Investing for Equity Versus Cash Flow: Which Pays More?

What should be the primary goal of a real estate investor buying and holding: equity or cash flow?

“Equity” means built-in equity (ie buying property below market value). Of course, if you buy a property below market value in Orange County or New York, it still won’t go to cash flow. You should turn it around or hold it at a loss in the hope that it will appreciate it.

As with most real estate business, your primary focus will depend on your situation and goals. But in this case, it is usually better for most people to focus on one goal.

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Equity vs. Cash Flow: Which Is Better?

Why not both?

You should definitely aim for a real estate investment with both a significant upfront equity margin and good cash flow. In addition, find a home in a decent area that is relatively easy to manage and is likely to be appreciated.

But like the Rolling Stones song, you can’t always get what you want.

Choices have to be made, and you will have to consider one criterion or the other more important. In general, it should be more important to go for built-in equity. But there is one notable exception. This exception probably only applies to about 0.1% of investors, but it’s still worth noting.

When cash flow matters more

Cash flow is the most important measure for institutional investors. They are constantly talking about the gross return (annual rent divided by the price of the properties) and what their “buy box” is (what range will they accept for the gross return of a portfolio).

These companies must achieve a certain return for their investors. For example, a fund may estimate an 8% return for its investors, or an insurance company may estimate a 9% return to cover the expected losses. For these types of Wall Street businesses, the built-in equity is nice, but the cash flow is the name of the game.

When equality matters more

Buying with built-in equity allows you to buy, rehabilitate, rent, refinance and repeat a home (BRRRR). Even if it was “different” here with a house with a better cash flow. Plus, it’s built-in equity that protects us from the dangers of leverage and allows us to reap the benefits (which are very large).

The IDEAL acronym (I: Income, D: Depreciation, E: Equity, A: Valuation, L: Leverage) is a good explanation of why real estate is such a good investment:

If you buy a home for $ 100,000 but get an 80% loan, you’re only putting down $ 20,000. Now if the property increases in value by 5%, your return is actually 25% ($ 5,000 / $ 20,000). This is a huge return.

Leverage is a double edged sword. Real estate can decline, which would result in a 25% loss … But getting a good deal protects you from the risk of leverage.

This doesn’t mean that cash flow doesn’t matter. You still need to buy properties with cash flow and net income. There are a few instances where the trends in an area are so strong that it makes sense to hold on to a property even if it is bleeding every month. But these cases are rare and should only be done with a small percentage of your portfolio. Getting big on properties with negative cash flow is more or less just speculation.

However, enterprising investors can hit the pavement and find the gems sliding between the bristles of the broad brush that institutional investors use. This allows investors to take advantage of the inefficient real estate market by finding motivated sellers, value-added opportunities and mis-listed properties (usually by institutions). This is the advantage that entrepreneurial investors have and the main reason real estate is the best way for someone with modest means to get rich independently. And it is equity that makes you rich. Cash flow is just the icing on the cake.

The scenario: two nieces and nephews

In this scenario, we have two cousins ​​going to buy a duplex. The valuation of each duplex is $ 250,000. Each room is exactly the same, consisting of two units with 2 bedrooms / 1 bathroom. Each cousin will live in one unit and rent out the other unit to a potential tenant. Each cousin has a paid job and earns $ 75,000 a year in income and each has $ 50,000 in savings. Let’s also assume that each of the cousins ​​was able to negotiate zero closing costs out of pocket.

Cousin A

Cousin A is a highly motivated person and wants to pay off the house as soon as possible. Cousin A only knows one way to use financing: put down as much money as possible and finance as little as possible. Cousin A is going to pay 20% because that’s what his parents did when they bought their house, and he gets a 15-year flat fee, which allows him to pay off the property in just 15 years.

Then any cash flow obtained from renting out the second unit must be spent on the monthly mortgage payment, and Cousin A could potentially pay it off faster than 15 years. Cousin A wants to build up as much equity capital as quickly as possible and at the same time pay off the mortgage as quickly as possible. The duplex is tracked and valued at 3% per year.

Cousin B

Cousin B is also a highly motivated person, but she knows less about finance. She decides to do the opposite of what Cousin A did and take as long as possible to pay off the mortgage, which means she has to be written off on her mortgage loan for 30 years.

She is going to invest as little as possible on the property, which in this case is 3.5% with an FHA loan. She’s going to save the difference in monthly mortgage payments ($ 302) and put that into savings. As in Cousin A’s duplex, Cousin B’s duplex is tracked, and it values ​​at 3% per year.

The first numbers

Here’s what each cousin’s calculation looks like when they buy the identical duplexes.

Cousin ACousin B
Purchase price$ 250,000$ 250,000
Deposit$ 50,000$ 8750
Loan amount$ 200,000$ 241,250
Monthly payment$ 1,787$ 1,485
Difference in monthly payment$ 0$ 302
Equity$ 50,000$ 8750
Cash after deposit$ 0$ 41,250
Rental income$ 1,500 / month.$ 1,500 / month.
Cash flow– $ 287 / month.+ $ 15 / month.
Appreciation3 years3 years

For the next five years, everything is going as planned for both Cousin A and Cousin B. The tenants appear to be for the long term. The rent has been consistent. There are no unexpected capital expenditures. The property is worth more five years later, so they both have built up a little bit of equity in the property. They still have a constant income, so there doesn’t seem to be anything wrong with the monthly payments and other expenses.

The figures after five years

Cousin ACousin B
Duplex value (5 years)$ 289,818$ 289,818
Loan amount (5 years)$ 145,355$ 218,204
Amortization of loans15 years30 years
Monthly payment$ 1,787$ 1,485
Difference in monthly payment$ 0$ 302
Equity (5 years)$ 144,463$ 71,614
Savings$ 0$ 59,370
Equity plus savings$ 144,463$ 130,984
Rental income$ 1,500 / month.$ 1,500 / month.
Cash flow– $ 287 / month.+ $ 15 / month.
Appreciation3 years3 years

This is the main difference: something happens in the seventh year. Cousin A loses his job and since he made such a large down payment on the property to ‘pay off the property faster’, he has absolutely no savings. The tenant in Cousin A’s duplex decides it is time to move, and he has no more income from the rental.

Coincidentally, the exact same thing happens to Cousin B. She loses her job, and the tenant in her duplex also decides to move at exactly the same time as the tenant with Cousin A.

The figures after seven years

Cousin ACousin B
Duplex value (7 years)$ 308,339$ 308,339
Loan amount (7 years)$ 120,468$ 207,618
Amortization of loans15 years30 years
Monthly payment$ 1,787$ 1,485
Difference in monthly payment$ 0$ 302
Equity (7 years)$ 187,871$ 100,721
Savings$ 0$ 66,618
Equity plus savings$ 187,871$ 167,339
Rental income$ 0 / month$ 0 / month

This is where the situation diverges. Since Cousin A no longer has any income, property or not, due to the loss of jobs and rental income, he has to make a difficult choice. Either he can’t pay his mortgage or he has to sell the house. Most likely, he will have to sell the duplex to get his equity.

Cousin B, on the other hand, is fine with where she is financially after the job loss and the loss of the tenant. She can only pay for the mortgage for years with her savings. She can take the time to find a tenant who is exactly what she is looking for.

The end.

There are several variables in this story that may or may not happen. But it illustrates a few points about residential investment properties, rental property values, rental income, property financing, and money in general.

Evaluation of cash versus equity

Cash is liquid money and is absolutely essential in real estate financing. Cash is much easier to use when things go wrong, while equity is completely useless. You should sell your property if you ever need the money quickly, and that’s not always the choice someone has to make when an event arises.

The value of a home will rise or fall, regardless of whether you have a mortgage on the home. Value is completely out of your control with residential real estate – after all, it’s usually based on someone’s opinion, not cash flow.

Remember, a good investment property is one that flows cash as desired, not one with ‘equity’. That is, the income generated by the property is greater than the property’s expenditure.

The main thing a buy-and-hold investor should look for is built-in equity. The second is cash flow. There are other things, of course, such as potential valuation, neighborhood stability and security, hassle, etc. But in real estate, equity comes first. Everything else follows from it.

More about cash flow from Pyjama People

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