Cash Flow is NOT Always King (Why Appreciation Matters)

by FI Fighter on March 26, 2015

in Real Estate Thoughts

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In order to reach early FI and retire young, most everyone knows that it takes a good amount of passive income to do so. For many on the journey to early FI, the lightbulb goes off when we realize that a high income is NOT the key factor to building wealth in one’s lifetime. Rather, financial freedom is attained through owning income producing assets that generate more and more income through the years.

When I first started out in 2012, my first order of business was to get the passive income stream rolling. For myself, this meant investing in dividend growth stocks that paid a solid yield of ~3.0% or more. After about a year of doing this, I realized that I could generate much more passive income through the form of cash flowing rental properties. Towards the end of summer of 2012, I acquired my first rental property, and ever since then it’s been full pedal to the metal; I now have an ownership stake in 8 rental properties.

Through the years, my philosophy has shifted. When I first started out with real estate, I did not have to make a compromise between: appreciation, cash flow, good neighborhoods, quality tenants, etc. Back in 2012, you could have all of the aforementioned and a bag of chips… Times were that good!

These days, as investors, most of us will have to compromise and pick and choose our spots. If you want good appreciation, best of luck finding even a morsel of cash flow! If you desire high Cash-on-Cash (CoC) returns of 20% or greater, be prepared to deal with some high maintenance and low quality tenants! Yes, I’m generalizing to a certain degree, but in the reality of real estate, there’s seldom any free lunches. Outside of another massive market meltdown, you will almost always have to make tradeoffs along the way…

Around 2013, I started getting frustrated with the low cash flow returns found in the Bay Area, and found the need to branch out and look for better opportunities out of state. I’ll admit that I was plenty naive at the time I got started, but fortunately I didn’t get scammed and ended up with some good cash flowing properties. To this day, my out of state portfolio still does cash flow better than my Bay Area properties, but I’ve learned that there’s more to things than meets the eye.

Ultimately, yes, I believe that cash flow is super important and necessary to help one achieve early FI. However, I also believe that appreciation is extremely underrated, and something that should not be overlooked when one is making an investment decision, especially one that will impact your future many, many years down the road.

There’s more to buying an investment property than just running numbers through an Excel spreadsheet…

Best of the Best

Why do some properties appreciate and others fail to even keep pace with inflation? When it comes down to it, it’s because of the quality of the neighborhood. When you invest for appreciation, by nature, you are buying into some of the best neighborhoods in that local area.

And, the best neighborhoods will ALWAYS attract the highest quality tenants, who are the lifeblood to your success as a real estate investor.

Here are the benefits of investing for appreciation, which will better insure you get the best tenants:

Top Schools

As an investor, you may not think that good schools matter, but you should think again! Nothing is more important to a parent than seeing their children succeed, and to most, nothing guarantees that more than to place their child in a top school district. Parents will sacrifice just about EVERYTHING to make sure their child gets into a good school. As an investor, you can certainly take advantage of the competition this creates in the marketplace for high quality rentals.

When you invest for appreciation, you will no doubt find out where all the best schools are located. Now, I’m not saying you have to go overboard and only buy into areas that host the top rated 10/10 schools… But even a solid area with ratings of 7/10 or 8/10 will still carry with it some hefty appreciation potential.

For example, I live in the South Bay Area and could never afford to invest in the Cupertino or Palo Alto school districts. Single family homes in those locations are pushing $1.5MM to $2.0MM+, which will never be attainable for me. However, one area that I’m really liking these days is Milpitas. The Milpitas School District is also extremely good, and parents will fight tooth and nail all day long to try and get their kids into those schools.

Here’s a recent open house that I attended that attracted MASSIVE traffic:

Screen Shot 2015-03-26 at 9.07.04 AM

http://www.redfin.com

If we focus purely on the schools, you’ll see that these aren’t the cream of the crop, but instead, simply above average. Still, that’s plenty good enough to get this listing favorited 157 times, and to create a line out door during the open house!

If I could win a similar type of deal, as an investor, I could rest assured at night knowing that my odds of locating a fantastic tenant are very good!

Screen Shot 2015-03-26 at 9.07.15 AM

http://www.redfin.com

Near Employment and Entertainment Centers

My first two side hustle deals did not focus on good school districts, but instead I concentrated on another important factor — easy and convenient access to major employment and entertainment centers.

Last year, I won two deals in Santa Clara, in an area that is up-and-coming, and quickly expanding. The location simply cannot be beat, as it’s positioned to allow for an easy commute to many of the leading tech companies out there: Cisco, Brocade, Intel, Samsung, Broadcom, Texas Instruments, etc.

So, you can say that I’ve got some peace of mind when it comes to picking out tenants — I don’t need to screen particularly hard to find a quality tenant who makes good income. For instance, when I first posted a Craigslist ad for Rental Property SH #1, I had 5 inquiries on the first night. Right now, there are 3 tech professionals living in each one of those side hustle properties, and each individual makes more than $100,000/year in income. With a combined “household” income of $300,000, my partners and I have no doubt that these tenants can afford to pay their rent on time!

In regards to entertainment, I believe that being close to the hustle and bustle can be a good thing. My own personal strategy is to attract young high tech professionals, so it makes sense for me to invest in “fun” areas. Most young folks in the Bay Area desire to live in San Francisco and are willing to pay an exorbitant amount of money for the amenities. In general, suburbs are more tailored for families, so I like to mix it up and also acquire properties that present a more vibrant social scene. With those last two side hustle deals, we bought within walking distance of Levi’s Stadium. Before long, there will be a new shopping district with pubs and restaurants to further enhance the area. The city of Santa Clara wants their downtown back!

I simply want a piece of that action…

Transportation and Commute

If you can’t win access into a centrally located employment center, the next best bet would be to invest in an area that provides convenient public transportation access. For Rental Property SH #3, that’s exactly what my strategy was — I purchased a townhouse that will be a few blocks away from the new Berryessa BART station.

In the Bay Area, the highways are a mess right now and traffic is absolutely dreadful during rush hour. A long commute is very taxing on a tenant, so if they can eliminate that stressor, they will!

Since my latest deal is next to the new BART station, I have no doubt that I will be able to secure a high quality tenant. The latest BART development will extend the line, connecting the South Bay to the East Bay and even to San Francisco for the first time. This single development will open up the doors to many more prospective tenants who probably wouldn’t have considered my property, otherwise.

Cleanliness and Safety

When I buy an appreciating property, I only buy it AFTER I’ve done my homework and figured out if it’s a property where homeowners live. If the property isn’t located in a homeowner dominated area, then I don’t consider it to be an appreciation play, but rather a pure cash flow deal. In that case, if the cash flow numbers don’t work out, I back off and look for the next property…

Why is buying into an owner occupied location so important to me? Pride of ownership. Homebuyers are much more likely to take better care of their properties, and keep the surrounding areas CLEAN. Well manicured lawns and good landscaping can do wonders in helping a neighborhood keep up appearances… which will keep your property appreciating through the years…

The last few deals I’ve won, HOA records show that over 60% of the units in the complex are owner occupied. My townhouse properties are engulfed from all sides by single family homes that sell in excess of $1.0MM…

Further, if your house is surrounded by affluent millionaire homeowners, I’m going to go out on a limb and say that you’re most likely buying into an extremely SAFE location. You can be certain that these wealthy homeowners will put in the time, effort, and funds needed to support things like a neighborhood watch.

When looking for tenants, these added bonuses will no doubt attract them to move in to your property.

Easy Exit Strategy

A major concern many investors have with rental properties is how difficult it can be to offload a property. Unlike stocks, houses are very illiquid, and it can take many months to close a deal.

So, if you want to make your life a little bit easier (and less stressful), it makes sense to invest in an appreciating area that will better your odds of selling (should the need to do so ever arise). If you invest for appreciation, just make sure that your property is desirable enough to be able to sell back to a homebuyer.

As we know, it’s difficult to make a deal with a savvy investor, because investors will always try to rip you off! However, homebuyers are typically extremely emotional and will gladly overpay to own their dream house. Couples will fall in love with the backyard, or kitchen remodel…

In my own situation, I like owning appreciating properties that are affordable not only for homebuyers, but also prospective investors. Since I don’t invest in the $1.0MM+ space, my units cash flow slightly better to where the numbers could possibly work if an investor was willing to put together a downpayment larger than 30-35%… Although selling back to an investor has almost no barring in my decision to purchase these type of appreciating properties, it is nice to know that I sort of could, if I had to…

Summary

There are many reasons to invest for appreciation, many of which cannot be captured or ascertained through a spreadsheet analysis. I learned awhile ago to go more with my gut instincts than to trust a Pro Forma…

Also, many skeptics will argue that appreciation is not guaranteed and merely speculative investing. I strongly disagree. Yes, appreciation is never guaranteed in life… only death and taxes are. However, I don’t believe it’s too difficult to logically deduce which properties stand a reasonable chance to increase in value over the years…

It’s kind of like with divided growth stocks… Coca-Cola (KO), AT&T (T), Johnson and Johnson (JNJ), etc. could all stop paying a dividend at any time… but we invest in those companies for passive income, anyway, because the odds are extremely likely that they will continue to keep churning out those dividends year after year.

With rental properties, it’s not all that much different. When you invest for appreciation, you just need to make sure you are buying into the best: school districts, employment/entertainment centers, transportation and commute lines, and the cleanest and safest neighborhoods that are predominantly owner occupied. All the above will almost guarantee that your property will keep increasing in value over the years, which will be the key to creating massive wealth in your lifetime. And should things ever hit the fan, the above “best-of-the-best” bullet points will at least better your odds of exiting out relatively unscathed.

As an investor, my portfolio consists of both cash flow properties and appreciation properties. I think there’s a place for both types of products. However, if you’re going to ask me which properties I believe will help me create massive wealth in the future, there’s no question that I’m going to say: Bay Area properties.

So, yes, my Bay Area properties don’t cash flow all that great today, but again, it’s more than just the Year 1 numbers for me. I’ve learned over the past 3 years that cash flow is not always king and that appreciation is also extremely important. As investors, it’s important to look more than just a few years down the line, and to peer off well into the distant future. As I continue to construct my investment portfolio, I want to make sure I comprise it with mostly high quality properties that I feel will become significantly more valuable down the line.

While I wait for the tide to turn and for cash flow production to pick up with the Bay Area properties, I’ll rely on my Midwest cash cows, for the time being.

Back to the stock analogies: AT&T (T) stock (Midwest properties) will pay me today, but Alibaba (BABA) stock (Bay Area properties) will feed many generations many times over in the future, hopefully! 😉

 

Fight On!

{ 10 comments… read them below or add one }

1 LauraNo Gravatar March 26, 2015 at 5:40 pm

Hi! Quick note – it’s pedal to the metal, not peddle to the medal, unless you mean panhandling until you reach some reward.

Reply

2 FI FighterNo Gravatar March 26, 2015 at 6:41 pm

Laura,

Oops, typo… thanks for pointing that out. Fixed! 🙂

Cheers!

Reply

3 markNo Gravatar March 27, 2015 at 8:13 am

I find panhandling to be very lucrative and will shorten my time to early FI by a few years at least.

Reply

4 FI FighterNo Gravatar March 27, 2015 at 2:46 pm

Mark,

Income is income, so however you have to hustle to get it! 🙂

Take care!

Reply

5 FerdiSNo Gravatar March 27, 2015 at 8:14 am

I’m impressed with your portfolio of rental properties. Given the very long term appreciation of property, I’m positive you’ll end up in a very good spot (especially with the Bay Area properties).

Reply

6 FI FighterNo Gravatar March 27, 2015 at 2:35 pm

FerdiS,

Thanks, I’m doing my best to buy into the right areas that will continue to experience good growth in the future.

All the best!

Reply

7 No Nonsense LandlordNo Gravatar March 27, 2015 at 1:49 pm

I would say a property that cash flows would appreciate faster that one that doesn’t. And if the market falls, which it can, you have the cash flow. Negative cash flow properties are very risky.

Hopefully these properties continue to rise. As long as incomes do, you should be set.

Reply

8 FI FighterNo Gravatar March 27, 2015 at 2:40 pm

Eric,

Agreed, cash flow is definitely the place where you want to be. When I say invest for appreciation, I don’t imply investing in properties that don’t cash flow.

Like most things, there are trade offs… But when you “sacrifice” CoC returns, say from 7% to something like 4%, it’s not as simple as saying a certain property is 3% worse than the other one… If the 4% property gets you better appreciation and all of the bonuses with it as outlined above, than it may still be worth pursuing.

Many investors are too spreadsheet driven and will nix a deal without analyzing other factors that aren’t as easily quantified. Since I’ve invested for both cash flow and appreciation, I wanted to point out some of the perks you get with appreciation.

But of course, in a perfect deal you’ll be able to get both cash flow and appreciation.

Cheers!

Reply

9 bobNo Gravatar March 27, 2015 at 2:30 pm

You haven’t yet experienced the downturn yet if you started in 2012. It could happen again

Reply

10 FI FighterNo Gravatar March 27, 2015 at 2:45 pm

Bob,

Of course, anything’s possible… But investing for appreciation doesn’t mean you have to accept negative cash flow in the process…

That’s why it’s always important to stash cash/reserves. Investing for appreciation gets a bad rap, and I’m not sure why… Many accidental millionaires have benefited from massive appreciation through the years, so to discount the huge upside made possible by it would be a shame.

It’s also possible to invest in both types of properties, which is what I’m trying to do.

All the best!

Reply

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