Investing in real estate can provide a whole spectrum of opportunities for investors, and the best approach will vary by personal and professional goals. In this article, we will outline the advantages and disadvantages of two common investment strategies: cash-flow and appreciation. We will also discuss the process of setting goals before committing to a specific investment strategy.
One common investment technique is called the appreciation strategy, which is based on building wealth via a quality-based asset. The goal is to use low leverage, if any at all, to acquire an asset. While the debt is serviced, the investor will receive a lower return in the short run. However, once the property is paid for, 100% of cash flow will go straight into the investor’s pocket ideally yielding a much higher rent than when. Since this is a longer-term model, the investor should seek out a strong location.
The appreciation strategy is a great for stability: If you buy a quality asset in a good location, you will be in a stronger position to endure a recession. Growing cities with diversified economic bases and areas with high demand for a specific property type make great potential locations to employ this approach. High demand and density matter because if one tenant leaves, you will want to quickly re-tenant. Additionally, if an existing tenant seeks unfavorable terms on their lease, you want to know you could replace them with a another tenant. In essence, higher density, high household income, and property demand mean more negotiation strength, quicker growth in value, and less volatility in your investment.
Financially, the appreciation strategy offers benefits as well. Theoretically the property will improving your financial position by increasing in value over time. For example, as rent appreciates with the market, your properties income potential also increases. Additionally, if you rely on low leverage, depending how to set yourself up, you can have some cash flow while your income from tenants pay down the existing debt.
No strategy is perfect; remember that, generally speaking, safer assets come at a higher price point relative to their income, resulting in lower cash flow in the short run, and a certain holding period has to pass before the return is impressive. Lastly, with uncertainty in the future of the real estate markets due to shifts in trends, it can be difficult to anticipate exactly the future return on any investment.
Utilizing the appreciation strategy with an add value component is one is the best ways to grow your income on these types of deals in the shorter term. Many long term real estate investors use this strategy when looking at opportunities. This way they get the safety with the potential to increase their cash flow with some kind of improvement to the property. For example, one very well located property we recently acquired gave a nice return with strong retail tenants. It was a nice return with that kind of income, HOWEVER, it was also over 50% vacant. The vacant portion of the building was the add value part that pushed the returns higher giving us the safety and quality as well as the cash flow we were looking to have.
Cash Flow Strategy
Another common investing approach is the cash flow strategy; a quantity based strategy. It is just what it sounds like: a strategy focusing on maximizing cash flow in the immediate period. It’s about the numbers and more immediate return. Of course, this kind of deal can be held onto for a long period of time, but in general cash flow properties don’t appreciate the same way as quality location properties. Cash flow opportunities also can have value-add aspects to them. Some investors with these properties, leverage debt to fix them up, and then trade them to get a quick return on their project. There is risk in doing this because you have to time the market correctly. As with the appreciation model, there are both disadvantages and advantages to this strategy.
The advantage of this model is geared towards a high return and improving an investors immediate financial position. Investors can acquire these assets at a lower price relative to income because they are typically in less desirable locations; additionally, they are typically sold at a higher yield. These highlights result in higher immediate cash flow for an investor. There is an additional bonus here: If an investor purchases in an up-and-coming location, they may reap the benefit from growing rents.
The disadvantages are more obvious with this strategy – there is differ risks. Investors looking for properties to fit this model often look in secondary locations because they may be able to improve the returns on these types of properties. The income is less dependable, so they sell for a lower price relative to income. One potential risk: If a tenant leaves or demands unfavorable terms, the landlord may succumb to their demands because replacing that tenant may be tough.
From a financial perspective, this strategy presents different challenges than the appreciation model. First off, the value of the property is solely based on cash flow. An investor cannot rely on the appreciation of the asset because these properties tend to be in secondary locations that are impacted more by economic downturns. That said, obtaining debt on these properties can be riskier as well. If a recession causes tenants to vacate the property, investors who maximized leverage on the asset (took out maximum debt) may be forced to sell and lose equity on the deal.
First, Identify Your Goals
Determining the plan to adopt depends on your goals and current financial position. To help assess which strategy to proceed with, ask yourself the following questions:
- What is your purpose in investing? Are you interested in investing in a secure asset or are you looking for a faster return?
- How much do you have to invest and how much debt are you willing to take on? How important is liquidity?
- How long do you plan on holding your real estate? Are you worried about the future value of a deal, or are you concerned with an immediate improvement in value of the real estate?
- How much management do you want to put into the property? Are you interested in a hands-off approach, or do you want to be involved in the day-to-day?
- What asset type are you interested in investing in? Does it help you achieve your goals?
- What level of risk are you willing to take on an investment?
The answers will help guide decision making. Both strategies present risks and no strategy is inherently better than the other; however, by understanding your short- and long- term goals, you can identify which opportunity best suits your needs. In short: Those willing to take on more risk who are looking for an immediate return should consider the cash flow model. On the contrary, those that are interested in a safer investment to prepare themselves for the future should consider the appreciation model.