When most people think about making money through real estate investing, I'd wager there mind immediately goes to cash flow. Once you've paid all your expenses for the month, what's left over from your tenant's rent payment is yours to stash away for future investments. Bonus points for this money being "passive" income! Cash flow is all well and good, but I personally think it's overly emphasized, and leads to a lot of shiny-object-syndrome for new investors.
First, Start With Why
Don't get me wrong, one of the core pillars of our investment philosophy at Here's The Deal is that every deal must cash flow. In fact, if it doesn't, then quite simply it isn't a deal. End of discussion. I could speak ad nauseum about what to look for in a potential deal, and what to avoid. At the very top of my list would be an underwritten positive cash flow. Positive cash flow is the base case for an investment property. That said, I still think it's overly emphasized in prevailing real estate investment philosophy.
Now, I can understand why most people emphasize cash flow so heavily. When you listen to most peoples' goals when it comes to real estate investing, they either want to retire early, get Mom/Dad out of a job so they can stay home with the kids, or they want to have some extra spending money for vacations, etc. And all of these things require, you guessed it, extra cash.
Naturally, this is what drives people towards emphasizing cash flow as the core part of their investment philosophy. And once we've gotten enough people screaming about it from the rooftops, it becomes the de facto investment philosophy that is talked about on podcasts and in books. It literally becomes a meme.
But I think emphasizing cash flow as the core pillar of your investment philosophy and not one core pillar of your investment philosophy is a potentially huge mistake. Let me explain why.
Cash Flow vs Wealth Generation
I would consider there to be five ways to make money through real estate investing. That may be up for some debate, and I use the term "make money" synonymously with "receive economic value", but I can certainly make a case for there being at least five. Two of the most well known are cash flow and wealth generation. We've defined cash flow, so let's turn our attention to wealth generation for a moment - which is actually a combination of two of the ways to get paid through real estate investing.
One component of wealth generation is principal reduction each time you make a mortgage payment. This is true whenever you have mortgaged any real property, and it's especially powerful in regards to an investment property, because your using other people's money to pay down that principal. The other component of wealth generation is property appreciation through time. The first component of wealth generation shouldn't be ignored, but it's this second component that is where some real magic can happen. More importantly, the second component is where the shiny-object-syndrome of cash flow becomes a problem.
Choose Your Path Wisely
Broadly speaking, when you invest in real estate, you get to choose between cash flow or wealth generation. There's a reason you can buy 10-cap investment properties in Detroit or the middle-of-nowhere Iowa, and it's not because the properties you've found are Grand Slams. It's because relative to increases in rents, values haven't increased as much.
The flip-side of that coin is true of other markets. In Denver, there's a reason why we're currently scraping through 4-caps: value growth has outpaced rent growth. And herein lies one of the most important concepts you must understand to successfully (as defined by your goals) invest in real estate. Broadly speaking, you get one of two choices with the market you invest in: higher cash-on-cash return or higher wealth generation. There are markets where you can end up with a mix of both, but picking these markets with any high degree of success is like trying to perfectly time the stock market - it's mostly a fool's errand.
Don't let anyone tell you which of these markets you should invest in. Let your investment goals guide your decision. If you're tired of wearing your golden handcuffs at your cushy corporate job, and you want to retire early, cash flow is almost certainly your goal. That said, there's one extremely important caveat that the cash flow investor needs to think through before betting the farm on a high cash-on-cash return portfolio.
Orders of Magnitude Matter
One thing I try to impress upon every client I speak with is that no matter what, without question, you will never get wealthy on cash flow. Please, for the sake of your own success, read that sentence again five times. Whether you own one property, or one hundred, you will never get wealthy on cash flow. And that's simply because the orders of magnitude are tilted against cash flow.
Regardless of the market you're in, a decent monthly cash flow on an investment property is anywhere from $200-500 per door. There's an equalizing factor across markets, so in Denver you might be on the lower end, and in some markets where 10-caps are possible you'll be on the higher end. That said, your cash flow each month when you purchase a property will be quantified in the hundreds of dollars.
Compare that to the value of the property you're purchasing. Even in the least-expensive markets, the value of the properties will be quantified in the tens of thousands of dollars, and more commonly in the hundreds of thousands of dollars. The difference between cash flow and value can be three orders of magnitude - in some cases a 1000x difference!
What does this mean as far as your investment philosophy? It means that you will always receive outsized economic value on the wealth generation side of the equation. Because when you're $500,000 investment property appreciates 3%, you've just received economic value of $15,000. But, when you're $3,000 rent appreciates 3%, you've only received $90 in economic value. Do you see how vastly different those numbers are? You will never get wealthy on cash flow.
Don't Focus on the Shiny Object
To sum up what's written above, the best advice I could give you is this: define your goals before investing in real estate. If you want to retire early, or go on more vacations each year, that's great. Cash flow investing is probably your best bet. But before you make the commitment to emphasize cash flow in your portfolio, understand that if you invest in markets where you can get greater cash flow, you're probably investing in a market that has seen lower appreciation than a market like Denver over the past 20 years. That said, please recognize that when the dust settles 30 years from now, you could literally be leaving millions (perhaps tens of millions) of dollars in economic value on the table.
If a city like Detroit appreciates at 1.5% over the next 30 years, and a city like Denver appreciates at 4.5% (close to 20-year average for Denver), the difference in value accumulation of a million dollar rental portfolio is $2.5 million dollars. That is a staggering amount of money. So, ask yourself, is a little extra cash flow each month worth that amount of wealth generation I'm leaving on the table? Only you can determine that. And no one can tell you you're wrong if you think the extra cash flow is worth it to you. Just be sure you frame the decision of cash flow v.s. wealth generation in this way before making your choice.
With Gratitude,
DH
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