Those who’ve read me for awhile know how I view the subjects of cash flow and capital growth — I love ‘em both. I have a soft spot for steak tacos. Jamocha almond fudge ice cream is my definition of Heaven. Yet you don’t see me adding ice cream to my tacos. It’s about timing. I’ll eat my tacos first, relax a bit, then dive into the biggest bowl of jamocha almond fudge I can get away with. To the extent I ‘mix’ the two, both suffer.
Cash flow vs Capital growth
Principle #1: To the extent the investor structures a transaction to generate cash flow, capital growth is hindered.
For instance, if you have $50,000 to invest, (forget closing costs for now) you can buy one property for $100,000 with 50% down — OR — you can acquire two for 25% down apiece.
The first approach will clearly yield far more cash flow — cash on cash return. Yet, since you put so much down, if appreciation should ever again show its pretty head, your capital growth rate will literally be around half of the second approach.
Vice versa with the second approach. Cash flow is relatively hindered, but your capital will grow at twice the rate. Let me illustrate in simple terms.
If the value rises by 5% on one property ($50K down), you made $5,000 — a capital growth rate of 10%.
The same value increase with two properties, but the same capital invested ($50K) would yield $10,000 — a growth rate of 20%.
Now, don’t be fooled by the elementary arithmetic. Imagine a world in which there is a stretch of several years of moderate appreciation — say 5%. The investor who opted for one property would see their capital grow a bit over 50% in five years. His two property counterpart would see his capital more than double. Think how this affects an investor’s capital over a 15-35 year period. After awhile, the investor who opted for 25% down left the other guy in the dust. And no, the extra cash flow the first guy made doesn’t begin to make up the difference. That’s an old myth that refuses to die.
It’s all about retirement income — not income now.
Principle #2: Cash flow is merely another way of saying yield on capital. Many like to make it more complicated, but it’s not. If the market yield is say, 7%, the guy with the biggest pile of cash makes the most dollars. It’s the same 7% any way we wanna look at it. $50,000 yields a lot less cash flow than does $1,000,000. The idea then, is to arrive at retirement with the biggest pile of capital and/or equity possible.
Let’s take a typical investor as an example.
Frank and Marian make $165,000 at work between ‘em. After taxes they manage to save $3,000 every month, give or take. In other words, their lifestyle doesn’t even spend what they’re making. They’re both in their early 40s, the peak years of earning power. They should be using a conservative leveraged approach to real estate investing, not buying for cash or puttin’ half down on everything they buy. It makes no sense for them to purposefully generate gobs of cash flow when 1) they literally don’t need it, and 2) they’ll be severely reducing their ultimate retirement income by putting a harsh governor on their capital growth rate.
They want each acquired property to easily pay for itself with a reasonable cash flow ‘buffer’. Given today’s post correction realities, 20-35% down payments generally prove to be adequate to the task. This is especially true given the historically low 30 year fixed rate loans now available to investors. (4-5.5% in the last 18 months or so.) They also want to maintain a very conservative — I prefer to say OldSchool cash reserve account. But that’s another post altogether. (Search this blog for ‘sominex account’.)
My policy is to analyze properties with two key assumptions in place: There will never be any appreciation in value; and the Net Operating Income (NOI) will never rise.
If our investors begin by acquiring $1 million worth of income property at an original capital outlay of approximately $275,000 (down payment + closing costs), and buy nothing more, ever, they’d end up with around $75,000 a year cash flow — read: yield on capital/equity — at retirement. That reflects a yield of 7.5%. Given the same yield, and the same original capital, but invested in only $500,000 of property, the result would obviously be cut in half at retirement. Less than $38,000 a year in income.
We’ll stop here for now, but this is the perfect lead-in for a discussion about the principle of Strategic Synergism and the crucial part it so often plays in a Purposeful Plan.
If you’ve been wondering what your next move might be, gimme a call at 619 889-7100. We’ll work together to figure out your options. Or, click on Contact BawldGuy and send me a note. Have a good one.