A Token of Appreciation
Why Cash Flow Isn’t the Only Reason to Invest
Any good investor should have a goal in mind before investing. As you probably know, real estate investments fall into one of two general categories. The first is flipping, which is for investors who want a lump sum of cash and are willing to put in plenty of elbow grease. These homes are often in need of major upgrades, which can be made for an immediate profit. The second category is buy-and-hold, which is how real estate investors build long-term wealth.
What you might not know is that there are different types of buy-and-holds which can vary drastically in their outcomes.
When people think of holding properties, they tend to think about cash flow, or the net profit that they take home each month. This is the most common metric for deciding whether or not to buy a particular investment property. Many investors try to abide by the 2% rule, meaning that monthly rent should be at least 2% of the home value. This is what investors refer to as the rent-to-purchase ratio. As Ali Boone points out, this rule is a bit antiquated — most people aim for a more realistic ratio of 1% to 1.5%.
There are plenty of potential pitfalls of having such an oversimplified rule, such as unexpected maintenance costs or hidden factors that make it an undesirable rental. This isn’t to say that it’s a bad rule. If you’re investing for cashflow, it’s not totally impossible to find, say, a $100,000 home in the Midwest that rents for $2,000 a month.
Most people’s criticisms of the 2% rule (and even the 1% rule) have to do with the fact that it’s unattainable in some areas. For instance, the typical rent-to-purchase ratio in Sacramento is around 0.5–0.6%. If Sacramento investors wants to abide by this rule, they’ll almost certainly have to look out of state.
So why are real estate investors flocking to Sacramento?
Well, let’s go back to the example of the $100,000 house in the Midwest. Assuming there aren’t any hidden costs, you know exactly what you’re getting: a single family home that’s likely been around for decades in a neighborhood with stagnant economic growth. In other words, it’s not going up in value very much, and the costs of maintenance and upgrades will often offset any appreciation that does occur. If all you’re worried about is a little bit of extra cash every month, then this might be a sound investment. If you’re trying to build long term wealth, however, you might want to explore other options.
If you follow Chalet’s blog, you know that we’re super enthusiastic about Sacramento’s real estate market in the long run. We called it a year ago, and not to brag, but so far we’ve been absolutely right. But most investors aren’t scooping up Sacramento properties for a monthly check. In fact, it’s not uncommon for investors to buy homes with negative cash flow in the short term, because they’re so confident that the home value will appreciate in the long run. Wes Blackwell, one of the most prominent Sacramento real estate writers, puts it best:
California is 2–4 times expensive as most of the rest of the country, so while you can get better ROI for rents in those other states, if you buy at the right time here in CA you will mop up cash-flow investors in the long run.
And that’s because 5% appreciation on a $300k property here in Sacramento is 3 times as much as some $100k property in the midwest. You’d be making $15k per year off of appreciation alone.
The whole 1–2% rule / test / metric is the bane of my existence because people think that the metrics you use to analyze that $100k property should apply out here in California where the median home price is $500k.
If you find me some $500k property that rents for $7,500 to $10,000 per month sign me up because I’ll be the first in line to buy it. Why would anyone rent a home for that price when they could buy it and putting 5% down on a 4.5% loan and own it for less than $3,500 per month?
Think of it this way. These numbers are obviously unrealistic, but if you were an investor 30 years ago, and you had to choose between a $100,000 house in San Francisco with a 0.5% rent-to-purchase ratio and a $100,000 house in the Midwest with a 2% rent-to-purchase ratio, which would you pick? Let’s say the Midwest house doubled in value, and you now get $4,000 a month in rent. The San Francisco house, on the other hand, went up to ten times its value and is now worth $1,000,000. Not only are you now getting $5,000 a month in rent, but you can also sell it for $800,000 more than the Midwest home. In this case, investing for appreciation is clearly the superior option.
As Sterling White points out, investing for appreciation is an inherently risky move, especially if you’re operating with negative cash flow. The market fluctuates, and it’s very possible that a home doesn’t appreciate as much as it’s expected to. Like I said, with the Midwest home, you generally know what you’re getting. If the market does hit a downturn, the cash flow property is more stable in that you can almost always keep rent constant.
Ultimately, whether you decide to invest for cash flow is a decision that should be based on your personal goals and your propensity for risk. Either way, make sure you do your due diligence and invest wisely. Otherwise, your bank account will be the one not showing appreciation.
What do you think? Is it better to invest for cash flow, appreciation, or a combination thereof? As always, Chalet would love to hear your input, so tweet at us, like our Facebook page, or give us a ❤ below!
