretical basement for risk. The closer he can get his purchase price to the basement price, the more risk he has taken out of the investment.

This is an obviously over-simplified description of his decision-making process, but it illustrates the principle of protecting your downside. In real estate, it makes a lot of sense to protect your downside as well.

Worst-Case Scenario

What is the worst-case scenario if you buy a piece of investment property? There are a million things that could go wrong, but here’s the short list:

Appreciation Strategies

1. Real estate market goes south and your asset loses value.

2. Can’t find a buyer for extended amount of time, forcing unexpected holding costs.

3. Home needs more repairs than budgeted

Cashflow Strategies

1. Can’t find tenant for extended amount of time, forcing unexpected holding costs.

2. Can’t get expected rent, forcing negative cashflow.

3. Tenant damages property, forcing unexpected repairs.

Limiting Risk

To limit your risk, you must do your due diligence to know exactly what you are getting.

Purchase Price

Never pay too much for a property. Don’t just look at comparable sales in the neighborhood, ask yourself what the bricks and mortar are worth. If it only costs $100,000 to build a comparable home in the middle of nowhere; don’t pay $600,000 for that property just because it’s in a great location. Overpriced properties like these are the first to get hit in a real estate downturn.

Cashflow

Cashflow is the ultimate downside-protector. If a property cashflows, you can hold it as long as you need to. The perfect flip is one that will cashflow in case of an emergency.

That being said, it takes due diligence to make sure a property will cashflow. How is the rental market? Are rents going up or down? What are the occupancy rates? What is the average time on market for a rental property?

Over-Budget

The biggest mistake people make in calculating cashflow is under-budgeting. It’s not as simple as subtracting the mortgage payment from expected rent. The problem is that there are several other expenses you need to account for in order to insure positive cashflow.

1. Holding costs. -It’s next to impossible to have a 100% occupancy rate for your rental property. Therefore, you need to budget a month or two between tenants where you will have to make the mortgage payment. Start with a 10% re-letting expense, meaning if you’re rent is $1000, you should budget $100 a month for this expense.

2. Maintenance. -Your property is going to need maintenance, guaranteed. If you don’t budget it in, you’ll be left with the bill. Budget another 10% maintenance expense.

3. Insurance, PMI, Taxes, Homeowner’s Association, and any other expense you can think of.

Complementary Properties

One way to limit risk on a flip is to find a complementary cashflow property to support it. If you’re making $200 a month cashflow on one property, it’s easier to buy a speculative property with -$200 cashflow. This way, if your flip doesn’t work out the way you expected, the worst that can happen is zero cashflow.

Make Your Money Upfront

Profits in real estate are made at the purchase, not the sale. If you can find a deal on a property that is already below market value, then you’re starting out ahead. Don’t rely on appreciation to carry you. It might not be there.

Sweat Equity

Real estate, like any market, is fiercely competitive. It’s not easy to find deals that will automatically make you money. You have to find an advantage somehow.

One way is to creatively see the potential in a property that other people can’t see. Then, do as much work as you can professionally do on your own to fix it up, and hire out the rest. Using “sweat equity” can yield excellent returns in the value of your property.

Don’t Settle

Your most powerful tool against risk is your ability to control your emotions and stick to your plan. Don’t fall in love with properties, and don’t get soft when it comes to your numbers. Make sure the property cashflows by your conservative estimates.

It takes patience to find a good deal. If it didn’t, everyone would be real estate investors.

Bottom Line

If there’s one thing we learned from the recent real estate boom and bust, it’s that you have to be smart about investing in real estate. It’s not as easy as just buying any property and watching it grow in value.

Do your due diligence, protect your downside, and be smart about your real estate strategy.

Related Articles:

• A Roadmap from Debt to Living your Passion
• Five Ways to Create Passive Income With Little or No Money
• Passive Income