Investing for cash flow vs appreciation is a common consideration for novice investors. I find that most people getting started in real estate investing today have a deep desire to create a bunch of cash flow.
They want to retire early or become work optional, and building some passive income via cash flow is the seemingly obvious way to get there.
But it’s not.
In fact, I see valuing cash flow over appreciation as one of the biggest mistakes real estate investors can make.
While cash flow is tangible, focusing on it instead of appreciation will likely result in lower total returns.
That means you won’t be hitting your wealth building potential and you’ll end up working longer than you’d like.
That’s a big statement, so let’s pick apart the cash flow vs appreciation debate and understand why appreciation should always be your focus.
It’s Hard To Beat Compounding Appreciation
Another way to look at the cash flow vs appreciation debate is from a growth vs income lens.
This is something that’s often discussed with stocks.
Would you rather invest in a growth index like the Nasdaq ($QQQ) or a dividend focused fund like the Schwab US Dividend Equity ETF ($SCHD)?
Many folks are attracted to dividends and enjoy a monthly payment. But when we look at historical returns, it’s a huge mistake to invest in $SCHD over $QQQ.
See for yourself:
That’s a look at the total returns of these two funds going back to 10/20/2011 ($SCHD’s inception). If you’re interested, you can play with the total return calculator here.
Over that period of time (nearly 13 years), $QQQ has returned 841% while $SCHD has returned just 390%.
So I ask again, where are you putting your money?
The answer is obvious. It’s $QQQ all day!
Yes, there will be more volatility and smaller, less frequent dividend payments. But for me, that’s just not worth a massive difference in total return.
So how does this relate to real estate?
Real Estate Markets Are No Different
When we take this same learning and apply it to real estate, hopefully we see how silly it is to invest for cash flow.
$SCHD is like the equivalent to a nice, stable, midwest market.
It spits off dividends and appreciates a decent amount each year, but it’s just not going to outperform a market like Miami or Los Angeles.
And buying a mobile home park is like parking all of your money into a pure income focused ETF like $JEPI.
In fact, here’s what it looks like when we throw $JEPI into our total return calculator. Note that data is limited to fund’s inception date som 4.3 years ago:
Yes, it will throw off more dividend income, but at what cost?
All things equal, I want the highest appreciating market possible… the $QQQ of real estate markets, if you will.
That might be Miami or San Jose. But it surely isn’t St Louis or a mobile home park!
With the stock market you can throw $10,000 into $QQQ or $SCHD (or anything else) and that’s that.
But it’s not that easy with real estate. All things aren’t equal and there’s far more to consider.
The Problem With Chasing Pure Appreciation Markets
Most people inherently understand that they want appreciation over cash flow.
But entering the highest appreciating market isn’t always an option, nor does it necessarily make sense.
In fact, there are a couple of glaring issues with simply buying the strongest appreciating markets one can find.
High Appreciation Markets Tend To Be Expensive
One of the biggest barriers to markets like Miami or San Jose are their entry points.
The median price in Miami today is $500,000 and well over $1,000,000 in San Jose.
Many investors are simply priced out of these areas and will have to watch the appreciation from the sidelines.
Holding Costs Make Many Markets Uninvestable
But even if you can afford to buy in these highly appreciating markets you’ll have another challenge.
The monthly holding costs simply don’t make sense for the vast majority of investors.
One of the biggest benefits of real estate investing is the potential to leverage your capital. And it’s also what makes the cash flow vs appreciation argument so complex.
The mortgage payment on a $1,000,000 home in San Jose is likely thousands of dollars higher than what you’re able to rent that home for. And that doesn’t even include other costs like maintenance and capex items.
So you’re either ok puking money each month and running at a deficit or you’re forced to put far more money down, compressing your leverage.
Again, neither of these solutions make sense for most investors.
And this is where most people feel they need to make a decision between cash flow vs appreciation.
But that’s not really the correct conclusion.
Subscribe to my weekly newsletter
Get unique real estate investing content you can't find anywhere else.
Buy The Highest Appreciating Market You Can Afford
The response to the above realizations should be to first filter markets by appreciation and then by price point.
The idea here is you want to get into the highest appreciating market that you can afford.
Only then do you start running numbers to see if you’re able to sustain the investment based on cash flow calculations.
This is a far different approach than most people take to real estate investing.
They weigh cash flow vs appreciation, often favoring cash flow, and look for the market where they can achieve that.
But appreciating markets will create cash flow over time. Higher prices ultimately pull rents higher as well.
And since the bulk of your monthly costs are fixed (gotta love 30-year fixed mortgages!), your numbers should get better and better over time.
All you have to do is make sure you’re positioning yourself in strong areas and being diligent about raising rents each year.
Cash Flow vs Appreciation Exceptions
Of course, to every rule there are exceptions!
And this is why I have been pounding the table on Detroit for years now. Prices in Detroit have doubled in the last 5 years with no sign of slowing down.
Best of all, you can still find cash flowing deals.
In short, Detroit is a highly appreciating market that pays you to wait. It’s a unicorn.
There is nothing like it right now, and I can’t imagine it lasts all that much longer. In fact, if prices double again in the coming 5 years like I think they could, I can’t imagine rents keeping pace.
The takeaway here isn’t that you should be buying Detroit hand-over-fist. It’s not a market for everyone.
But recognize that if you can uncover an overlooked market that may be going through massive revitalization, you may be able to catch lightning in a bottle and get both cash flow and rapid appreciation.