When I decided to write 100 articles answering 100 most often asked questions, and began compiling what those 100 questions might be, it occurred to me that some of the questions are that should be on the list, aren’t. I think folks assume that the answer is very straight-forward, and those questions never come up.
Not many things in real estate investing are as they seem, and the question , What’s more important when buying rentals – equity or cash flow, is worth some consideration. This could easily become a hugely complex conversation, worthy of a book. Obviously, in this article, I’ll attempt to hit some of the highlights – that’s all…
The Basics – Why do We Buy Rentals?
In most basic terms I think we can all agree that the basic premise behind rentals is income. We buy rentals because we are trying to replace earned income, or at least supplement it. I think it’s fair to say, therefore, that everyone tends to focus on income as the defining driver of value in rentals.
While on the surface I can not argue with this basic premise, there is some eloquence that can be added. Let’s consider:
Return on Investment
It’s just fine to consider real estate as nothing more that a retirement, something you buy, hold for 30 years, pay off the mortgage, and have a revenue stream to retire on. For many people this is a good way of thinking. However, if we can have a bit of a more sophisticated conversation, I can tell you that this strategy will result in very low return on investment in terms of IRR and NPV. Indeed, you need appreciation (equity growth) in order to drive the IRR.
We could have a lengthy conversation around IRR and NPV, but this is not the time and place. Simply put, the value of income erodes over time for many reasons, and the only two things that can compensate for this (and achieve a higher IRR), is growth of income and equity, which brings me to my next point:
Why Do Rental Rates Grow?
Ask yourself – why do rents in your rentals grow over time? The answer is two-fold:
A – because what they are and where they are, your rentals remain desirable to the marketplace, and as price inflation drives up costs on so many other things, so do your rents go up.
B – because the demographic trends and population trends in your market/submarket are conducive to rent growth.
How Does Investment Property Equity Change?
Yes, the value of income-producing assets improves as function of income – that’s the whole point. But forget about that for a minute. Instead, can you see how if the marketplace and the asset possess aspects of desirability which facilitate rent growth, do you see how the building will more than likely appreciate over time for the same reasons? I mean, if people want to live there so much so that they are willing to pay more rent year over year, then shouldn’t property investors want to continue wanting to own this property. And if so, value should go up in tangent with income.
Even in small towns, there are submarkets that are historically better than others in terms of desirability!
Now – Let’s Walk this Thinking Backwards
Considering everything above, can you see how if we start with the premise of focusing on equity growth, and walk it backwards, then it’s reasonable to say that – if this building appreciates, then more likely than not, rents will as well… Think on that.
Economic Losses and Rental Properties
I know what you’re thinking – doesn’t matter if rent doesn’t go up; I am getting a good deal, and I am happy with this rental income as is.
The thing to remember is that the lower your rents get relative to the marketplace, the less quality tenants you’ll be able to attract. Why – because people with credit and money will pay more rent to be in a better location and better property. And, of course, the issue with less qualified tenants is that they are obviously less financially stable, which in the end results in much higher economic losses. So, what you end up with, is stagnating income, and increasing expenses to boot!
What Happens to my Rental’s Equity in this Situation?
That’s right – you’ve bought a property which looked good today, but since it never appreciated, you cannot count on the backend equity to offset the ever increasing losses to your cash flow. And there go your returns…right down the toilet!
Not to mention that every time you have to put money into the property, you now feel like you are throwing good money after the bad – you’ll never get it back…Ooops
Equity and Cash Flow simply cannot be decoupled in your decision-making process, and it’s impossible to say which is more important in the long run. And, I haven’t even talked about bridging of the equity growth into additional asset and growing your foot-print…