The Great Cash Flow Myth

Today I would like to dispel what I think is one of the greatest myths in real estate investing.  There will no doubt be many who disagree with me and will say that I am an idiot, but bear with me until you see the numbers.  Of course, people have different goals and reasons for investing so some of those that disagree me will be correct for their specific situation.

The great myth that I am referring to is: "Invest for cash flow not appreciation. Any appreciation is just gravy on top of the cash flow."  This statement has been worded in many different ways but in some form or another is drilled into beginning investors by the gurus as gospel.  I truly believed in this for years until really delving into the financial returns of my investments and realizing that appreciation was the largest driver in BUILDING WEALTH.  Monthly cash flows are great for creating passive income and allowing you to retire from your W2 job but if you have a longer view of things and are trying to build true wealth, I would say invest for appreciation and the cash flows are the gravy on top.  Another way of looking at is; cash flows are how you hold on to the property but appreciation is how you make your money.

Let's look at a quick example to illustrate why I believe this to be true.  Two markets that I have some experience with are Memphis, TN and Denver, CO.  Memphis is known for it's affordable, high cash flow properties.  Denver is known for it's high prices and difficulty cash flowing.

Memphis:

• Property purchased for $72,000 with a 20% down payment + closing costs, appraisal, etc. = $19,000 total investment.
• Monthly rent of $785 less PITI, management, vacancy, reserves, etc. = $230/month or $2760/year cash flow
• Cash on Cash return = $2760 / $19,000 = 14.5% 

This is a great number!  Most investors would be ecstatic with a 14.5% return on their invested capital. If you are strictly after cash flows this is a pretty good deal but lets look at the appreciation picture.

• Total home price appreciation in Memphis since 2000 is reported at 38.57%.
• If that $72,000 home was purchased in the year 2000 it would now be worth $99,360 which is a gain of $27,360.  Based on our $19,000 investment that is a return of 144%.

If we add the total gain over 20 years from the rental cash flows and appreciation we come up with:

• Cash flows = $2760*20 years=$55,200
• Appreciation = $27,360
• Total gain = $82,560 / $19,000 = 434% return on your invested capital

​Denver

• Property purchased for $250,000 with a 20% down payment + closing costs, appraisal, etc. = $65,000 total investment
• Monthly rent of $1800 less PITI, management, vacancy, reserves, etc. = $216/month or $2592/year cash flow
• Cash on Cash return = $2592 / $65,000 = 4%

This is not a great number for most people although it still crushes an interest bearing bank account. The number is positive and allows us to hold on to the property and pay all of its expenses while still pocketing a bit of cash.  Based on this number alone, most people would choose the 14.5% return of Memphis over the 4% return in Denver but lets look at what happens over time.

• Total home price appreciation in Denver since 2000 is reported at 137.61%
• If that $250,000 home was purchased in the year 2000 it would now be worth $594,025 which is a gain of $344,025.  Based on our investment of $65,000 that is a return of 529%.

If we add the total gain over 20 years from the rental cash flows and appreciation we come up with:

• Cash flows = $2592*20 years = $51,840
• Appreciation = $344,025
• Total gain = $395,865 / $65,000 = 609% return on your invested capital

This is a very simplified model and does not include things such as rent increases, depreciation and many other factors but the point is that it takes a lot of those $230/month cash flows from the Memphis property to make up for the huge difference in appreciation of $316,665.  

Personally, I would still never invest in a negative cash flow property but am willing to take a lower cash on cash return since my time horizon is longer and I feel confident in choosing markets that will continue to outpace the national average of home price appreciation.  If you need the money now, the higher cash flows are your best bet, if you have a longer time horizon to build wealth, look at the long term market appreciation.

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