The goal of investing in real estate is to make money, and 2 of the ways investors hope to make a profit are through cash flow and appreciation. When purchasing rental property, many people wonder if investing for cash flow or appreciation makes better business sense.
Of course, the answer to this question depends on the real estate investor’s unique financial goals and strategies, because there are pros and cons to each approach. To help you decide on a strategy that may be right for your business, let’s look at cash flow versus appreciation and how investors aim to make money from cash-flow properties and appreciation.
- Cash flow is the money left over at the end of each period after all rental income has been collected and all of the bills have been paid.
- Rental property cash flow can be positive, negative, or even.
- The benefits of investing for cash flow include using the tenant’s rent to pay for operating expenses and the mortgage and generating recurring income streams.
- Appreciation is the change in property value between the original purchase price and the current market value.
- Home prices have historically increased but may decrease during periods of time.
- The benefits of investing for appreciation include using the increase in owner’s equity to purchase additional rental property, as well as flexible uses, such as using the property as a short-term rental (STR) to generate a higher level of gross rental income.
Cash flow from rental property
Cash flow from rental property is the money remaining at the end of each period, after all rental income has been collected and all of the bills have been paid. Ideally, rental property cash flow is positive, and there is more rental income than there are expenses.
However, sometimes you can have negative cash flow. For example, a property may be in between tenants, or the cost of an unexpected emergency repair exceeds the amount of rental income in a given month.
How to calculate cash flow
Here’s how to calculate cash flow from a rental property over a multiyear holding period.
In this example, we’ll assume an investor makes a 20% down payment on a $150,000 single-family home. Operating expenses are increasing at an annual inflation rate of 5%, and the annual vacancy rate is 5%. According to the most recent annual rent report from Zumper, rents have been increasing by about 12% per year.
Before reading on, remember that annual changes in rent prices and operating expenses may be higher or lower than those in this example and may vary from market to market and from one year to the next:
|Year 1||Year 2||Year 3||Year 4|
|Gross rental income||$18,000||$20,160||$22,580||$25,290|
|Vacancy rate of 5%||-$900||$1,008||-$1,129||-$1,265|
|Net rental income||$17,100||$19,152||$21,451||$24,025|
(principal and interest)
Advantages of investing for cash flow1. Tenant rent pays for the mortgage and property operating expenses.
Cash flow from the rental income collected is used to pay the costs of owning and operating the property or as contributions to a capital expense (CapEx) account, with any excess cash as owner profit, provided the property has positive cash flow.2. Reinvesting rental income helps to build wealth faster.
Using extra cash flow to make improvements that allow the rent to be raised, or making extra payments on a mortgage, can help to increase equity more quickly and raise funds for the down payment on an additional rental property.3. Cash flow creates multiple income streams.
Rental properties with positive cash flow can create additional income streams for an investor, leading to increased financial freedom and possible early retirement.4. More attractive financing options are available for a rental property with cash flow.
Lenders look at the amount of cash flow of an investment property to determine loan terms and conditions, interest rate, and even if the loan will be approved. The debt service coverage ratio (DSCR) is calculated by dividing net operating income (NOI) by the annual debt service., It’s a key metric lenders use to determine whether a rental property is generating enough cash flow to cover the debt payments.
There are numerous advantages to investing in cash-flowing rental property. However, sometimes cash-flow-positive rental property can be difficult to find, especially in markets where home prices are rapidly rising and rent prices haven’t caught up.
That’s why some investors focus on home price appreciation first and cash flow second.
Appreciation in real estate
Appreciation in real estate is the increase in home values from one year to the next. When home prices appreciate, owner’s equity also increases because there is a greater difference between the price of a home and the mortgage balance or original purchase price.
For example, assume an investor purchases a $150,000 single-family home with a 20% down payment of $30,000. At the time of purchase, the mortgage balance is $120,000 and the owner’s equity is $30,000, which is the difference between the property value and the mortgage balance.
Now, fast-forward 5 years and assume home values have increased by 50%. The single-family home would now be worth $225,000 and the mortgage balance would be $110,000, because part of each monthly mortgage payment made is principal used to pay down the loan balance.
Owner’s equity would be $115,000, which is the difference between the current property value and the mortgage balance. In other words, the $30,000 invested as a down payment in this example is now worth $115,000 after 5 years.
How much have home prices historically increased?
While the appreciation percentages used in this example may seem large, home prices have historically increased quite a bit over the past few years.
According to Zillow, the typical value of a middle-price-tier home in the U.S. increased by 56% over the past 5 years. On the other hand, median sales prices of houses sold in the U.S. have increased by 31%, according to the Federal Reserve.
It’s worth noting that different data sources can show different results and that home prices can go down as well as up. For example, during the financial crisis of 2007 to 2009, the Federal Reserve reports that median home sales prices declined by about 20%.
Why some investors focus on appreciation
Some investors using a buy-and-hold investment strategy focus on appreciation first and cash flow second.
The following example illustrates how an investor could make money from a home with even cash flow, which means that there is just enough rental income to pay for the property operating expenses and the mortgage.
We’ll assume that the home is purchased with a 20% down payment; rent prices and operating expenses do not increase or decrease; and home values are increasing by 8% per year:
|Year 1||Year 2||Year 3||Year 4|
|Gross rental income||$18,000||$18,000||$18,000||$18,000|
|Vacancy rate of 5%||-$900||-$900||-$900||-$900|
|Net rental income||$17,100||$17,100||$17,100||$17,100|
(principal and interest)
Advantages of investing for appreciation1. Buy-and-hold investing strategy.
Investing for appreciation may be a good strategy for investors buying and holding property over the long term. While home values may fluctuate from one year to the next, home prices have historically increased. Since 1990, median sales prices of houses sold in the U.S. have increased by over 229%, based on research from the Federal Reserve.2. Cash-out refinance.
Owner’s equity can be pulled out of a property with a cash-out refinance. After turning equity into cash, an investor may use the capital generated from appreciation as the down payment for an additional rental property while still holding on to the first home.3. More flexible uses.
A rental property that doesn’t generate positive cash flow as a long-term rental may be cash-flow-positive when used as a short-term vacation rental, depending on the local market and property amenities.
According to the STR analytics company AirDNA, the average daily revenue (ADR) of short-term vacation rentals is $264.60 per night, as of January 2021. Note that while STRs can provide higher rental income, operating expenses are greater as well.4. Defer capital gains tax.
Profits from the sale of a rental property are subject to depreciation recapture tax of up to 25% and capital gains tax of up to 20%, depending on an investor’s income bracket and filing status.
Rather than having a large percentage of appreciation profits go to taxes, an investor may defer paying capital gains and depreciation recapture tax by purchasing a replacement property within 180 days of selling the relinquished property.
Cash flow vs. appreciation: How to choose?
There are pros and cons to investing for cash flow and investing for appreciation. In most cases, an investor doesn’t have to choose between these 2 options, because a rental property may appreciate and generate cash flow, depending on the holding time.
When analyzing rental property to purchase, it’s important to consider a variety of scenarios, such as changes to rental income and operating expenses and appreciation.