Understanding your goals, budget, and risk tolerance will guide your strategy, whether you're looking for properties with long-term appreciation, immediate cash-flow potential, or something in between.
Choose your strategy
The 3 real estate investing strategies below can help you determine the types of single-family rentals (SFRs) that may be right for you. Use this link to build a buy box and view these types of properties on the Roofstock Marketplace.
Appreciation
Investing in real estate for appreciation is similar to buying a growth stock. While there may be little, if any, recurring income, the underlying asset's value is anticipated to increase faster than the market average.
Real estate investors using the appreciation strategy hope to make money at a later date when the property is sold for a profit. However, in some cases, an investor may also be able to “force” appreciation by proactively increasing rents and cash flow, identifying opportunities for generating additional income, and smartly managing property operating expenses.
To hang on to profits from appreciation when a property is sold, an investor can defer paying capital gains taxes by using a 1031 exchange to sell one investment property and buy another.
The appreciation strategy may also be attractive for those who want to build multigenerational wealth by passing real estate to their heirs. As a rule of thumb, the cost basis of inherited property is “stepped up” to the current fair market value when passed to an heir. This means an heir is only liable for tax on future capital gains when and if the property is eventually sold.
Appreciation is a strategy generally used by investors who don’t need immediate cash flow and who can buy and hold for the long term. For example, while home prices in the U.S. historically increase, there have also been periods in the not too distant past when home prices declined.
In some cases, a rental property with little net cash flow may require additional capital investment to make repairs or cover operating expenses when the home is vacant between tenants. An investor may be able to avoid negative cash flow by making a larger down payment to reduce the monthly mortgage payment amount.
Most home values tend to increase over a long period of time, provided they are properly maintained. However, several factors contribute to some properties appreciating faster than others.
First, appreciation rates can significantly vary from one real estate market to another. Home prices typically increase in value when there is consistently more demand than supply. Areas with high demand for housing usually have a strong job market and overall economic growth, an increasing population, and desirable amenities nearby, such as schools and shopping.
Timing can also have a significant impact on appreciation. That’s why some real estate investors say that money is made when a property is purchased and not when it is sold.
Closely monitoring local and national real estate market cycles can help an investor make a more accurate estimate of future appreciation. For example, an investor purchasing rental property during a market crash when many sellers are distressed may increase the odds of significant appreciation in the coming years.
The cost of financing also affects real estate appreciation. When mortgage interest rates are low, people can afford to pay more for a home because the monthly mortgage payment is lower. The demand for real estate increases, which in turn drives property prices higher.
Over time, a property originally purchased for appreciation may turn into a balanced investment of appreciation and cash flow. Payments remain the same with a long-term fixed-rate mortgage, and rising rents year over year can lead to increased cash flow.
Pros
- Significant profit potential when a property is sold during periods when housing demand exceeds supply.
- Force additional appreciation by adding amenities to increase rental income and cash flow and wisely managing operating expenses.
- Multiple options for accessing accrued appreciation to purchase an additional rental property, including a cash-out refinance, home equity loan, or home equity line of credit.
- Defer capital gains tax by conducting a 1031 tax-deferred exchange or passing a property on to an heir.
Cons
- Property with large appreciation is often found in markets where home prices are higher, which may result in minimal or negative net cash flow until rent prices rise.
- A property with high appreciation but little cash flow may require additional capital investment for repairs or paying operating expenses during a period of extended vacancy.
- Appreciation is not guaranteed because home values can decline as well as rise due to factors such as normal real estate market cycles or changes in mortgage interest rates.
- Generating a profit from appreciation may require an investor to hold a property for longer than anticipated if the market is in a downward cycle.
Cash flow
Investing in real estate for cash flow is similar to buying a dividend-paying stock. While the underlying asset's value may increase at the market average or sometimes less, the trade-off is that a steady stream of recurring income is being generated.
Cash flow properties are those that generate enough rental income to pay for all operating expenses and the mortgage payment while still having cash left over at the end of each period. With the cash flow strategy, an investor may give up some potential appreciation over the long term in exchange for receiving money over the short term, month after month.
A good way to understand the advantages of cash flow real estate is by thinking about the time value of money. When given a choice between receiving a predictable monthly payment or the promise of a bigger payday at some point in the future, many investors would choose to balance risk with reward by focusing on cash flow.
The cash flow investing strategy may be a good option for those seeking specific financial goals over a certain period of time. For example, an investor may purchase cash flow real estate to reduce the amount of time spent working for someone else, fund a child's education or a retirement account, or take early retirement altogether.
A cash flow strategy can also be an excellent way to scale up and grow a real estate portfolio by reinvesting rental income.
Rather than thinking of the cash left over at the end of each money as extra income, an investor may reinvest cash flow by making an extra mortgage payment to pay down a loan balance faster to increase equity or by saving monthly cash flow to raise money for the down payment on an additional rental property.
Recurring cash flow from a rental property isn't subject to capital gains tax and is generally exempt from payroll taxes such as Social Security, Medicare, unemployment, and federal and state income tax withholding. Instead, rental property income is reported as passive income on an investor's federal return and taxes are paid according to the tax bracket the investor is in.
Several characteristics make a market or neighborhood good for cash flow property.
Home prices are relatively affordable, which is important because overpaying can reduce net cash flow. In addition, job and population growth are strong, and the economy is diverse and not dependent on one major employer. Cash flow markets also have a strong demand for rental property with a large percentage of renter-occupied households.
Compared to appreciation, investing in cash flow real estate can also offer a broader range of potential opportunities to increase rental property cash flow and profits.
An investor may be able to increase rent after running rent comparables, making improvements or upgrades to increase the monthly rent price, or by generating additional revenue streams such as collecting pet rent or appliance rent.
Net cash flow from rental property can also be increased by decreasing operating expenses, thoroughly screening for qualified tenants, and purchasing rental property in states with low property taxes and median home values.
Pros
- Provide a steady stream of recurring net cash flow month after month in exchange for lower potential appreciation over the long term.
- Cash flow rental property often has a large pool of prospective tenants looking for middle-income and moderate-income housing that is affordable and close to jobs.
- Cash-on-cash return from cash flow rental property can be more meaningful than other real estate investing strategies.
- Cash flow property is generally more affordable with a lower purchase price, especially in smaller secondary and tertiary real estate markets.
Cons
- Cash flow property may mean an investor receives lower future potential appreciation in exchange for monthly net cash flow.
- Property may be more management intensive due to frequent repairs on older property, tenant rent collection, or higher than expected vacancy rates.
- Cash flow from rental property can significantly vary from one neighborhood or zip code to the next, requiring an investor to spend time analyzing the best areas for cash flow properties.
- Unforeseen circumstances such as declining rent rates, higher than expected vacancy, or larger expenses can all impact rental property cash flow.
Balanced
The balanced real estate investment strategy attempts to balance risk and reward with rental property that generates recurring monthly cash flow and appreciation over the long term.
Focusing solely on appreciation means potential returns are back-ended until the property is sold while investing strictly for cash flow often means sacrificing some potential appreciation in exchange for recurring cash flow. On the other hand, a balanced strategy can offer the best of both worlds.
Balanced real estate investing may generate returns in several different ways.
Net cash flow is earned after rental income is collected and operating expenses and the mortgage payment are made. Because rental property purchased using the balance investing strategy is usually moderately priced, income collected from a tenant generally covers expenses and debt service with some money remaining at the end of each period.
An investor may choose to reinvest rental income by paying down the mortgage principal to increase owner’s equity, making upgrades and improvements to increase the rent and cash flow, or a combination of both.
Rental property purchased for an affordable price may also appreciate at a higher rate than more expensive homes. As property value grows over time, accrued equity can be accessed by refinancing or with a home equity loan product. The cash can then be used for the down payment on another rental property.
Some investors combine the balanced strategy with the “snowball” method for investing in more rental property to grow a real estate portfolio. First, as much net cash flow is saved as possible. Then, when there is enough equity in a property, additional cash is pulled out by refinancing. Money saved plus equity converted into cash is then used for the down payment on another rental property.
The balanced real estate strategy may also be used to maximize tax benefits. For example, operating expenses and mortgage interest are fully deductible expenses, while annual depreciation expenses can be used to reduce pre-tax net income. In some cases, an investor may report little or no taxable net income while owning a rental property that generates healthy cash flow.
Rental property purchased using the balance strategy may generate recurring income for an investor through retirement. In addition, if the home is transferred to an heir, the cost basis is stepped up to the current market value, allowing an investor to create multigenerational wealth by avoiding capital gains tax.
During an investor's active investing years, tax-deferred exchanges can also be used to defer paying capital gains tax when an investment property is sold by purchasing a replacement property within a specific period of time.
Pros
- Potential for the best of both worlds with recurring net cash flow plus appreciation in property value over the long term.
- Property purchased using the balanced strategy generally has a mid-range price point and may be found in smaller real estate markets where population and job growth are robust and the cost of living is lower.
- Balanced properties may also be less management intensive, with more predictable repairs and more moderate tenant turnover.
- A balanced real estate investing strategy can be used to meet specific financial goals, scale-up and grow a rental property portfolio, harvest tax benefits, and grow long-term multigenerational wealth.
Cons
- Because of the numerous potential benefits of the balanced real estate investing strategy, these properties are highly sought-after by many investors.
- Competition for rental properties that generate both cash flow and appreciation frequently is subject to a competitive bidding process with multiple offers.
- Housing inventory may be older and require more ongoing maintenance than homes with high levels of appreciation, but typically less than pure-play cash flow properties.
- A balanced real estate strategy is generally best for buy-and-hold real estate investors, making the method less desirable for those seeking quick short-term gains.
