A question that has ended more real estate investor meetup friendships than monopoly: Is it better to invest for appreciation or cash flow? Proponents of appreciation argue that investing in strong markets, regardless of price, will outperform over the long run. Cash flow investors believe in a steady, predictable stream of income that can support their lifestyle.
Different classes of properties will be found in “appreciation” markets and “cash flow” markets.
Appreciation markets typically have high barriers to home ownership. Limited housing supply and concentrated employment drive rental rates higher. Residents typically rent for longer and have steady, high paying jobs. Vacancy is typically low, regardless of property condition, and properties can be operated at lower operating expense ratios. In the current market, capitalization rates can be as low as 3.5% and are less sensitive to changes in interest rates.
Cash flow markets are typically located in areas with lower barriers to home ownership, and residents who rent tend to maintain lower incomes and more volatile employment. Rental rates grow at a slower pace as land is plentiful and housing supply can keep up with demand. Vacancy can be volatile and dependent on property conditions. In the current market, capitalization rates are typically higher, between 6.5% to 8.5%, and they are more sensitive to changes in interest rates.
Side Note: Capitalization Rate (or "Cap Rate")
Capitalization rate is a common valuation metric in real estate. Found by dividing net operating income by current value, the cap rate is a measure of return for an un-levered property (without debt).
Though a common proxy for the profitability of an investment, a property’s cap rate does not consider value-add potential. Investment decisions should always be informed by market research and a good cash flow model (shameless plug: KRE).
Let the Numbers Speak.
Given the following base assumptions, the below table shows an empirical analysis of the cash flow vs. appreciation debate. Given varying cap rates and market growth over a 5 year period, an IRR was calculated on a hypothetical equity investment. The properties considered in this analysis are assumed to be stabilized with negligible value-add opportunity.
Assumptions - Loan to Purchase: 55%, Interest Rate: 5%, Amortization: 30 Years, Hold Period: 5 Years
The Verdict: Empirical evidence supports that both investing in high growth, low cap rate markets and low growth, high cap rate markets can produce comparable returns. Let the debate continue!
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