At the most basic level, every real estate investor has the same goal. Whether they fix and flip homes, diversify their portfolios with syndicated (aka “crowdfunded”) commercial real estate securities, or use investment properties to earn rental income, the ultimate objective is to make money – period.
But naturally, there’s more nuance to it than that.
Real estate has a well-earned reputation for helping generate wealth; after all, 77 percent of U.S. millionaires have real estate in their portfolios. But just as there are dozens of different ways to invest in real estate, there are dozens of different ways to capitalize on its value.
Two of the most important of those ways are appreciation and cash flow. The two concepts can, and often do, work in tandem to facilitate successful investments. Yet depending on an individual investor’s goals, it’s important to understand the difference between the two in order to evaluate whether a potential investment aligns with one’s objectives.
The Appreciation Game
Commonly discussed in terms of home prices, appreciation (also referred to as “equity buildup”) is a huge factor in commercial real estate (CRE) investments, as well. Appreciation is the uptick in value of an asset over time; it earns investors money when they relinquish the asset to realize a price increase since purchase. Appreciation comes in two forms in the real estate world: market appreciation and forced appreciation.
Market appreciation is the organic increase in a property’s value due to a variety of factors outside the investor’s control, including local market forces and surrounding property values. Forced appreciation, on the other hand, occurs when the value of the property increases as a direct result of actions taken by the owner or investor: think renovations, additions, or the incorporation of new features.
Why Appreciation? For long-term buy-and-hold investors, appreciation – especially market appreciation – is the magic of real estate investing: The chance to make money on an asset as it simply sits there.
Why Not? No matter how strong a given market, no investor can put too many financial eggs in the appreciation basket, since solely doing so amounts to speculating that the market will increase in value.
“Some people buy real estate expecting it to appreciate a lot over time,” says David Reiss, a professor of law and research director of the Center for Urban Business Entrepreneurship at Brooklyn Law School. “But it can be risky – or even foolish – to pay so much for a property that you’re losing money on an operating basis just because you think it will appreciate.”
Cash Flow is Key
In fact, making money on an operating basis is where cash flow comes into play. With real estate investing, cash flow is the result of proceeds from rent payments.
Investors can earn returns from cash flow on an ongoing basis, either as owners of a given investment property (i.e, as “active” owner-investor landlords) or as pooled “passive” or “crowd” investors in an income-generating property. For the latter, cash flow results in regular cash distributions from the investment – whether distributed monthly, quarterly, semiannually, or annually.
Why Cash Flow? Unlike appreciation, the potential cash flow of a property can easily be calculated in advance of a purchase and packaged to investors in clear investment terms. Positive cash flow also presents owner-investors with an opportunity to more easily refinance (or pull cash out of the property) if necessary.
Why Not? As with all else in real estate, cash flow involves a lot of unknowns – think issues like repairs, maintenance costs, non-paying tenants, and all the rest – and failing to properly factor in the impact of such variables can be a costly mistake.
“Many beginning investors do not account for the unknown, because they really want to make a deal work,” writes Mark Ferguson of Invest Four More. “If you really want to make a deal work and you fudge the numbers to get everything to line up correctly, you may end up with negative cash flow every month.”
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