Cash Flow or Equity?

Every investor has a different reason for wanting to invest in real estate. Some people look to real estate as a “passive” income stream that augments retirement pensions, savings or even supplements current income streams. Passive forms of investing are also known as hands-free investments and are well positioned for those that want to invest in real estate but don’t have the time, knowledge or desire to operate an investment property.

Others are interested in a more “active” or “hands-on” approach whereby they have the time, expertise and desire to be the CEO of their real estate investment properties and manage them directly.

In addition to deciding whether you want to be an active or passive investor, you will also need to decide on your income and wealth goals. Quite simply, are you looking for money today or wealth for tomorrow? Like everything else in life, there is typically a trade-off that investors need to make. This brings me to the point of this article, which is to dig into the trade-off between cash flow and equity appreciation.

Others want to invest by rehabilitating a problem property and selling it for a significant gain. Some people look at real estate through a buy-and-hold lens and seek value appreciation. These investors are the ones who look at the charts produced by the Toronto Real Estate Board, showing the average sales price rising from about $400,000 in January 2010 to about $850,000 today [1]. While those numbers are not for multi-family units, they underscore how significantly real estate values can rise within a matter of years.

Knowing your reason for investing is crucial in determining what properties to buy. You cannot buy the right property to satisfy your financial goals if you don’t have those completely solidified! Let’s take a look at the two main reasons investors buy multi-family units, cash flow and equity appreciation.

Cash Flow
With the right purchase structure, multifamily apartment buildings can generate a significant income stream relative to your initial investment. As a quick example, a structure that houses ten apartments at even $2,000 in rent will bring in $20,000 in revenue monthly. Of course, there will be expenses associated with that, such as maintenance, utilities, upgrades, taxes, and a vacancy expense. Still, the potential for a strong return on investment through a regular income stream is significant in some markets.

In commercial real estate, the cash flow return is called the “capitalized rate” or “cap rate,” for short. The definition is the net operating income divided by the current market value [2].

If you buy an apartment complex for $2,000,000 and expect to receive $100,000 in net operating income (income after expected expenses), then your cap rate would be 5%.

For some investors, having a regular cash flow is essential. Retirees often fall into this category. Although real estate investing does carry some level of risk, it can provide a stable income as part of a balanced portfolio. People seeking to pay off a loan that was taken out to acquire the investment (like a HELOC) also need cash flow to make those monthly payments.

Equity Appreciation
The other way in which real estate investments can make money is through equity appreciation. Property values frequently rise over time. In high demand markets like Toronto – these property prices rise faster than in other places, like Sudbury. If you purchase real property at $2,000,000 and 10 years later it is worth $4,000,000, then you have just had a 100% appreciation on your building.

Equity growth enables you to sell your building for more money than you paid for it in the future, or you can access that money via a line of credit to buy more buildings. This process is leverage – you can use the equity in one unit to buy another.

Investors that are looking to sell their properties eventually benefit significantly from equity appreciation. If you are looking to leverage your assets to buy multiple properties, you’ll also need equity appreciation. Without that growth, it’s a long process to wait until you make enough with cash flow to afford another building.

Can I Have Both?
In theory, it would be possible to have a high cash flow and equity appreciation. In reality, that’s rarely the case. The market will always find an equilibrium that will force a tradeoff between the two.

Consider the following example: Suppose you purchased a multi-family unit in 2010 for $1,000,000 in Toronto. After all expenses, your net operating income was $70,000. Now – assume that ten years later – that unit has followed the general housing trend and has doubled. It’s now worth $2,000,000. This appreciation is fantastic! However, rents would have – at best – only grown by 30% during that time. Your $2 million property might only be earning $90,000, which is only a 4.5% cap rate.

You could sell your $2 million property and buy two $1 million properties in Sudbury, which may have a combined income of $140,000, thus returning you to your original cap rate of 7%. Nonetheless, those properties are unlikely to appreciate at the same rate as your Toronto-area one.

Since the market is always looking for equilibrium, investors usually need to pick whether they are looking for cash flow or equity appreciation.

How Do I Pick Cash Flow vs Equity Growth?
As you may have been able to glean from the cash flow and equity descriptions, cash flow has an immediate financial effect. If you need the money right now to live or to pay back debts, you need to be investing with an eye on cash flow. You need to find higher cap rate markets (like Sudbury or Windsor), which will put money in your pocket as soon as possible. Your investing goal is to make money in the shorter-term with rental income.

On the other hand, if you have a steady stream of income and don’t need the money to live, then you should look for a market with lower cap rates. The reason they often have lower percentages is due to equity appreciation. The divisor keeps growing, which lowers the percentage. Not needing the money to live on today means that you can invest in long-term projects that will pay well once you finally sell them.