Cash Flow Versus Appreciation

In this 2 hour and 7 minute class, James walks you through the difference investing in a primarily home price appreciating market (appreciation) compares to investing in a primarily rent appreciating market (cash flow). Taught via allegory about “Cash Flow” Brian versus “Appreciation” James.

“Cash Flow” Brian lives and invests in a real estate market where buying a property with 20% down starts with $100 per month in cash flow. Plus, rents are going up at the same rate as inflation, 3% per year. Property values in “Cash Flow” Brian's market are not keeping pace with inflation; they are increasing at 1% per year. Properties become better cash flow deals over time because rents are going up faster than property values.

In the city over, “Appreciation” James is investing in a real estate market where he's break-even for cash flow with 20% down payments. Property values are rising at the same rate as inflation, 3% per year. However, rents are lagging behind inflation and only increasing at 1% per year. Properties become worse cash flowing deals as time passes. Prices are going up a lot faster than rents.

“Cash Flow” Brian is making an extra $100 per month per rental he buys, but “Appreciation” James is making about $7,000 more per year in appreciation. Would you rather have an extra $1,200 per year or $7,000 per year? Which is better? Why?

This class was taught by James on Brian's birthday April 15, 2020.

Topics Covered

Brian starts off the presentation giving us an update on how COVID-19 is impacting the real estate investing business.

James discusses why the past does not equal the future. He explains why you shouldn't just assume that because a real estate market has done well in the past that it will do well in the future. Likewise, just because a real estate market has performed poorly in the past does not necessarily mean it will continue to perform poorly in the future.

Later in the presentation, James will compare a market where property values are going up and keeping pace with inflation, while rents lag behind inflation to a different market where home prices lag behind inflation while rents keep pace. To give folks an idea of what historical home price and rent appreciation rates have been, he shares with you some data about historic appreciation and price appreciation rates.

For more details on the home price appreciation across 552 real estate markets but the following charts show you the best and worst price appreciating US markets between 2010 and 2018. It was calculated as the change in compound annual growth rate in median home price from 2010 to 2018.

The best home price appreciating markets.

The worst home price appreciating markets in the US.

The best rent appreciating markets from the complete list of rent appreciation rates from 552 markets.

And, finally, the worst rent appreciating markets.

Remember though, the past does not equal the future and so investing in a market because it has done well historically is not a guarantee of future success.

Since most of the folks on the live recording were from Colorado, James also covered home price and rent appreciation rates for the major Colorado cities.

James also briefly discusses the historic inflation rates we've seen in the US.

“Cash Flow” Brian and “Appreciation” James

The main course of the presentation was James telling the comparative story between “Cash Flow” Brian and “Appreciation” James.

  • “Cash Flow” Brian invests in a market that ultimately has…
    • 3% Annual Rent Appreciation
    • 1% Annual Home Price Appreciation
  • “Appreciation” James invests in a market that ultimately has…
    • 1% Annual Rent Appreciation
    • 3% Annual Home Price Appreciation

Both James and Brian have the following in common:

  • Same starting amount of money… $300K
  • Earns 7% per year in the stock market
  • Earn $5K/month
  • Save $500/month (month 2)
  • Target Monthly Income in Retirement: $5K
  • Safe Withdrawal Rate = 4%
  • Effective Income Tax Rate = 16.870%
    • Based on being married earning $60K/year in Fort Collins, CO
  • Properties are essentially the same, except…

Here's what is different:

  • “Cash Flow” Brian has…
    • Rent is higher… with 20% down payment, he gets $100/month at start (get's better over time)
    • Higher rent appreciation: 3%/year
    • Lower home price appreciation: 1%/year
    • Property cash flow gets better over time: better price-to-rent ratio
  • “Appreciation” James has…
    • Rent is lower… with 20% down payment, he gets $0/month (break-even cash flow) at start
    • Lower rent appreciation: 1%/year
    • Higher home price appreciation: 3%/year
    • Property cash flow gets worse over time: worse price-to-rent ratio
Is it better for “Cash Flow” Brian to collect an extra $100 per month per property or “Appreciation” James to collect an extra $7,000 per year per property in appreciation?

So, how does each do buying 20% down payment rentals?

While “Appreciation” James does better early on, eventually “Cash Flow” Brian crushes James in terms of Net Worth.

Is that the whole story? Nope. Not even close.

We dig in to see that “Cash Flow” Brian is able to buy properties a lot faster than “Appreciation” James. He has better cash flow to be able to save faster and the properties he wants to buy are not going up quite as fast.

As you can see, “Cash Flow” Brian is able to buy properties much faster and get to 10 properties sooner than “Appreciation” James. Check out the chart of Number of Properties Owned above.

Since “Cash Flow” Brian starts with higher rent and better cash flow with each property and his properties also get even better with time, it shouldn't surprise us that the Total True Cash Flow™ is much better for “Cash Flow” Brian than for “Appreciation” James.

We set a  Goal of having our investments provide enough passive income to live on $5,000 per month (inflation adjusted). Both cash flow and a 4% safe withdrawal rate of money invested in the stock market can contribute toward achieving our  Goal.

So, it shouldn't surprise anyone that “Cash Flow” Brian is able to easily reach the  Goal and exceed it.

And, here's a zoomed in version of the same  Goal chart. It is easier to see that “Appeciation” James never quite hits the  Goal of having cash flow and safe withdrawal rate provide enough passive income to provide an inflation-adjusted $5,000 per month.

But, what about equity? Surely, “Appreciation” James has a ton of equity, right? Yes!

As you can see above “Appreciation” James has almost 4 times the equity that “Cash Flow” Brian has after 60 years—a number we often use to make sure we model it long enough for young people looking to achieve Financial Independence and Retire Early (FIRE).

But the chart of Total Equity is not adjusting for inflation. Since “Cash Flow” Brian's properties are not appreciating at a rate fast enough to keep pace with inflation, his equity over time is actually going down once he has paid off some of the properties.

You can see this more clearly in the inflation-adjusted version of the same Total Equity chart. The non-inflation-adjusted version is above. The inflation-adjusted version is below.

Are these problems made worse by “Appreciation” James not being able to buy properties as quickly as “Cash Flow” Brian? Let's see.

If only there was a way that both James and Brian could buy properties at the same pace starting with the same $300K. Eureka! There is… they could both use the Nomad™ real estate investing strategy.

Change My Assumptions

Want to change any of my assumptions for these  Scenarios or see even more customized  Charts?

“Appreciation” James

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“Cash Flow” Brian

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Nomad™

Nomad™
Nomad™

By using the Nomad™ strategy, both “Cash Flow” Brian and “Appreciation” James are able to use just 5% down payment to purchase each property, live there for a year and then convert it to a rental.

Each can then buy 10 properties over 10 years with just $300K each.

How does this impact Net Worth?

Net Worth doesn't change that much. “Appreciation” James starts off doing better, but eventually the cash flow for “Cash Flow” Brian just takes over.

We can see this in the Total Account Balances chart below

The lack of cash flow for “Appreciation” James means he has very little cash in his account invested and contributing toward toward his Target Monthly Income in Retirement.

But, what about equity? Surely, “Appreciation” James must be equity rich, right?

You'd be correct in guessing that. See the chart of Total Equity below.

But Total True Cash Flow™ still sucks (a very technical term to describe it when it is not good at all) for “Appreciation” James. See the inflation-adjusted Total True Cash Flow™ chart below. Even after “Appreciation” James pays off properties, Total True Cash Flow™ starts to decline because it is not keeping pace with inflation. Ouch!

“Cash Flow” Brian still achieves his  Goal of financial independence quickly and easily. That was expected (at least by me).

But, the somewhat good news is that “Appreciation” James does… eventually… achieve financial independence as well by switching from 20% down payment to the 5% down payment Nomad™ strategy.

You can see that in the  Goal chart below.

If we zoom in on the  Goal chart, you can see more clearly.

Instead of trying to read when the lines cross the dotted red line (when each person reaches 100% of their  Goal of financial independence), here's a chart showing what month that happens.

It is highly unlikely we'll see a market with 1% rent appreciation for 60 years.

Here's a chart showing the break-down of the largest 552 real estate markets in the US. It shows what percentage had better than 3% per year rent appreciation between 2010 and 2018 and what percentage had between 0% and 3%. There were none with less than 0%.

Earlier, I showed you the worst rent appreciation markets and none were close to the 1% we've been modeling here. Maybe we will see it with COVID-19 or whatever the next crisis or two are. If we do, this allows us to see what could happen and what we might do about it.

So, now that I've told you we're not likely to see something this bad, let's see what we might do if we do find ourselves in “Appreciation” James' situation.

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“Appreciation” James Nomad™

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“Cash Flow” Brian Nomad™

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Sell Them All

How much equity would we have if we sold all of our rentals (not the one you're living in) with a real estate agent? The Total “Sell With Agent” Equity chart tells us.

It calculates your equity if you sold the property minus 1% for closing costs and 6% for real estate commissions and subtracted the mortgage balance.

Here's how much Total “Sell With Agent” Equity “Appreciation” James has.

What if “Appreciation James waits until the Total “Sell With Agent” Equity minus taxes from any capital gains and depreciation recapture taxes are enough that if he puts it in the stock market, he has enough to live on. In other words, a 4% safe withdrawal rate is enough to provide an inflation-adjusted $5,000 per month.

Let's see if we can do this.

When “Appreciation” James has enough equity to sell and live off his investments, sell them all but the owner-occupant property.

We’ve assumed he sold with an agent and paid:

  • Real estate commissions
  • Closing costs
  • Taxes on capital gains
  • Depreciation recapture taxes

Of course, if you sold to a tenant-buyer or by yourself, you could trade the cost of the real estate commissions for you doing the work of the both real estate brokers. But, we did not do that here.

If “Appreciation” James does this, it turns out he can reach financial independence much quicker than before. Not as fast as “Cash Flow” Brian, but much better.

See the  Goal chart below.

This chart shows what month each of them achieves financial independence for the first time.

So, that's encouraging and good. If “Appreciation” James wants to convert from real estate to stocks, he can do that with what we've modeled.

By doing so, he sells 9 of his properties and keeps the one he lives in. This is shown in the chart below.

Of course, selling 9 of your properties and paying closing costs, real estate commissions, capital gains taxes and depreciation recapture means “Appreciation” James lowers his Net Worth.

But, converting equity to cash is great for his Account Balances.

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“Appreciation” James Nomad™ – Sell Properties If SWR Allows FI

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Sell Properties As Needed – One At-A-Time

Perhaps selling all the properties at once is rash. Perhaps it would be better if “Appreciation” James just sold a property each time he needed cash and lived off his equity. Is it?

Let's see.

We'll use the same calculation that we did when we sold them all at once. He's still paying closing costs, real estate commission, capital gains taxes and depreciation recapture taxes.

However, now, “Appreciation” James will only sell a property if his account balance gets low.

The chart above shows the equity in the first property “Appreciation” James purchased. The equity grows over time until he sells it. Then, the equity drops sharply to zero.

This chart above shows both the first property and the second.

“Appreciation” James lives off the equity in the first property, cannibalizing it until it is mostly gone. Then, he sells the second property.

Repeat for the third property.

And the fourth.

Fifth.

Sixth.

Seventh. You can see that “Appreciation” James can live on the properties with more equity a little longer each time.

It takes quite awhile before he needs to sell the eighth property. But, eventually he does.

But not the ninth. He can keep that one.

And the one he is living in as well. He does not need to sell that one either.

The chart above shows you all the individual “Sell With Agent” equities in each property, graphically stacked on top of each other. This allows you to see the graphical sum of the total amount of equity you have at any given month.

I find it particularly pretty.

But, what happens to the account balances with this  Scenario especially compared to the others we've looked at.

The chart below shows us.

But selling properties as “Appreciation” James needs money doesn't actually get him to passive financial independence.

In other words, he never gets to the point where the cash flow from his properties and a safe withdrawal rate on his money in stocks is enough to support an inflation-adjusted $5,000 per month.

Instead, I modeled “Appreciation” James stopping work at 10 years.

His living expenses continue to drain his accounts, but anytime he needs money, he sells a property and lives off the sale proceeds.

So, looking at the  Goal chart, you never see him reach the 100% goal achieved dotted red line.

And, you don't see him listed as a month when he achieves financial independence.

Even though, he really stopped working after 10 years.

Would it be better for “Appreciation” James to keep the properties and do cash-out refinances instead of selling the propeties?

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“Appreciation” James Nomad™ – Work 10 Years Then Sell Properties for Cash Flow

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Cash-Out Refi Instead of Selling Properties

“Appreciation” James has tons of “Cash Out Refi” Equity, but cash-out refi equity is harder to access than selling properties.

First, “Appreciation” James can only cash-out refinance up to 75% loan-to-value. So, he would need to leave a lot of equity in the properties compared to what he could net when he sells a property.

Second, banks may not be super eager to allow him to cash-out refinance without a job. Remember, in our model, “Appreciation” James stops working after 10 years (before he does a single cash-out refinance).

Third, these properties are getting worse ratios the farther out we go, so keeping them is not improving his situation.

Fourth, loan programs change. He may not be able to do cash-out refinances like this 15 years from now.

Fifth, interest rates for cash-out refinances are higher than the owner-occupant financing he got when Nomading into the property to begin with. So, pulling out money is more expenses and cash flow will get worse.

But, let's look at it anyway.

Here's a chart showing the Total “Cash Out Refi” Equity both “Cash Flow” Brian has and “Appreciation” James has.

But, let's look at each property owned by “Appreciation” James. Here's the “Cash Out Refi” equity for the first property in a chart.

As you can see, he starts with negative cash out refi equity—he only put 5% down when he bought it and you can only do cash out refis up to 75% loan-to-value.

Eventually, there is enough cash out refi equity and he does a cash out refinance. Cash out refi equity goes down to zero, but starts to build up again. He cash out refinances again later. It grows again. He cash out refinances one more time.

So, this is the same property that he has refinanced 3 times.

Plus, he has to do similar stuff with other properties. Here's a chart showing both the first property he bought and the second.

He refinances each of them 3 times.

What about the third property? See the next chart.

Similar, right?

Here's the fourth.

And the fifth.

And the sixth.

Seventh.

Eighth.

Ninth.

And the 10th which he is living in. He's cash out refinancing even the property he is living in.

And, because I can and because I like rainbows… here's a summary of all the cash out refinance equity in each of the properties summed graphically.

Similarly to when “Appreciation” James sells a property every time he needs cash, when he does cash-out refinances, he never quite managed to achieve financial independence.

He stops working after 10 years, but he's living off his equity… not passive income from cash flow or safe withdrawal rate from the stock market.

You can see this in the  Goal chart below.

In fact, in this chart you can see he needs to cash-out refinance a lot more frequently than sell properties because he can't get at nearly as much equity.

Well, that and his expenses are going up because the properties he's cash-out refinancing are more and more negative in their cash flow. More on that in a bit.

In the meantime, here's when the other  Scenarios hit financial independence.

Doing cash-out refinances never technically achieves financial independence, but “Appreciation” James did stop working after 10 years in this  Scenario.

How about Net Worth? Check out this chart that shows all the Nomad™  Scenarios.

And, here's the Total Account Balances chart.

You can see how ugly cash flow gets when you're constantly cash-out refinancing your poorly cash flowing (and getting worse over time) properties.

If you want to look at how a single measure of risk (Debt To Net Worth) compares for the various  Scenarios we covered for “Cash Flow” Brian and “Appreciation” James, check out this chart.

The next chart shows you the sum of all the properties owned for each  Scenario.

The next three charts show you the Return On Equity for three different components of the Return On Investment Quadrant™.

First, Return on Equity from Appreciation.

Next, Return on Equity from Cash Flow.

And, finally, Return on Equity from Debt Paydown.

Change My Assumptions

“Appreciation” James Nomad™ – Work 10 Years Then Allow Cash Out Refi for Cash Flow

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Afterthought: Skip Real Estate and Invest in Stocks

And, after I prepared this presentation I had an afterthought. What if James or Brian decided to forgo investing in real estate and just took their $300K and invested in stocks at 7% per year? That's what this  Goal chart shows.

Change My Assumptions

1 Nomad and Stocks Only

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1 Nomad and Stocks Only with 2  Accounts, 1 Property, 3 Rules,
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